March and April have seen a marked 70% rebound in the oil price from the January lows of about $26 a barrel. The move owes much to the dynamics of the energy market itself, but it is being interpreted by financial markets as a sign that global demand should be sufficient to deliver at least trend growth (say, 3% - 3½%) in world output in 2016. The mood has changed sharply from January’s alarmist hysteria, much of it due to so-called “analyses” from the Bank for International Settlements, the International Monetary Fund and leading investment banks. (These organizations ought to have known better, bluntly.) The line taken in International Monetary Research Ltd. notes has been that recession in 2016 is extremely unlikely. Only hopelessly incompetent monetary policy decisions could cause a recession to start from a situation in which upward pressures on inflation have been and remains weak, and the price level has been and remains more or less stable. I don’t have much respect for the top brass in the major relevant institutions (i.e., the Fed, the ECB, etc.). But, to initiate a recession, they would have had to be yet crasser than they were in the last period of idiocy, in late 2008. In practice, the absence of upward pressures on the price level has allowed significant monetary-policy easing in China and the Eurozone. It seems that in China M2 growth has run about 1% - 1½% a month (i.e., at annualised rates of 13% - 20%) in early 2016. In the four major developed “countries” (i.e., taking the Eurozone as a country) – the USA, the Eurozone, Japan and the UK – the annual rates of broad money growth are currently 3.9%, 5.0%, 2.6% and 4.5%, and the three-month annualised growth rates are 5.1%, 4.4%, 2.8% and 5.0%. If asked for an ideal rate of money growth, Milton Friedman would typically reply – at least for the USA – “5% a year”. The Bank of Japan seems unable to see the light in the “broad money vs. monetary base” debate. But in truth money growth trends in the main countries are not far from perfection at present.
Press reports have suggested that the International Monetary Fund has become unhappy with the Greek government’s austerity measures, since it felt not enough was being done to maintain fiscal solvency. Anyhow the latest tranche of money has been credited to the Greek government and life goes on, although Greece’s international creditors are watching the budget numbers month by month. The following note recognises that the Greek government is not far from achieving a ‘primary budget balance’ (i.e., non-interest public expenditure is only slightly above tax revenues). In that sense, much has been done to restore the creditworthiness of the Greek state. However, the cost has been calamitous, with falls of about a quarter in real terms in both national output and government expenditure. Even worse, it is not clear that the big austerity drive so far will be sufficient. Two points have to be emphasized. First, output has fallen so heavily from the peak (i.e., in 2007), and is still falling at such a rate, that a budget surplus would be needed to stop the debt/to/GDP ratio from rising further. There is no sign of that. Despite the defaults to private sector creditors, IMF data show the debt-to-GDP ratio now at about 175%. Second, the drop in output has of course a large cyclical element and, sooner or later, a cyclical recovery must surely happen. However, a deeper problem is now emerging, that international investors are shunning Greece and the trend level of output may be going down. To halt the rise in the debt-to-GDP ratio, Greece therefore needs an overall budget surplus over a series of years and not just a primary surplus in an emergency period Again, there is no prospect of that in any relevant planning horizon.
Mario Draghi denies that he is an actor. But in July last year he is reported to have paused, with great effect, between two sentences in an interview for the Financial Times. The two sentences were, ‘Within our mandate, the ECB is ready to do whatever it takes to preserve the euro. And, believe me, it will be enough.’ On the basis of these two sentences, which were followed by a spectacular rebound in the euro on the foreign exchanges and in European share prices, the FT made Draghi its ‘Person of the Year’ for 2012.* But Mario Draghi, like King Canute, is not omnipotent. He cannot break the laws of arithmetic and the principles of accountancy which depend on those laws. He cannot – by mere pronouncement – conjure up the real resources required to fill the hole in Cypriot banks’ balance sheets. Equally, if that hole is €17b. (or about 80% of Cyprus’s GDP of €22b.), the Cyprus Parliament cannot by rejecting the terms of an international bail-out make the people of Cyprus richer in any meaningful sense. The cost of filling a hole of €17b. is the cost of filling a hole of €17b. It was supposed to be met by an increase in Cyprus’s public debt of over €10b. and the highly controversial deposit haircut of €5.8b. The Cyprus Parliament’s unanimous rejection of the haircut does not mean that – automatically, immediately, magically and finally – the €5.8b. has fallen like manna from heaven. We have a stand-off. The ECB has indicated that, on the provision of the appropriate collateral (Greek government bonds?), it will lend to the central bank of Cyprus sufficient amounts for it to meet cash calls from the commercial banks. These banks would then have enough cash to repay depositors with legal-tender notes. But do Cyprus’s banks have appropriate collateral in sufficient amounts? Do they, in Draghi’s terms, have ‘enough’?
