Rogoff sees ECB monetisation followed by recapitalisation or seigniorage and currency depreciation

Everyone is focused on the narrow issue of whether Greece can be cowed into austerity-induced depression and whether they will hold a referendum, default or leave the euro zone. There are bigger existential issues. Harvard Economist Kenneth Rogoff has a post up at Project Syndicate which does a good job in laying out the core conundrum that Europe faces in the sovereign debt crisis. He theme is exchange rates and currency revulsion. But the underlying framework Rogoff presents is anchored in a presentation of debt and monetary policy issues that is similar to what you read at Credit Writedowns.

His basic points are as follows:

  1. The October 26th “comprehensive package” for Greece will not hold up because it is inadequate. It is a gimmicked hodge-podge of vague promises which do not cut the sovereign debt levels in Greece nearly enough to put the country on a sustainable fiscal path.
  2. This so-called solution is all the more inadequate because Euroland would need a tighter fiscal union if it is to avoid the kind of liquidity crisis it is now experiencing. As this is something that requires constitutional changes which take time, “it seems clear that the European Central Bank will be forced to buy far greater quantities of eurozone sovereign (junk) bonds.”
  3. “That may work in the short term” but eventually “the ECB will in turn have to be recapitalized. And, if the stronger northern eurozone countries are unwilling to digest this transfer – and political resistance runs high – the ECB may be forced to recapitalize itself through money creation.”
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I would quibble with bits of his analysis, like the part where he says that sovereign default risks will again likely materialise. The default risk is a lender of last resort risk. Here’s how I put it last month when discussing currency revulsion:

In the euro zone, the governments are not monetarily sovereign (like states in the US) and have only an implicit backstop from the ECB (akin to Fannie and Freddie). So, rightfully people are tacking a default premium onto the term structure. Germany has almost zero default risk. France has slightly more. Spain and Italy have even more.Greece has nearly 100% default risk. That means there is enough doubt about whether the ‘independent’ ECB stands at the ready to backstop the French sovereign to cause French spreads to German Bunds to increase.

Notice that the macro debt fundamentals of France are worse than Spain’s (higher debt to GDP and deficits since the euro began and higher present debt to GDP and same large budget deficit). Yet spreads are much lower. That tells me that France has a perceived backstop that Spain does not. If the ECB credibly committed to ‘monetising’ deficits as the Fed has done, yields would immediately fall to reflect the diminished default risk. The ECB has not done so because this backstop would create currency revulsion and weaken the euro.

So let’s be clear here. If the ECB were like the Fed and it was backstopping a central European treasury that emitted Eurobonds, there would be no problem in Euroland. In fact, the Europeans could run government debts up to 200% of GDP like the Japanese without currency revulsion or spiking interest rates – not that they should want to, but they could. But, that’s not the institutional structure in Euroland, so they can’t do that and so they are exposed to currency revulsion and rates are spiking.

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There’s a further problem.

The failure to sort out the ambiguities concerning the distribution of the fiscal burden that may arise through bail-outs of banks operating in multiple Euro Area nation states puts a large question mark behind the effectiveness of the Euro Area financial stability arrangements. The Euro Area has proven itself to be capable of handling a banking sector liquidity crisis. The institutional arrangements, including the fiscal burden sharing key, for handling a banking sector insolvency crisis are opaque at best, non-existent at worst.

We must know who would recapitalise the ECB should it suffer a material capital loss, and through what mechanism this would occur.

Willem Buiter, May 2008

If the “stronger northern eurozone countries,” as Rogoff puts it, did not stand at the ready to recapitalise the ECB, then the ECB would have to print money and allow seigniorage to work it out of its insolvency. As long as the ECB stays clear of loading itself up with dollar swap liabilities with the Fed, it can just print money and eventually the seigniorage from that money printing will recapitalise the ECB.

The problem, of course, is currency revulsion. As soon as the ECB starts printing money like crazy to work its way out of the insolvency it created by buying duff Greek and Portuguese assets off the Belgian, French and German banks desperate to unload the stuff, people will flee euro assets like the wind. You want price instability aka currency revulsion, well there you go.

In sum, the present 50% haircut for private creditors only is never going to work. More writedowns are coming. Everyone knows this and so the sovereign debt crisis continues unabated. In fact, it is worse. Because the Europeans have what Rogoff calls a “halfway house” between full fiscal integration and national currency sovereignty, the crisis can only be tamped down by the ECB monetising periphery debt.

But, of course, that presents a solvency issue for the central bank. If countries remain intransigent, the ECB will print money and the euro will have a serious gravity test and fall like a stone, inflation will climb, and you will see the mother of all competitive currency devaluations thereafter. on the other hand, if the Europeans care about price stability at all, which the Germans, the Dutch, and the Austrians et al do, then they’re going to fork over a wad of cash to top up the ECB’s capital base on a pro-rata basis – end of story.

Bottom Line: The ECB will monetise and the Europeans will top it up with capital. That is how this is going to play out.

