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Why the EU Summit Decisions may Destabilise Government Bond Markets

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By Paul De Grauwe, Professor of international economics, University of Leuven, member of the Group of Economic Policy Analysis, advising the EU Commission President Manuel Barroso, and former member of the Belgian parliament. Cross posted from VoxEU

Among the questions still remaining since last week’s summit of European leaders is whether the new measures will stabilise government bond markets. This column’s answer is ‘no’.

This was the nth summit meeting of European leaders billed as finally solving the Eurozone crisis. Yet there were a number of important and useful decisions taken at last week’s summit:

A new banking union with a European supervisor that has some teeth; and
the possibility of organising recapitalisations of banks at the European level.
These are both positive steps. The last one in particular is important.

One of the main weaknesses of the Eurozone lies in the fact that banking problems have to be resolved by the national government where the banks are located. As a result, insolvency of local banks threatens the solvency of the national government, leading to a vicious circle of interacting solvency crises of local banks and the local sovereign. Cutting the link between the two is therefore key to creating a more stable financial environment in the Eurozone.

Banking union: Devil in the detail

While the principle of a European mechanism for resolving banking crises is now accepted, major practical problems of implementation of that principle lie before us.

• What will be the supervisory powers of the ECB?
• Who will run the recapitalised banks?
• What if a bank has to be nationalised?

These and many other practical questions will pop up on the road to implementing the new principle.

The European Stability Mechanism

The focus of this column, however, is on the new role that is given to the European Stability Mechanism (ESM), otherwise known as its bailout fund, that should start its operations very soon.

In addition to its conditional financial assistance to member countries, the ESM was given two new tasks.

• The first one (that I just discussed) is that it will be able to directly recapitalise troubled banks.
• The second one is that it will be allowed to buy government bonds in the secondary markets so as to prevent further destabilising surges in bond rates.

These are eminently important objectives.

Surely something must be done about the inexorable rise in the sovereign bond rates of a number of Southern European countries? These surges in the interest rates are only partly the result of bad fundamentals. For countries like Spain and Italy, a significant part of the increases in the spreads is the result of fear and panic in the markets that have the potential of driving countries into bankruptcy in a self-fulfilling way (De Grauwe and Ji 2012).

The question then is whether the ESM will be able to stabilise the government bond markets. My answer is ‘no’.

Why ESM will fail to stabilise government debt markets

The ESM has financial resources amounting to €500 billion. Compare this with the total government bonds outstanding of close to €2,000 billion in Italy and of about €800 billion in Spain and it is immediately evident that the ESM will be unable to stem a crisis involving one of these two countries, let alone the two countries together.

In fact it is worse. As soon as the ESM starts intervening, it will quickly destabilise the government bond markets in these two countries. The reason is the following.

Suppose a new movement of fear and panic, triggered for example by the deepening recession in Spain, pushes up the Spanish government bond rate again.

• To stem the tide the ESM starts buying Spanish bonds. Suppose it buys €200 billion worth of Spanish bonds.

At the end of the operation it will be clear for everybody that the ESM has seen its resources decline from €500 billion to €300 billion. Less will be left over to face new crises.

• Investors will start forecasting the moment when the ESM will run out of cash.

They will then do what one expects from clever people.

• They will sell bonds now rather than later.

The reason is not difficult to see. Anticipating the moment the ESM runs out of cash forcing it to stop its intervention, they expect bond prices to crash. To prevent making large losses, they will have an incentive to bring their bond sales forward to the present rather than wait until the losses are incurred. Thus the interventions by the ESM will trigger crises rather than avoid them.

This feature is well-known from the literature on foreign exchange crises. The classic Krugman model, for example, has the same features (Krugman 1969, see also Obstfeld 1994). A central bank that pegs the exchange rate and has a finite stock of international reserves to defend its currency against speculative attacks faces the same problem. At some point, the stock of reserves is depleted and the central bank has to stop defending the currency. Speculators do not wait for that moment to happen. They set in motion their speculative sales of the currency much before the moment of depletion, triggering a self-fulfilling crisis.

Only the ECB can stabilise bond markets

The only way to stabilise the government bond markets is to involve the ECB, either indirectly by giving a banking license to the ESM so that it can draw on the resources of the ECB (see Gros and Mayer 2010), or by direct interventions by the ECB. But the European leaders were unable (unwilling) to take that necessary step to stabilise the Eurozone.