Draghi’s commitment to do ‘whatever it takes’ to preserve the Eurozone undoubtedly has the support of the European political elite, particularly the German political elite. However, every balance sheet has two sides. If ‘doing whatever it takes’ implies that the ECB’s balance sheet is to expand, a further consequence is that its creditors (i.e., for the most part banks keeping cash reserves with it) are more exposed to its failure. As the following note (which is based on my next column in Standpoint) explains, the ECB’s dominant creditors nowadays are German banks, which keep over €750b. cash reserves with the Bundesbank. (See the chart on p. 2 below.) If the banks that borrow from the ECB (which nowadays are predominantly from the PIIGS [Portugal, Italy, Ireland, Greece and Spain] cannot repay their loans, and if the ECB’s modest capital of about €10 billion is exhausted by other losses, Germany’s banks are theoretically liable to a maximum loss of the full €750b. or so. I say ‘theoretically’, because Eurozone governments would be expected to recapitalize the ECB and to prevent such losses. In this disastrous situation they would of course - well, presumably – carry out the recapitalization. But the cost of the recapitalization would add to nations’ budget deficits and public debts. Further, the German constitutional court has just given its legal endorsement to the €150b. German commitment to the European Stability Mechanism. If the PIIGS’ banks and governments cannot repay in full their debts to the ECB and the ESM, the losses fall back on Germany. We are of course talking about losses that could reach €200b., €300b. or more. The following note (see chart on p. 3) also shows that the pattern of PIIGS’ borrowing from the ECB has changed. Whereas in 2009 the ECB was lending mostly to banks in Ireland, Greece and Portugal, in the last 18 months its new loans have been mostly – indeed almost exclusively – to Spain and Italy.
Greece’s financial plight is intensifying, despite the promises made to international creditors and, more specifically, to the Troika of the International Monetary Fund, the European Commission and the European Central Bank. Fiscal austerity had become essential after the budget deficit reached 15% of GDP in 2009, but – because Greece is a member of the Eurozone and does not have its own currency – fiscal austerity could not be offset by monetary expansionism. Because of the wider Eurozone malaise, the attempt to reduce the budget deficit has had to be made while demand in Greece’s main trade partners has been weak. The data show that the attempt has failed. According to the IMF’s latest database (prepared in April), Greece’s gross domestic product was 230b. euros in 2010, but will fall to about 205b. euros in 2012 and 2013. The IMF also gives the ‘net borrowing’ of Greek general government as 15.6% of GDP in 2009, falling to 10.6% in 2010, 9.2% in 2011 and 7.2% in 2012. Well, that isn’t the message from the Greek government itself, which helpfully publishes a website with the data. The data show that the government deficit was 23.3b. euros in 2010 and 27.3b. euros in 2011, and is running at a somewhat higher level (although not dramatically higher) in 2012. The detail of the figures shows that serious efforts at fiscal restraint have been imposed, but the slump, and the resulting fall in tax revenues and increase in welfare spending, have overwhelmed the Roughly speaking, the Greek budget deficit is stuck at about 15% of GDP despite all the efforts of international and local officialdom.
