“While each component makes sense in its own narrow terms, the EU policy as a whole is madness for a currency union. Stephen Lewis from Monument Securities says Europe’s leaders have forgotten the lesson of the “Gold Bloc” in the second phase of the Great Depression, when a reactionary and over-proud Continent ground itself into slump by clinging to deflationary totemism long after the circumstances had rendered this policy suicidal. We all know how it ended.”

Ambrose Evans-Pritchard

The meeting took 14 hours and produced numbers large enough and rhetoric credible enough to trigger today’s short covering that might continue at least through half of tomorrow.

But all the actual announced funding comes from the same nations that are having the funding issues. There is no external funding of consequence of national govt borrowing needs coming any source other than the euro governments, nor can there be, as the the funding needs are in euro. And the ECB, the only entity that can provide the euro zone with the needed net financial assets, remains limited to ‘liquidity’ provision which does not address the core funding issue.

Yes, the funding needs have been move evenly distributed among the national governments. But even the financially strongest member, Germany, is structurally in need of continually borrowing increasing quantities of euro to roll over existing debt and fund continuing deficits, with no foreseeable prospects of even stabilizing its debt to GDP ratio or debt to revenue ratio. Adding this new financing burden only makes matters worse, and do the austerity measures now under way in all the member nations.

The one bright spot is the ‘whatever it takes’ language that presumably includes the only move that can make it work financially- actual funding of national govt. debt by the ECB either directly or indirectly through guarantees. But there can be no assurance, of course, that it’s just another bluff to buy time, hoping for a large enough increase in net exports which would be evidence of the rest of the world deciding to reduce its euro net financial assets via the purchase of goods and services from the euro zone.

And with a meaningful increase in exports likely to happen in a meaningful way only with a much lower euro, the terms and conditions of today’s announcements introduce conflicting forces. The austerity measures work to strengthen the euro to the extent they succeed, and to weaken it to the extent they result in increased national govt debt and changes in portfolio preferences.

My best guess is that market forces will soon be testing this new package and its core weaknesses.

26 Responses

  1. My best guess is that market forces will soon be testing this new package and its core weaknesses.

    The smell of blood is in the water and the sharks are circling. As long as Germany holds its leash on the ECB preventing it from acting in its role of central bank, the blood is only going to get thicker.

    Will Germany hold out? After all, it is its own banking system that is ultimately under attack since they are as toxic as Wall Street.

  2. “…even the financially strongest member, Germany, is structurally in need of continually borrowing increasing quantities of euro to roll over existing debt and fund continuing deficits, with no foreseeable prospects of even stabilizing its debt to GDP ratio…”

    On the other hand, isn’t most of the debt owed by Germany owed to European commercial banks, who in turn got the money from the ECB, which in turn is owned by Euro governments? Isn’t this the equivalent of the monetary base of the U.S. which is nominally a debt owed by the Fed to holders of monetary base, but in reality is not a debt in any normal sense of the word debt?

  3. “the ECB, the only entity that can provide the euro zone with the needed net financial assets”

    that doesn’t sound right

    the national governments produce net financial assets via deficit expenditure, on an ongoing basis, like any national government

    the ECB can’t do that; nor can any central bank

  4. true the national govs provide net financial assets to the other sectors in the form of their outstanding debt.

    But only the ECB can provide net financial assets to the ‘other sectors’ including the national govts by making expenditures, which can reduce the national gov deficits without taking ‘savings’away from the ‘private sector’

    1. Warren,

      You have established that a Euro-zone member’s budgetary constraint is akin to that of a US state, unlike the Fed gov, which, you say, spends like this:

      1- The Treasury sells $100 billion of treasury securities.
      2- Paying for the new securities reduces member bank balances held at the Fed by $100 billion.
      3- And our holdings of treasury securities increase by $100 billion.
      4- The Treasury spends the $100 billion it got from selling us the $100 billion of new treasury securities.
      5- This increases member bank balances at the Fed by $100 billion.
      Recap:
      * Bank balances are back where they started from.
      * Our holdings of treasury securities, which are financial assets and saving, have increased by $100 billion.

      I suppose 1- is preserved in the case of a Euro-zone member.

      The ECB (via the NCBs) is, as per Euro legislation the “fiscal agent” of the state, so you’d think that 2- and 3- also applies. 4- is kinda obvious, and 5- is a result thereof. Where’s the difference?