The ECB is the only institution that can prevent panic in the sovereign bond markets from pushing countries into a bad equilibrium, because as a money-creating institution it has an infinite capacity to buy government bonds. The fact that resources are infinite is key to be able to stabilise bond rates. It is the only way to gain credibility in the market.

The SMP is the wrong precedent

The ECB did buy government bond markets last year in the framework of its Securities Markets Programme (SMP). However it structured this programme in the worst possible way. By announcing it would be limited in size and time, it mimicked the fatal problem of an institution that has limited resources. No wonder that strategy did not work.

The only strategy that can work is the one that puts the fact that the ECB has unlimited resources at the core of that strategy. Thus, the ECB should announce a cap on the spreads of the Spanish and Italian government bonds, say of 300 basis points. Such an announcement is fully credible if the ECB is committed to use all its firepower, which is infinite, to achieve this target.

If the ECB achieves this credibility it creates an interesting investment opportunity for investors. The latter obtain a premium on their Spanish and Italian government bond holdings, while the ECB guarantees that there is a floor below which the bond prices will not fall. (The floor price is the counterpart of the interest rate cap). In addition, the 300 basis points acts as a penalty rate for the Spanish and Italian governments giving them incentives to reduce their debt levels.

The ECB is unwilling to stabilise financial markets this way. Many arguments have been given why the ECB should not be a lender of last resort in the government bond markets. Many of them are phony (see De Grauwe 2011, Wyplosz 2011). Some are serious like the moral hazard risk. The latter, however, should be taken care of by separate institutions aimed at controlling excessive government debts and deficits. These are in the process of being set up (European Semester, Fiscal Pact, automatic sanctions, etc.). This disciplining and sanctioning mechanism should then relieve the ECB of its fears of moral hazard (a fear it did not have when it provided €1,000 billion to banks at a low interest rate).

Understanding the ECB’s reluctance

The deeper reason for the ECB’s reluctance to be a lender of last resort in the government bond market has to with its business model. This is a model whereby one of the ECB’s main concerns is the defence of its balance-sheet quality. That is, a concern about avoiding losses and showing positive equity – even if that leads to financial instability.

When the ECB was instituted, it was deemed necessary for that institution to issue equity to be held by the EU-governments. Thus the idea was created that in order to sustain its activities the ECB needed to obtain the capital of the member countries. This idea was reinforced in 2010 when a decision was taken by the Governing Council to raise the amount of capital by €5 billion. It is useful to read the justification of this decision: “Taking into account the increase of the ECB’s balance sheet total over the last years, it is considered necessary to increase the ECB’s capital by €5,000 million in order to sustain the adequacy of the capital base needed to support the operations of the ECB” (ECB 2010).

It is surprising that the ECB attaches such an importance to having sufficient equity. In fact, this insistence is based on a fundamental misunderstanding of the nature of central banking. The central bank creates its own IOUs. As a result it does not need equity at all to support its activities. Central banks can live without equity because they cannot default. The only support a central bank needs is the political support of the sovereign that guarantees the legal tender nature of the money issued by the central bank. This political support does not need any equity stake of the sovereign. In fact it is quite ludicrous to believe that governments that can, and sometimes do, default are needed to provide the capital of an institution that cannot default. Yet, this is what the ECB seems to have convinced the outside world.

All this would not be a problem were it not that the ECB’s insistence on having positive equity is in conflict with its responsibility to maintain financial stability. Worse, this insistence has become a source of financial instability. For example, in order to protect its equity, the ECB has insisted on obtaining seniority on its government bond holdings. In doing so, it has made these bonds more risky for the private holders, who have reacted by selling the bonds. This also implies that if the ECB were to take up its responsibility of lender of last resort, it will have to abandon its seniority claim on the government bonds it buys in the market.

What should be done?

The correct business model for the ECB is one that has it pursuing financial stability as its primary objective (together with price stability), even if that leads to losses. There is no limit to the size of the losses a central bank can bear, except the one that is imposed by its commitment to maintain price stability. In the present situation the ECB is far from this limit (Buiter 2008).

The creation of the European Financial Stability Facility (EFSF) and the ESM has been motivated by the overriding concern of the ECB to protect its balance sheet. This has been misguided. The enlarged responsibilities that are now given to the ESM are to be seen as a cover-up of the failure of the ECB to take up its responsibility of the guardian of financial stability in the Eurozone; a responsibility that only the ECB can fulfill.