The European Central Bank’s two long-term repurchase operation exercises had a hugely positive effect on the Eurozone’s peripheral sovereign bond markets, but that effect seems now to be largely played out. That does not mean that yields will return to their highs in November 2011, when the “Draghi bazooka” would indeed have failed. (The high last November for 10-year Spanish government bonds was 6.7%. That yield dipped briefly to under 5% in early March, but has since surged back to about 6%.) The purpose of this week’s note is to set out some of the key facts and figures, in order to get a better feel for the risk that the yields jump back towards 7% or higher in the next few months. Markets and commentators are jumpy, which by itself is one reason for fearing that the LTRO exercises will fail. Spanish banks’ borrowings from the ECB/the Eurosystem (which in fact are identified from the Bank of Spain’s balance sheet) increased sharply in February and March, provoking much adverse comment. (Average net borrowings by Spanish banks climbed to 227.6 billion euros from 152.4 billion euros in February, according to the Bank of Spain website. The figure was well under 100b. euros as recently as last summer. Spanish lenders took 29 percent of the total LTRO facilities.) But there was nothing surprising at all about these large increases. The meaning and purpose of the LTROs was that commercial banks in such countries as Spain, with serious difficulties in funding their assets, would take up lines from their national central banks (i.e., the national central banks that together constitute the Eurosystem) in order to replace inter-bank lines. It seems entirely plausible that – when fully drawn down – the Spanish banks’ borrowings from the ECB will reach or even exceed 500b. euros. How significant would that be relative to Spain’s GDP and its total banking system balance sheet?
and ‘Draghi vs. King: who is right and who is wrong?’Should central banks lend to solvent commercial banks at all (or at most on a temporary basis) when they are short of cash? Are long-term central banks loans to commercial banks a mistake, with the central bank wrongly assuming responsibilities that – properly understood – belong only to the government and the private sector? These questions have always been controversial in central banking theory. Their contemporary importance has been heightened by the contrast between the recent actions of the European Central Bank and those of the Bank of England, and the central banking ‘philosophies’ of Mario Draghi, president of the European Central Bank, and Mervyn King, governor of the Bank of England. Draghi has overseen – and is sometimes said to have masterminded – two immense long-term refinancing facility tenders for the Eurozone’s banks since he became ECB president on 1st November, 2011. These facilities have been very cheap and have undoubtedly helped Europe’s banks to fund their assets (including low-quality sovereign bond debt). However, in the UK King has set his face against any kind of long-term lending to the banking system. King’s critics contend that his obstinacy was at least partly to blame for the run on Northern Rock in 2007, and that his hostility to the UK’s banks has subsequently undermined their competitiveness and efficiency. Who is right, Draghi or King? The following note discusses various aspects of the question, to try to get nearer the truth.
Mario Draghi became president of the European Central Bank on 1st November, 2011, at a critical moment for the euro. Banks – particularly banks in the Club Med countries (i.e., Italy, Spain, Greece) – were having difficulty rolling over their inter-bank lines. As the lines matured with little prospect of renewal, the banks were being forced to sell liquid assets. As these included bonds issued by Club Med countries, the price of the bonds fell and their yield increased. A surge in Italian and Spanish government bond yields was taken to constitute “the Eurozone sovereign debt crisis”. The media were full of talk of “a bazooka” of some sort to bring the crisis to an end. In October last year such talk usually focussed on the expansion of the European Financial Stability Facility, a back-up fund with resources provided by all Eurozone member states and able to extend credit to particularly hard-pressed governments. A widely-held view was that the EFSF might need to exceed 900b. euros, or even 2,500b. euros, if it were to have the fire-power to meet the crisis. In the event, negotiations for the EFSF have not got far enough, while its credibility in financial markets has been undermined by the credit rating agencies’ downgrading of several member states. But Draghi has found a big, powerful bazooka and aimed it with precision. Between 4th November 2011 and 20th January 2012 the ECB’s lending to banks has jumped from 580.0b. euros to 831.7b. euros, or by over 43%. The new lending has taken the form mostly of three-year facilities at 1%, which – on the face of it – are extraordinarily privileged loan arrangements for the banks. Further large expansion of such lending is to be envisaged. The banks have stopped selling government bonds, the yields on Italian and Spanish bonds have fallen, and the sovereign debt crisis is over, at least for the time being. This weekly e-mail analyses the effect of the Draghi bazooka on Eurozone M3 growth, because of the importance of money to macroeconomic outcomes more generally.
