Words ought to be a little wild, for they are the assault of thoughts on the unthinking
- J.M. Keynes

Wednesday, 30 May 2012

Monetisation: The last arrow in the quiver

As politicians squabble on whether to grow more austere or promote growth austerely, the Eurozone is fast reaching the point of no return. Unproductive summits and proclamations of well being are only adding to the general sense of bemusement. At this point, the Eurozone is well past the stage of ‘moral suasion’ where officials can make the market believe that they will resolve all problems satisfactorily. Fiscal union, structural reform and Eurobonds which are being bandied about as solutions can only be achieved in the long-term, if at all.

The current situation resembles a bank run. Capital is fleeing Europe as foreigners and funds scale back their exposure. While this is a symptom of a more serious malaise that ails Europe, it has to be arrested to ensure that the patient lives. Effective treatment of the malaise through reform requires time which is only available if the system survives. In moments of panic, tactics dictate that a lender of last resort must step in to provide succour even if it runs contrary to longer term strategy. National governments along with the ECB performed this function during the credit crisis when they supported the banking system. The design flaw of a monetary union without a fiscal union meant that governments were ill-equipped to perform the role of lender of last resort. Unsurprisingly they now find themselves embroiled in the crisis and sinking fast. At this juncture, and much to its distaste, the ECB is the only lender of last resort available.

The ECB has been cognisant of its duty and has intervened at various stages to stem panic through MROs, SMP, LTROs etc. However it has been a hesitant lender of last resort out of respect for the principles of its father, Deutsche Bundesbank. This hesitation has been justified to some degree by the reluctance of peripheral economies to undertake painful reform as soon as market pressure is lifted. Time bought by the ECB has been squandered by European politicians in meaningless summits, backtracking and poor policy decisions.

However, all this is water under the bridge. Given massive loss of confidence and preparations for a Greek exit, the critical question that European officials and politicians need to answer is whether they want the union or not. At this point, it has become a simple yes and no answer without ifs and buts. Conditionality and reform has to happen later after assuring survival. Assuming that the answer is yes, the ECB has to step in and uninhibitedly perform its duty as lender of last resort.

This only means one thing – explicit monetisation. The reasons for this are threefold. 

First, investor distrust of peripheral sovereign debt has increased new debt servicing costs to such a great extent that it risks pushing otherwise solvent nations into insolvency. Higher interest rates also impact growth through both fiscal and monetary channels. On the fiscal side, to achieve the same deficit target governments have to cut spending by more. On the monetary side, increased interest rates on household and corporate credit increase debt servicing costs and curtail credit growth. These classic debt-deflationary conditions are in evidence across the periphery. Unless arrested, economic depression and social unrest will soon to follow as is happening in Greece. Although structural and fiscal reform will work, they will only do so over the medium to long-term. The immediate need is to artificially lower interest costs facing the periphery and assure their continued access to the market.

The second reason for monetisation is to support the banking system. There is a collateral constraint on borrowing by banks. Not only is quality collateral in extremely short supply but European banks have already pledged most of their eligible collateral to borrow. In addition, even though collateral eligibility criteria have been relaxed, they have not been uniformly implemented. Also, the large haircuts on newly eligible collateral further reduce the actual amount that can be borrowed by banks. As deposits leave and markets refuse to roll over funding, banks may soon exhaust their collateral and insolvency will surely follow.

The third reason why explicit monetisation is required is because implicit monetisation through ELA (Emergency Liquidity Assistance) has failed. ELA by national central banks has proved counterproductive. Accepting dodgy collateral to provide cash has increased investor distrust in the country’s banks and led to capital flight, the very outcome ELA was seeking to prevent. Moreover, ELA causes conflict within the Eurosystem due to the internal difference in monetary policy stance created by it. Central banks which engage in it are viewed suspiciously by others who suspect them of engaging in monetary debauchery.

In view of these three reasons, the ECB needs to embark on a policy of explicit monetisation to prevent economic collapse and dissolution of the union. Rather than buying multiple assets, it should only support European government debt through its purchases. This is because the associated risks are easier to monitor and evaluate. Also, once the panic subsides at the national level, the benefits can be passed through.  However, article 123 of the Lisbon treaty prohibits ECB from buying government debt directly. This can be easily circumvented by tweaking the SMP and buying debt in the secondary market without sterilisation. The strong signal that this action carries should obviate large scale bond buying as long as two conditions are met.

The first condition is that the ECB must emphasize that Greece did not set a precedent regarding de-facto debt seniority. Its bond buying should not subordinate private bondholders. This would make them more likely to hold on to their bonds. The second condition follows from the first. If the ECB is going to take credit risk then it must ensure that governments must not rejoice and increase credit risk by rescuing every Bankia in the country. The governing principle should be: depositors to be protected; insolvent banks to fail. If every country follows Ireland (as Spain seems to be doing) then the monetisation requirement will increase drastically causing a precipitous decline in the value of the Euro and subsequent loss of confidence. The ECB’s task is to ensure that national debt is beyond reproach not that all bank, municipal, city and regional debt will be repaid in full.

The consequences of such an action would be the immediate shutdown in funding of banks, municipalities, cities and regions in peripheral and probably some core countries as well. Investors will flee first and analyse later. Federal support will be required to ensure that the system does not collapse. However, this is not antithetical to the idea above that national governments should not bail out everyone. A certain realistic deficit level can be agreed while monetisation is taking place. This ensures that welfare and essential spending is maintained at a level to prevent economic collapse. It also ensures that fiscal policy is expansionary in an environment where the private sector is contracting. Simultaneously, a resolution and restructuring authority must be created for banks and local governments. The insolvent must be terminated quickly while the solvent should be nurtured until the markets reopen for them. 

ECB monetisation and subsequent policy will still prove to be painful. Moreover it is an extremely difficult course to pursue successfully. The two biggest problems are monetary policy disagreement within the Eurozone and ECB, and the politics of patronage. The former makes it impossible to act quickly and cohesively in a situation which demands the two. The latter ensures that any advantage gained by an initial action is frittered away. Politicians are loath to change the very power structures which brought them to power and provide sinecures to them and their supporters. As soon as the headlines recede, they do a volte-face. The two rounds of bank stress tests in 2010 and 2011 are emblematic of the lack of political will to face up to reality and reform. JK Galbraith put it well when he said that people of privilege will always risk their complete destruction rather than surrender any material part of their advantage.

Given political intransigence, the situation gives little cause for optimism. The Eurozone has only one arrow in its quiver which it is reluctance to use. If it doesn’t fire it now, it may not get another chance.  

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