Draghi's debt trap

After days and days of objections from the Bundesbank, threats to resign from its chairman, secret meetings, press leaks and shady deals, Draghi has got his way. The ECB will make "unlimited purchases" of certain Eurozone nations' government bonds with maturities of up to three years. It will use newly-issued euros to make these purchases. To address concerns about debt monetization, the ECB will sterilise these purchases (withdraw the newly-issued money from circulation) by some means yet to be defined.

Firstly, let's be completely clear about the justification for this. It is absolutely not to relieve the problems of debt-laden sovereigns. It is to protect the Euro. As I pointed out recently, the stability of the Euro is under threat because of a growing belief among investors that some countries will abandon the Euro and issue their own currencies. According to Draghi, interest rate policy is now ineffective in those countries that investors think might leave the Euro, because yields are instead driven by the risk of redenomination. This is serious. Redenomination risk makes it impossible for the ECB to control inflation (or, in the periphery, deflation) and increases the likelihood of speculative attack on the Euro. Therefore - in Draghi's view - the ECB must act to eliminate redenomination risk.

The ECB's weapon of choice is selective QE focused on rapidly-deflating parts of the periphery. I have previously argued for QE in the periphery - and reverse QE in Germany - as a means of managing the huge variation in the money supply across the Eurozone that is evident from the Target2 imbalance. Draghi has proposed QE in order to limit interest rate variation across the Eurozone. It amounts to the same thing. Despite the concerns of the Bundesbank and others, this is MONETARY policy. Bailing out distressed sovereigns is a side effect, but it is not the aim of the purchases.

The problem is that, side effect or not, sovereigns will receive relief, and that is likely to act as a disincentive for them to follow through with the fiscal reforms they have agreed to both as conditions for their debt relief programmes and in the Fiscal Compact. Draghi threatens to end purchases for sovereigns that fail to follow through with reforms: but as James Mackintosh at the FT points out, this threat is empty. If a sovereign failed to implement agreed reforms and the ECB pulled the plug on bond purchases, it would be likely to default - in which case the ECB would suffer huge losses on its holdings of that sovereign's debt, and the Euro would probably collapse. So how could fiscal discipline and structural reform possibly be enforced?

Leaving aside the headache for Merkel that such moral hazard will create, there is also the problem that QE amounts to direct funding of governments by the ECB, which is explicitly forbidden by EU treaty. Draghi originally argued that if QE is used as a monetary policy tool, the fact that it is also monetisation of government debt is merely a side effect and therefore not a treaty breach, but Jens Weidmann of the Bundesbank was not impressed. Today, to calm the fears of Weidmann (and others) about inflation arising from debt monetisation, Draghi agreed to "sterilise" the bond purchases. This means that the newly created money used to buy the distressed government bonds would be withdrawn from circulation after the purchase, returning the money supply to exactly as it was before the purchases were made.

Draghi has - perhaps wisely - not explained exactly how he plans to do this. He could offer banks term deposits at a slightly higher rate of interest than they currently get in the regular deposit facility - that wouldn't be difficult, since ECB deposit rates are currently zero. Or he could sell some of the junk on the ECB balance sheet in open market operations, assuming he can find buyers willing to pay him something near the amount he paid for the junk - we can't have the ECB making losses on its investments, now can we? Alternatively, the ECB could issue a short-dated debt instrument for the amount of money created: this would probably mop up what is possibly rather a lot of new money more effectively than term deposits, since it would be offered to a wider range of investors.

An ECB debt instrument might also go some way towards addressing the shortage of collateral that Cardiff Garcia notes. Mind you, the way that would work is simply priceless. Spanish bank sells Spanish government bonds to ECB for new Euros: ECB sells ECB bonds (bills?) to Spanish bank, thus "buying back" the new Euros: Spanish bank repos ECB bonds at the Spanish national bank or the ECB for new Euros......Complete circularity. You really couldn't make it up, could you?

But entertaining though that is, there is a much better variety of Euro fudge, or rather Vampire Squid ink, lurking at the heart of this proposal. From the very start of the Euro crisis, Germany has adamantly refused to countenance the prospect of Eurozone common debt issuance. Merkel has made it clear time and again that Euro bonds are not an option while peripheral government debt and deficits remain well above the Maastricht limits. But if the ECB buys peripheral government bonds, then sterilises the purchases by issuing an equivalent amount of its own debt, it has effectively replaced the national debt of distressed Eurozone countries with common Eurozone debt, guaranteed (via ECB capitalisation) by the Eurozone member states and in particular by Germany. Admittedly it would be short-term debt, but the precedent would be set.