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  1. tiebie66

    The idea that a CB has “infinite” fire power because it can create its own IOUs seems as misguided as the Solow-Stiglitz fallacy where capital and labor can infinitely substitute for natural resources (more bread can be baked without more flour, needing only a bigger bowl and faster stirring). Somewhere, finance must have purchase on the real economy. An “adequate” capital base may provide at least some link with reality. I fear the developed economies have entered a regime where attempts to restore financial stability with more credit creation and bond buying will only light a slow burning fuse and destabilize the real economy although it may temporarily stabilize the financial system. Nevertheless, I admit difficulty in articulating what I perceive as being problematic. Help appreciated.

  2. Hugh

    “The central bank creates its own IOUs.”

    Well yes, if this means it can create money. Central banks can create money and large amounts of it, with inflation being the only limiting constraint. This is a strange post because aside from this one apparent admission it shares the same neoliberal framework that Das uses in his writing. But if one accepts that a central bank of a fiat currency controls money creation, then who really cares about the bond markets? Why even have them at all? The ECB could simply back the individual country’s action. There would be no need for debt issuance and the ECB could even begin redeeming the outstanding bonds as they came due. Government bonds are just a subsidy to the rich. So why continue them?

    As for inflation due to money issuance, remember the ECB can control this by increasing its reserve requirements for banks.

    I mean this is pretty basic MMT stuff, and I am not even an MMTer.

    It’s important to understand that while this can be done it is insufficient. It doesn’t change the distribution of wealth in Europe. It doesn’t affect Europe internal trade patterns. It doesn’t restrain predatory banking and bankster gambling.

    As tiebie66 touches on above, there needs to be a return of money back to the actual producers in the economy and away from nonproductive rentiers. Money needs to be brought back into phase with production. Or to use my resource approach, resources need to be shifted to those who will actually use them to realize those goals of fairness and individual security and fulfillment which society has set for itself and its members.

    1. joebhed

      Very well said.

      The incongruity of the Euorozone seems to be that its ‘central bank’ doesn’t seem to know who its “bankers” are, when called on to act as its “bankers’ bank”.

      There being no European “nation”, the survivors of the present debt-driven fiasco can readily be either the banks or the EU member states as sovereigns, but not likely both as presently structured.

    2. Foppe

      I mostly understood Yves’s choice to post this as ‘look, Serious Persons are starting to realize the ECB’s mandate is kind of stupidly limited’..

    3. Susan the other

      Who needs a bond market anyway? That sounds like the question of the decade. And the very word “bond” is a fantasy because you cannot bond the impossible. So this article exposes the ECB as an anachronism. It is very Holy Roman Empire when you think about. Or Holy Roman without the Empire. Maybe a German affectation – altho’ I’m always in sympathy with Germany.

      In early medieval times all the German feudal princes reassured their subjects at harvest time. To prove the state of the principality was strong they dumped the barley harvest in a huge pile and a loyal knight rode his very large horse up to the top of the pile where it was proven that it was not a fake pile just covering up rocks and rubble. No. The proof was in how deeply the stallion sank. If he sank up to his testicles, the crowd was convinced and they remained loyal to the prince.

      Non sequitur here maybe. But the EZ does have enormous wealth.

      1. F. Beard

        Who needs a bond market anyway? Susan the other

        The banks and other financial institutions:

        The US government issues its own currency and, in intrinsic terms, never needs to fund its own spending in US dollars. The issuing of public debt is an entirely voluntary act by the US government and provides the bond markets with “corporate welfare”. Just imagine what the uproar would be from the bond markets and investment banks if the US government announced it was cutting off this source of corporate welfare.

        It happened in 2001 in Australia when the Australian government had virtually caused the official bond markets to dry up when it used the surpluses it was running to run down outstanding debt. The Sydney Futures Exchange led the charge and demanded that the Government continue issuing debt, which gave the game way – if debt-issuance was to fund net government spending (deficits) then why would they be issuing debt when they were running surpluses?

        Answer: it was patently obvious that the outstanding debt was private wealth and its risk-free nature allowed the private investment institutions to price other risky assets and maintain a safe haven when uncertainty rose (by holding bonds). from http://bilbo.economicoutlook.n… [emphasis added]

  3. jake chase

    Hard to imagine the Euro lasting much longer. Soon they’ll be fighting with sticks and clubs. Is it time to bet on Germany? Will the US save England and France again? Get your popcorn ready.