      This cannot be : the Euro member must keep an account at a private bank, not the ECB, so that 1- does not cause 2-, an increase in bank reserves.

      But in this case, what does “fiscal agent” means?!

      A similar question was asked on billy’s blog. Whichever is answered first, I’ll update the other.

      Thanks.

      1. UPDATE to my comment May 13th, 2010 at 5:25 pm

        Here is an earlier comment (Capital letters –> WM) that sheds light on the problem:

        [1- Is the ECB the fiscal agent of the member states (via the NCBs)?

        YES, THE NATIONAL CB’S HAVE ACCOUNTS AT THE ECB, TO THE BEST OF MY KNOWLEDGE

        2- If so, can the ECB, nonetheless, bounce a treasury check, say if the deficit does not comply with the Stability and Growth Pact (SGP) rules?

        THE NATIONAL CB’S CAN’T RUN OVERDRAFTS IN THE ECB ACCOUNTS, TO THE BEST OF MY KNOWLEDGE. SO THE NATIONAL GOVTS HAVE TO BORROW FIRST, AND THEN SPEND, RENDERING THEM SUBJECT TO A LIQUIDITY CRISIS AND DEFAULT.]

        How does this ties in with the sequence 1-5 in my previous comment?

        I’m beginning to think the sequence is unchanged for Euro-zone member, correct?

        In this case, taxes don’t fund anything either, correct?

        I guess default would occur, if the markets didn’t want to buy the Tsy’s, so that the gov would -eventually- have to run an overdraft with the ECB, which it is not allowed.

        Finally, all this seems quite different from a US state, which is the analogy that was used. Do US states keep an account at the Fed or a private bank?

        Lots of questions and confusion. Any clarification would be very appreciated.

      2. Bx12,

        Not related to the discussion – just one point.

        The NCBs have unlimited and uncollateralized overdraft at the ECB.

      3. That makes no sense – how does a CB of any type require an overdraft – example?

      4. Ramanan,

        “The NCBs have unlimited and uncollateralized overdraft at the ECB.”

        Thanks. As you have said yourself, this does not change the problem. For practical purposes, NCBs and ECB are one.

        Anon Reply:
        May 14th, 2010 at 8:43 am

        “That makes no sense – how does a CB of any type require an overdraft – example?”

        Let’s say the gov has a “net worth” (equity) of X. If it spends X without issuing debt, it will run into overdraft with the CB. Correct?

        Note that net worth, here is pure accounting without any actual real meaning, I think. “net worth” may not be the actual label used at the Fed. It would good to know the exact terminology.

        It’s a little bit fuzzy what the legal limits on overdrafts are. I think Warren, Bill etc. are of the view that the limit should be infinity.

        This point is actually crucial in relation to the claim that the gov is not operationally revenue constrained, right?

        Note that if the government were to spend without issuing debt, this would result in increasing volume of reserves, hence the ST rate would converge to zero, everything else equal.

        I think it is forbidden, is it? Equivalently, though, the CB could purchase the bonds, that’s called debt monetization.

        That’s not to say it would result in increasing money supply, though, as the money multiplier is pure fiction.

        I’m throwing a lot of claims with the hope that someone will interject with TRUE/FALSE : I’m only a pupil, here, so don’t take anything I say at face value.

      5. “If it spends X without issuing debt, ”

        Correction : if it NET spends X i.e. G-T = X.

      6. “say the gov has a “net worth” (equity) of X. If it spends X without issuing debt, it will run into overdraft with the CB. Correct?”

        That’s a government overdraft with the CB.

        That’s not the same as a CB overdraft with the ECB.

      7. Bx12,

        Will write more in a while. Short on time. Yes even I don’t think the ECB is required if others are bailing the governments out. If the govt debts goes from 100 to 110, private sector networth increases by 10 as well. In fact, if people decide to not transact in currency notes – just cards, the ECB balance sheet would shrink.

        Anon,

        NCBs require an overdraft because: imagine someone transfers a billion euros from his Greek bank account to his German bank account. In that case intraday, bank of Greece will owe Bundesbank a billion and the greek bank will owe the Bank of Greece a billion more and German banks will reduce their debt to Bundesbank by a billion.

        Near the end of the day, the greek bank will try to reduce its advances from the Bank of Greece, because it will cost 75bp more so it will borrow from some german banks. Else, Bank of Greece and Bundesbank will settle accounts at the ECB. In that case Bank of Greece will have a liability to the ECB. In fact if you see the balance sheet of the Bank of Greece – on liabilities you can see around 38b Euros owed to the rest of the Eurosystem which really is the liability to the ECB.