This is Draghi's debt trap. He set it up for the Bundesbank and, like the idiots they have so often shown themselves to be, they walked straight into it. In blindly pursuing their aim to prevent monetisation, with its attendant risk of inflation, they have unwittingly enabled Draghi to force their Chancellor into a position where she no longer has any power to prevent the issuance of common Eurozone debt.

You see, the ECB's sole mandate is to ensure price stability, which it can only do if the Euro is stable and monetary policy is effectively transmitted. So within its mandate it can do whatever it considers necessary to stabilise the Euro and maintain effective interest rate policy. Just as monetising peripheral government debt, if done solely for this purpose, would be MONETARY policy and therefore not illegal even though EU treaty specifically outlaws it, so converting peripheral government debt to common Eurozone debt would also be MONETARY policy. And the conduct of MONETARY policy by the ECB cannot, under EU treaty, be subject to political control. Unless Merkel can prove that in some way the ECB would be in breach of treaty by issuing its debt instrument, there is nothing whatsoever she can do to prevent it.  From now on, Magical Mario is running this show and all the other players are his puppets.

There are two morals to this story. The first is the one that Bob Diamond learned to his cost: never, ever pick a fight with a central banker. They have much bigger guns than you.

And the second is this: never, ever pick a fight with a central banker who learned his trade at Goldman Sachs. You will end up lovingly entangled in his tentacles while he bleeds you dry.


  1. Forgive my ignorance, but doesn't Draghi's scheming and out-manouevring of Merkel overcome a major hurdle? Will such schemes protect the Euro and sideline Merkel's and German objections to effective intervention?

    1. Yes. From the point of view of Euro survival it is certainly positive. From the point of view of the future of Europe, I'm not so sure. Never, ever underestimate the ability of politicians to pick unnecessary fights with the wrong people when their political ambitions are frustrated.

    2. I don't know, can Merkel simply state Germany does not back the new debt? Germany is not trapped at all, they buy more time, and can walk away from this debt just like everyone else.

      If people like us figured out Draghi's game, doubtful the Germans were duped.

    3. Bob,

      I don't think she can without being herself in breach of EU treaty. The ECB is owned and capitalised by the European Union member states, but it is independent of political control. Refusing to capitalise the ECB because she didn't like its decisions would be political control, surely?

      The Bundesbank is making it very clear it does not like the ECB's proposals. Perhaps they were out-manoeuvred rather than duped.

  2. Before ascribing convoluted and nefarious motivations to Draghi, it is worth considering precisely who the ECB is bailing out since it is the Germans who are by far the largest creditors to the periphery, and it is the Germans who will suffer the most as a result from extreme dislocation.

    1. The ECB is not bailing out anyone - not peripheral economies, and not Germany either. It is defending the Euro.

      You are absolutely correct that debt relief in the periphery also benefits Germany, but that's not the ECB's concern.

    2. As Frances alluded to several times, consider the concomitant, incidental fiscal implications Draghi exacts from an ECB policy that - not surprisingly, given its explicit mandate - defends the Euro.

      Nefarious? That's a moral question: draw your own conclusions. Convoluted? Most certainly!

      Consider for a moment that Draghi/GC/ECB have been hopelessly ensnared in a web of EZ-wide fiscal ineptitude and political deadlock. If he/it/they can devise a monetary policy trajectory that has second-round fiscal products - epiphenomena in their realm but with compulsory fiscal implications salutary to their cause - that helps him/them escape: why not? Sure it seems byzantine and crafty: but that stuff can occur outside Dan Brown novels.

      Puppetmaster policy chicanry or creative stroke of central banking genius? The truth is somewhere in between. Frances does an excellent job explaining Draghi's objective. Fascinating as it is, on to the more important question: will it work?

  3. Frances, I think we had a conversation a few months ago about redenomination risk. Have you changed your mind about it?

    1. Yes. I think things have changed. Breakup is now openly discussed as a serious possibility, and people are moving funds out of the countries they think may leave the Euro into countries they think are safe. That's pushing up periphery yields and pushing down German yields, along with Danish and Swiss yields. Both Denmark and Switzerland have now taken steps to protect their currencies from Eurozone capital flight.

      But it's not what I think that matters. It is what Draghi thinks that matters, and he clearly thinks that redenomination risk is putting additional strain on the Euro.

  4. The structure of the ECB balance sheet is unique among world central banks,
    in that the #1 line item on the asset side is gold. This asset is "marked to market"
    on a quarterly basis, and is now the most significant element on the asset side.
    What is the significance of this fact? Well, as was intended by the Euro architects,
    Jelle Zjlistra, Wm Duisenberg, (both former BIS presidents) intended, as expansion
    of the liabilities side takes place, the asset side is "automatically" re-balanced by
    a rise in the price of gold in that currency. Pretty neat, huh? And that is what is
    happening now, today. Don't believe me? Well, just watch as this counterbalancing
    mechanism works over the next several months.

