Does the ECB have what it takes?

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Equities ripped, bonds sold off, and the little Aussie bruiser rallied to ~1.04 last night on reports that ECB Draghi said the ECB would do ‘whatever it takes’ to hold the Euro together…

I doubt the ECB has what it takes …

First of all, let’s think about what a central bank does – it buys (and sells) securities and pays for them with high powered money. So its assets are the securities it owns, and its liabilities are the money that it creates.

Sounds like something for nothing – real assets in exchange for ‘created’ money – but it is not. The money it creates is a taxpayer liability, and is booked as a loan from the banking system (who in a closed system are forced to hold the central bank’s liabilities).

If one thinks of the high powered money the central bank creates as a part of total government liabilities (and one ought to) it is immediately clear that all the central bank does is lengthen and shorten the duration of outstanding government liabilities.

When a central bank buys long term government bonds, for example, they exchange short term government liabilities for long term government liabilities.

Do you really think the trouble in Europe is that they are trying to issue too much long term debt?

I do not. I think Europe’s problem is that they cannot afford to repay the debt that is currently outstanding. Shortening the term structure of those liabilities will reduce the duration (and hence risk) held by the private sector – and this may cause the private sector to make other more risky investments … But i doubt it will have an especially large impact.


  1. Most of core Europe has lower government debt to GDP than the US or Japan. The difference is that those countries can print their own money while Spain and Italy cannot. If the ECB were truly willing to print as much as it takes, Europe’s debt-related issues would not be as great.

    1. So you are saying that if inflation risk was higher yields would be lower? Doesn’t make sense to me.

      Last night’s comments were framed within the ECB’s mandate, which means the 2% inflation target remains – so i doubt we will see unlimited QE.

      1. Yields are high because of fear of default. If easier monetary policy reduces that fear, yields could fall in Spain and Italy, as they did last night. After all, weren’t yields in these countries lower pre-GFC when inflation was higher? But yes, to really stabilise yields, the ECB would need to go further than 2% inflation in the short term – maybe adopt a level target based on a 2% trendline from 2006.

        1. I agree that high yields reflect default risk – if they had their own currency their FX rate would have collapsed.

          I just do not see the ECB as capable of fixing europe. They might be able to turn it into Japan – i think that would be a very good outcome just now.

          Sent from my iPad

  2. This is only loosely related, but Ricardo you said a while ago that you might do a piece debunking MMT (or something to that effect). Is that still on the agenda?

  3. The solution is printing… and a lot of it.
    However the problem is how do you distribute the money that is printed to all countries fairly (even the countries that do not need it), when some countries need a lot more than others. Plus the “distribution” must not be a loan (no repayment necessary), but just lowering the outstanding sovereign debt by repaying who owns the debt with printed money.

    1. Yep, inflation will make the real claims on the treasury ‘affordable’. It is hard to avoid that conclusion just now. The question is, however, will Germany remain in an inflationary union?

      Sent from my iPad

      1. Inflation is the least of the problems right now in the EU. :) They wish they had some!

        1. Totally agreed. I happen to think that it is harder to get inflation than most realise. All we are getting for the big duration swap is very low bond yields. Makes some sense – the taxpayer ‘owns’ the central bank’s bond portfolio so in a ‘perfect’ model, they would know that their ultimate risk had not changed much and would not change their behavior much as a result.

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