      8. “NCBs require an overdraft because …”

        a) That’s not an overdraft facility. It’s a credit facility. The Central Bank of Greece is not “overdraft” on it’s own deposit account with anybody (an overdraft facility is based on a deposit account as an asset). It’s simply lost reserves (a liability) to the Bundesbank. The Bundesbank lends it the money at the end of the day to replace the reserve funding. It’s a credit facility to replenish reserve funding. Think of it as similar to a commercial paper funding backstop. It’s a funding credit facility – not an overdraft facility. CB’s don’t go overdraft on their own accounts.

        b) The credit facility is that of the Greek central bank with the Bundesbank – not with the ECB. These unlimited credit facilities are bilateral.

      9. Ok Anon – wrong usage of the phrase “overdraft” by me.

        However, the annual report of the ECB has this to say

        Here: http://www.ecb.int/pub/pdf/annrep/ar2009en.pdf and http://www.ecb.int/pub/pdf/annrep/ar2010annualaccounts_en.pdf

        Intra-ESCB balances/intra-Eurosystem balances
        Intra-ESCB transactions are cross-border transactions that occur between two EU central banks. These transactions are processed primarily via TARGET2 – the Trans-European Automated Real-time Gross settlement Express Transfer system – and give rise to bilateral balances in accounts held between those EU central banks connected to TARGET2. These bilateral balances are then assigned to the ECB on a daily basis, leaving each NCB with a single net bilateral position vis-à-vis the ECB only. This position in the books of the ECB represents the net claim or liability of each NCB against the rest of the ESCB.

      10. how do NCBs respond to outflows or inflows of reserves with other NCBs?

        i.e. how does the system manage reserve redistributions?

        e.g. outflow of reserves from Greece to Germany?

      11. Not sure what you are asking Anon.

        If there is an outflow – such as a Greek puchasing a German car (with payment happening instantly), Greek banks’ debt to the Bank of Greece will increase. Since EoD, it goes into the marginal lending facility automatically, greek banks will try to borrow reserves from abroad in which case, Bank of Greece’s position at the ECB goes back to where it started from – before the car purchase.

        If I understand you correctly – you are asking how does the whole system manage so that “deficit” countries manage to borrow from abroad neatly, don’t know – that would need some research.

        Btw, interesting accounting here. It is usually said that Current account balance = capital account balance depending on how you define it. So CAB = KAB. However, there is a correction to this:

        CAB = KAB + OSA

        where OSA is the official settlement account – the settlement between central banks. So if a Greek purchases a car and makes the payment, CAB and OSA change. When Greek banks borrow reserves KAB and OSA change – with the latter’s sign opposite to that of the first set of transactions, assuming a perfect reveral of reserves. So CAB = KAB again.

      12. e.g.

        run on Greek banks to German banks
        Greek bank deposits decline
        Greek bank reserves decline
        Greek central bank reserve liabilities decline
        Greek central bank reserve liabilities less than required in total

        What does the Greek central bank do?

      13. Anon,

        Very complicated questions which the designers didnt pay attention to!

        The ECB monetary policy implementation document says that banks have umlimited access to the marginal lending facility as long as they provide collateral. So there is no moral suasion like in other countries. The ECB simply allows unlimited usage of the marginal lending facility.

        I think the huge LTROs which were done last year and which are likely to happen at the same scale will prevent some bad things from happening.

        Some academicians make the distinction between Anglo Saxon economies and call them asset-based and others overdraft economies. In the latter, the central bank provides banks with the reserves they need to satify reserve requirements. So the central banks have an item “claims on banks” in their balance sheets. Even in the US, the Fed provides overdrafts, but it works toward eliminating that item by doing repos with primary dealers and nonbanks. In the Euro zone, the main refinancing operations are simply lending the banking system the reserves they need to satify reserve requirements. The fine tuning happens by moving government deposits in and out of the banking system.

        The LTRO was to solve the problem of hoarding reserves – the ECB (via the NCBs) lent banks to help them satify reserve requirments and their needs to hold more reserves. It was not some QE. They could have simply lent the banks at the marginal lending facility but that is at a higher rate. So they just announced a big operation. So the ECB seems fully accomodative but banks have to provide collateral.

        The greece central bank’s own position is not worrisome because it just does what the ECB asks so there is absolutely no issue with the BoG.