    (Jacques Reuff, Jean Monnet and Alexandre de Lamfalussy were the other founding
    architects of this new currency structure)

    1. Oh dear. Yes, I do know how the ECB's balance sheet is structured. You have this the wrong way round. Expanding the liability side does not automatically result in a rising gold price - the gold price is influenced by worldwide factors, not the behaviour of one central bank. However, marking to market the gold base of the ECB enables it to expand the money supply in line with the rising gold price without risking inflation. Conversely, if the gold price were falling the ECB would have to reduce its liabilities (monetary tightening). It is a form of gold standard and it is intended to prevent the ECB doing inflationary monetary expansion.

      The proposed bond-buying is self-balancing, since the ECB is buying assets from the private sector. Yes, the liabilities side will expand, but so will the assets by an equal amount. The gold price has nothing whatsoever to do with this. Furthermore, since the bond-buying will be sterilised, it will not involve monetary expansion. While I understand what you are saying, therefore, it is not remotely relevant here.

  5. "The proposed bond buying is self balancing..." regarding the ECB balance
    sheet. Quantitatively, yes. Qualitatively, no. Your argument would be then
    equally valid for the "good bank" - "bad bank" arrangement, as is now
    going on in Spain. (See Golem XIV)

    What the gold price actually balances is the qualitative difference. Yes, it
    responds to "worldwide factors". The principal worldwide factor it truly
    responds to, more than any other, is a deterioration in fiat quality. It does
    so by counterbalancing that loss of quality by demanding more of the
    currency in question, (a price rise). By placing it on the asset side of the
    balance sheet, that inflationary effect neutralizes the qualitative deterioration.

    1. You need to think through your logic. For the marking to market of gold in Euros to work, you must assume that monetary expansion of the ECB balance sheet will cause the euro to depreciate against the dollar while the dollar price of gold remains unchanged. That isn't what you are saying, though - and it's a very big assumption anyway. Monetary expansion does not necessarily cause currency depreciation.

  6. "Monetary expansion does not necessarily cause currency depreciation."
    Absolutely correct! It is always "all in the details" of for what purpose the
    monetary expansion is undertaken. When, for example, it funds useful
    self sustaining investment, it may even strengthen the currency. If, on the
    other hand, it is used to fuel unneeded consumption, the opposite may occur.
    The market will judge which of these is taking place, of course, and the
    price of gold "in that currency" (since gold is in fact a currency in its' own
    right) will adjust to that reality. Of course, if there are forces in play to
    demonetize gold's useful function in this regard, then the "the canary in
    the coal mine" may fail to sing when needed. In the US that is the case.
    In India, or China or the middle east, not so much.
    My contention, which those 5 great minds instrumental in the founding of
    the euro architecture planned, is that by placing gold on the asset side of
    the balance sheet, to act as a counterbalance for those occasionally
    necessary actions which might harm the currency in a qualitative way,
    (like swapping German for Spanish debt) the euro would be protected.

    The blog FOFOA has a wealth of information on this issue should you be
    interested. By the way, apart from this one difference of opinion, I think
    your article above has pretty much "nailed it". I will make a point to
    keep up with your posts in the future. Cheers.

    1. You are in effect saying that the gold price acts as an indicator of the market rating (approval/disapproval) of central bank macro-economic policy. It does to some extent, but it is also influenced by other factors. Therefore I think your counterbalance can only be partially effective.

      I also think you confuse risk to the central bank with risk to the currency. In the current situation ECB buying Spanish debt and selling German would strengthen, not weaken, the euro, because it would reduce the spread between Spanish and German yields- the size of the spread between German and other yields is an indicator of the strains in the Eurozone and therefore the risk to the Euro. But it unquestionably increases the balance sheet risk of the ECB. Surely the point of the gold is to protect the central bank, not the currency? Obviously protecting the central bank does protect the currency, because the central bank is the issuer, but you are suggesting that the purpose of the gold is to protect the currency from actions of the central bank. That can't be right - it is the central bank's primary job to protect the currency.

      I've read FOFOA's blogs. I have considerable reservations about his arguments, which I have discussed at great length on another post. I would rather not discuss them again here if you don't mind. It's not the point of this post.

  7. nice post Frances
    will read the rest when I can find the time.

    came here through FOFOA. I agree with you.
    (but please keep discussions over there, and me out of it, I've had my share ...)

  8. ou are absolutely correct that debt relief in the periphery also benefits Germany, but that's not the ECB's concern.


Post a Comment

Popular posts from this blog

WASPI Campaign's legal action is morally wrong


What really happened to Signature Bank NY?