A recurrent theme in the e-mails from International Monetary Research Ltd. since early 2009 has been that sudden, large-scale bank recapitalizations – of the kind implemented in the UK particularly (but also elsewhere) in late 2008 – are deflationary. (See, for example, the weekly e-mail of 14th September 2009, with its account of ‘the paradox of excessive bank regulation’.) This has often puzzled people, since – surely – recapitalization makes banks safer and the safer are banks, the less likely are crises. (As far as I am aware, no evidence has been produced [by e.g., Mervyn King, John Vickers, the Basle regulatory bureaucracy etc.] for the theory that macroeconomic instability [as measured, e.g., by the standard deviation of GDP growth] is inversely related to the banking system’s capital/output ratio. I am indeed pretty confident that – when tested against data – the theory does not hold up, but let this pass for now.) So this week I explain, again, why bank recapitalization is deflationary. What evidence can I call upon to substantiate my argument? Well, in effect the whole sorry financial and macroeconomic mess in the leading industries countries since mid-2007. Officialdom has repeatedly demanded that banks have more capital and, for all their problems, banks have higher capital/asset ratios today across the industrial world than they had in mid-2007. Yet the four years have been a misery and officialdom wants the banks to raise still more capital! How many more times does it have to be said that the key to macroeconomic stability is steady growth of the quantity of money at a low, non-inflationary rate? That is what matters, not the current rigid and ideological approach towards banks’ capital being taken in the Bank of England, H M Treasury, the US Treasury, etc. (Mercifully, not every country’s official economic policy agencies have been captured by the unfortunate and false doctrine that ‘the more capital banks have, the better for the world’.)
Ireland, Greece, Portugal and Spain tend to be grouped together as the Eurozone’s most troubled economies, the PIGS, the GIPS or whatever. Their economies are in fact very different in character, as are their financial difficulties. Until the crisis Ireland’s public finances were among the strongest in the Eurozone, quite unlike Greece. Although its public-debt-to-GDP ratio has now moved up to over 105%, this owes much to ‘creative accounting’, in the sense of misleadingly pessimistic accounting. The essence of the Irish problem is not that public expenditure has been extravagant and foolish, but that the state has assumed a high proportion of the liabilities of the banking system, which in the boom was extravagant and foolish to a remarkable degree. Last year the government in effect ‘took a charge’ on future banking system losses equal to over 30b. euros. This was not a cash item in its budget and no interest has to be paid until banking losses are crystallized. Interest on the public debt is still only about 3½% - 4% of GDP and at no point in the foreseeable future does it threaten to exceed 10% of GDP. Again, the contrast with Greece (where the debt interest burden would spiral out to over 10% of GDP without the EU/IMF rescue programme) is very marked. Nevertheless, Ireland is challenged. In the first four months of 2011 the Exchequer deficit was 9.9b. euros, up by over 40% on the same period of 2010. In November 2010 Ireland’s Department of Finance projected an Exchequer deficit for 2011 as a whole of 19.3b. euros, the same as in 2010. On present trends the Exchequer deficit could exceed the official projection, with an outturn of, say, 22b. – 24b. euros, about 11% - 12% of GDP. Further, Ireland would benefit from an easier monetary environment and a lower exchange rate (i.e., leaving the Eurozone). A central difficulty is that the budget deficit threatens to stay high, because the European Central Bank’s restrictive monetary policy depresses the economy and so raises the budget deficit.