Source: A Gravity Test for the Euro – Kenneth Rogoff, Project Syndicate

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7 Comments
  1. Tim Coldwell says

    1. EUR Treaty mods to enable EZ countries to exit EZ but remain in EUR, single market etc.
    2. IMF to help finance such counties as it usually does.

  2. PLB says

    I agree. But that will be the last big “kick”… and while we’ll have a well capitalized ECB, we’ll still have years of austerity to mop up all these unecessary delays and necessary consequences.

    And so… where will that leave us re “austerity and democracy revulsion” impacts on IMF-target and sovereign default risks?

    I think we’re entering the stage where the periphery may wield more power than they do today…

    Entertaining Papandreou flip flops… Berlusconi next?

  3. Diego Méndez says

    Rogoff is smart, I can’t understand why he wrote this piece.

    The eurozone is balanced vs. the rest of the world. It doesn’t need external inflows.

    On the other hand, the US has a huge trade deficit. It needs to borrow 10% GDP from the rest of the world, every year. And only sovereigns (dumb money) are betting on the dollar.

    This points to an appreciating euro and a devaluing dollar in the long term. Why would investors bet on the long-term equilibrium, ignoring short-term risks? Because they may fear capital controls and/or a US dollar collapse in the short term.

    1. David Lazarus says

      Capital Controls are coming. It might take time but it will be the only solution to stop contagion of banks in future. As you said Europe could cope if it managed to overcome its nationalistic tendency to defend its own little corner even if it destroys the group.

  4. don says

    “Bottom Line: The ECB will monetise and the Europeans will top it up with capital. That is how this is going to play out.”

    Does not capital from Europeans deposited in ECB result in capital flows out of German, etc., production and into the ECB vaults not result in economic stress to the ‘real’ economy of those counties? Is this not just shuffling the deck?

    Is not the real ‘problem’ one in which surplus countries, namely Germany (historical background: with the West/East German re-union, neo-liberal policies resulting in reduced wages/heightened productivity in Germany, resulted in the co-existing need to lend to Italy, etc., i.e. deficit countries, in order to increase those county’s consumption/imports from German — the financialization of Italy, etc.), funded Italy’s, etc., deficit to absorb German exports the root of the problem: one of imbalances and overproduction? How does monetization address these structural imbalances?

  5. Max Shifrin says

    How would the ECB buying bonds of euro countries help solve the competitvness issue of certain countries in the EU? If the Euro tanks, then setting aside bank problems, Germany is still more competitive than Greece/Spain etc.. ECB bond buying would cause inflation across the EU but won’t solve the fundamentals as far as I understand.

    Correct me if I’m wrong?

    1. Edward Harrison says

      Buying sovereign debt or putting a price floor on it is a stopgap liquidity measure to prevent a panic and nothing more. In fact, it is a moral hazard if done in the wrong way. The EU needs to restructure its institutions.

      remember, the competitiveness arguments are canards because Scotland and the north in the UK are not ‘competitive; with the south. Yet the monetary union works there. The same has long been true in the South of the US versus the North and for the Eastern Canadian provinces. There will always be areas that are ‘uncompetitive’. The right way to deal with that is to have capital and labour mobility and potentially fiscal transfers. But, since the euro zone is an amalgam of national economies, no one wants a transfer union and so you have a problem. That’s the REAL problem; Europe can never truly become the United States of Europe.

    2. Edward Harrison says

      Buying sovereign debt or putting a price floor on it is a stopgap liquidity measure to prevent a panic and nothing more. In fact, it is a moral hazard if done in the wrong way. The EU needs to restructure its institutions.

      remember, the competitiveness arguments are canards because Scotland and the north in the UK are not ‘competitive; with the south. Yet the monetary union works there. The same has long been true in the South of the US versus the North and for the Eastern Canadian provinces. There will always be areas that are ‘uncompetitive’. The right way to deal with that is to have capital and labour mobility and potentially fiscal transfers. But, since the euro zone is an amalgam of national economies, no one wants a transfer union and so you have a problem. That’s the REAL problem; Europe can never truly become the United States of Europe.

  6. Max Shifrin says

    How would the ECB buying bonds of euro countries help solve the competitvness issue of certain countries in the EU? If the Euro tanks, then setting aside bank problems, Germany is still more competitive than Greece/Spain etc.. ECB bond buying would cause inflation across the EU but won’t solve the fundamentals as far as I understand.

    Correct me if I’m wrong?

    1. Edward Harrison says

      Buying sovereign debt or putting a price floor on it is a stopgap liquidity measure to prevent a panic and nothing more. In fact, it is a moral hazard if done in the wrong way. The EU needs to restructure its institutions.

      remember, the competitiveness arguments are canards because Scotland and the north in the UK are not ‘competitive; with the south. Yet the monetary union works there. The same has long been true in the South of the US versus the North and for the Eastern Canadian provinces. There will always be areas that are ‘uncompetitive’. The right way to deal with that is to have capital and labour mobility and potentially fiscal transfers. But, since the euro zone is an amalgam of national economies, no one wants a transfer union and so you have a problem. That’s the REAL problem; Europe can never truly become the United States of Europe.

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