      14. Bx12,

        Leaving aside the fact that the US govt has authority over both the Fed and the Bureau of Engraving and Printing which means that it can print dollars at will (which none of the Euro countries can), here’s the way I see it:

        In dollars, the US govt (combined with the Fed) is the only game in town. By the end of each business day, each holder of dollars has to make a decision — either leave the dollars under his mattress and earn no interest, or put the dollars into a US govt security (including Fed overnight or term repos) and earn some interest. The choice is pretty easy, so almost every dollar is recycled back into a government security in some form. To the extent additional dollars are stored under mattresses or in a drug lord’s safe, the Treasury can physically print more dollars without causing inflation.

        In the Eurozone, Euro holders have additional choices. At the end of a business day, a holder of Euros can put them under his mattress, or at his national central bank (which pays interest I think) or in a government security from any one of 16 different countries. Nobody has to buy a Greek bond for instance in order to earn interest. That, coupled with the fact that Greek bonds are inherently risky because Greece cannot print Euros, makes the funding situation vastly different and more precarious.

      15. “By the end of each business day, each holder of dollars has to make a decision — either leave the dollars under his mattress and earn no interest, or put the dollars into a US govt security (including Fed overnight or term repos) and earn some interest.”

        Really, those are the only options?

      16. Bx12,

        I really liked your questions. At some level, it works exactly like the US. In fact, even in the US, the Treasury has accounts at commercial banks and when someone purchases Treasury securities, the deposit of the Treasury at the commercial banks increases instead of the funds moving into the Treasury General account at the Fed.

        Same with the Euro Zone – the NCBs can transfer funds to the bank accounts or the account of the Treasury with itself. In fact, the ECB/NCBs use it for fine tuning reserves. Usually, the Main Refinancing Operations happen once a week. Between the two MROs, the NCBs move government deposits in and out of the banking system – like they do in Canada.

        Here is my understanding of how things go wrong. Deficits add to net worth of the private sector. The accounting rules still hold. However, some countries will run a current account deficit. While they do that, the income of the private sector goes down. The surplus countries enjoy higher incomes. Allow me to make a short division of the yield curve into short term and long term. The short end is controlled by the monetary policy. The long end is left to the markets. The current account deficit countries will have less funds to purchase the govt debt because of lesser income. However there is a complication. The residents of the current account surplus country may also bid for the government bonds of the ‘weaker’ country. However, there is imperfect asset substitutability. The ‘strong’ country residents may not prefer the weak country’s debt as much as residents of the latter. Hence the weak country may have issues with the long end of the yield curve. The question is – is there a mechanism for any relief for the long term yields and the answer is no. Add to all this – uncertainty, complexity, investor psychology and rating agencies’ opinions. Plus the fact that there is no central bank to purchase government debt in case markets create troubles.

        In the US, which also runs current account deficits, the situation is somewhat different. The portfolio preferences of the rest of the world to purchase US treasuries is higher than the residents of the US. So there is a mechanism to provide relief to the long term yields and prevent any crowding out. Plus the fact that the Federal Reserve can purchase debt indirectly through the secondary markets if the primary dealers stop participating in the auctions is a good thing.

        I completly agree with you – if there is someone bailing out governments in the Euro Zone, the NCB/ECB do not have to do anything special. However simply by logic, some countries will still run current account deficits and we may land into the same troubles. Another solution is to ask countries like Germany to run higher fiscal deficits, though these are not pemanent solutions.

      17. Ramanan,

        Thanks for your comment, I may get back to it at another time as I have yet to fully grasp all the technicalities.

        In an earlier comment related to this thread you said

        “If the govt debts goes from 100 to 110, private sector networth increases by 10 as well.” (in the context of Euro)

        which strikes as contradicting what I had assumed earlier, based on the fact that net spending by a US state is the analogy that was used (here) for a EMU member, and it is a horizontal transaction.

        Am I too Manichean about it?

      18. Bx12,

        Yes one may look at it as horizontal. In fact I prefer to look at as just sectoral balances instead horizontal/vertical.

  5. PS:

    “Note that if the government were to spend without issuing debt, this would result in increasing volume of reserves, hence the ST rate would converge to zero, everything else equal.

    I think it is forbidden, is it? Equivalently, though, the CB could purchase the bonds, that’s called debt monetization.”

    By doing this, I think the CB could still maintain the ST to its target, and not let it converge to zero (assuming target is indeed >0 ), by setting overnight deposit rate = target rate.

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