ECB Says No!

It has now become commonplace to read stories about how the ECB must purchase large quantities of bonds.

It is not going to happen, folks.

The EU is more likely to break up than the ECB is to buy 1tn of Italian and Spanish paper – which is probably what’s required to stabilise EU Govt Bond markets. Indeed, ECB purchases of that quantity of paper is probably the largest single existential threat to the union, because it would materially exceed the Bank’s mandate.

The reason is that this sort of monetary policy – expanding the money supply to buy assets – is actually fiscal policy.

The ECB is in a funny place as a central bank: unlike most central banks, they do not represent a unified treasury. Rather, there is a capital subscription formula. A consequence of this is that they lack some of the authority and flexibility that normal central banks (such as the BoE, Fed and RBA) enjoy.

This ‘treasury problem’ makes it hard for the ECB to do QE. When a central bank creates reserves to purchase an asset, it creates the ‘high-powered money’ out of nothing – but it’s not free! On the central bank balance sheet we would see an increase in liabilities (the high powered money created to buy the asset) and an increase in assets (typically Government bonds, covered bonds, or mortgages).

If the price differs from what the central bank paid, the profits or losses are shared according to the ECB’s capital formula. Thus, ECB QE transforms a specific liability (say Italian or Spanish debt) into a liability that’s distributed according to the ECB capital formula: 19% Germany, 14% France, 12% Italy, 8% Spain, etc.

For this reason, ECB SMP is actually a sort of Eurobond – something many think is the endgame here, but which requires both legal changes and the consent of various polities. Elected officials need permission from voters to enter a fiscal union. If the ECB entered that realm, there is a real risk that public opinion would turn against the EUR in Germany, and the other big creditor nations (it’s a bit like someone pinching your credit card!).

I think that a break-up is more likely than a full transfer union, as I doubt that the permissible transfers to GIPSI nations would be large enough to ease the pain sufficiently to put out populist movements to leave the EUR. After all, the vast bulk of people have few assets, and the required structural adjustment just means a long period of high unemployment.

These nations have ‘twin deficits’ problems, and are suffering from a sudden-stop of capital account inflows – as their lenders have lost faith in them.

recall:

Y = C + I + G + X – M

and

Y = C + S + T

combining and rearranging, we obtain:

(S – I) + (T – G) = (X-M)

The problem for these nations is that they have lost credibility as a payer, and so must collapse the LHS (increase savings and taxes, and cut investment and Government) of the equation to ‘fund’ their current account deficit. Because they are part of the EUR, they cannot rely on currency depreciation to boost NX, and drive them out of this hole.

The equation must balance, so adjustment is required. Given the fixed nominal FX peg, adjustment on the right hand side (NX) occursis via relative inflation (which raises or lowers the REER).

Deflation that’s stronger and more acute than in their competitors will lower their REER, boost exports, and ease the adjustment. However, this is not happening at the minute.

Italian and Spanish CPI for the year to October were 3.35%y/y and 3%y/y, respectively. By contrast, Germany was 2.85% and the Netherlands 2.75%.

The adjustment hasn’t even begun!