  4. Samuel Conner

    Hi tiebie66,

    I think that Professor De Grauwe is not claiming that the ECB’s formally infinite capacity to issue Euros is the solution to all the problems of the Eurozone. He is making the much narrower case that this capacity is the solution to the self-fulfilling investor fear that Euro-periphery sovereign bond spreads will blow out, leading to flight from those bonds and the blowout of spreads. As this would eventually lead to disorderly dissolution of the Eurozone and worsening of recession/depression in much of the world, ECB intervention to stabilize the finances of the Euro periphery nations is something worth hoping and arguing for. But it is only a partial fix. The underlying problems of the economies would remain.

    The large and important long-term problem of productive uses of real resources is not in view in Prof De Grauwe’s post, though it seems likely that in the depression that would follow a disorderly Eurozone breakup, productive economic activity would be further impaired in much of the world. Even regarding this concern, there is, arguably, from the MMT perspective a useful role for the Central Bank to play in financing fiscal operations of the associated national government(s). You might find the Prof Randall Wray’s MMT Primer at the New Economic Perspectives weblog of interest, particularly the parts toward the end that discuss the role of the Job Guarantee/Employer of Last Resort function of the fiscal authority in the MMT framework.

    I hope that’s helpful.

    1. tiebie66

      Thank you, thanks also to Hugh. I will follow on with the MMT primers. Nevertheless, a nagging confusion is the feedback loops between finance and the real economy. Prof. De Grauwe addresses the psychological impact of soaring bond yields and getting the ECB to counter this with buying as you point out. But this must have real-world, in addition to fincancial, consequences. Yields rise due to worries about the real economy, then yields rise because yields are rising and expected to rise more. Countering the self-reinforcing feedback does nothing to fix the underlying problems – the partial fix that you refer to. But my worry is that the partial fix, that is, addressing the financial problems, have adverse, rather than no consequences, on the real economy. It also has adverse consequences for the financial system (moral hazard, but maybe there are others), I suspect.

  5. jsmith

    Dear Sirs:

    Please allow me to translate this piece that appeared on your blog:

    blah blah blah…give more money to the banks and not the people…blah blah blah…


    Hon. O. Bvious
    63 Somerset
    High Peak

    1. docG

      “blah blah blah…give more money to the banks and not the people…blah blah blah…”

      You got it! That’s it precisely. But we hear comments of this sort all the time and clearly they’ve done no good and will continue to be little more that futile gestures. The plutocrats are in full control and there is no power on earth that can stop them

      Save one. The people themselves:

      1. GCT

        DocG the reason you hear this is most including myself do not agree with MMT. Everytime we tyr to discuss it or try to learn it most MMTers do exactly what you just did. You cut off the communication. Currently under treaty in the Eurozone MMT will not work as you are not dealing with a fiscal and government union. You are dealing with soverign countries that do not want to continue to bailout countries that honestly will not meet their obligations at all.

        Frankly I do not blame Germany for not wanting to keep bailing them out. We tend to make Germany the bad guy and if you look at the contribution tables they contribute the most.

        Honestly the whole system is built on greed and corruption. This is from top to bottom. Most MMTer’s, not all, get upset when we do not agree with you. I understand MMT and MMR very well but that does not mean I have to agree with it. I do agree the USA is not fiscally constrained because they can print and control the currency, but if a country is fiscally constrained and not meeting their obligations set forth in treaties why should I in another country bail them out or continue to bail them out?

        1. Hugh

          “if a country is fiscally constrained and not meeting their obligations set forth in treaties why should I in another country bail them out or continue to bail them out?”

          The standard answer in the European case would be that you are not actually bailing out Southern countries, you are bailing out your own banking sector. Most of the money that Northern governments send south turns around and heads straight back north to pay debt held by Northern banks.

          If you look at this in terms of 99%s, the 99%s of the South are not being bailed out, they are suffering under greater and greater austerity and worsening economic conditions. The 1%s in the South can take their loot from their Ponzis and not paying taxes and send it to the North. The 99%s of the South are stuck with the bill for being looted by their 1%s. But the story doesn’t end there. Because the backdoor bailout of the Northern banks is not for the benefit for the Northern 99%s either. It’s to keep the banks bondholders (the Northern 1%s) whole are as close to as possible.

          The genius of class war is to turn natural allies into adversaries and in doing so distract both from their real enemies. German, Spanish, Greek, etc. 99%s have much in common with each other. They are all being looted by their 1%s. And that is the key realization that needs to happen. It really isn’t about North-South. It is 99% vs 1%.

  6. gerold k.b. weber

    This is once again an important piece by Professor De Grauwe. It explains why the ECB doesn’t have the same power to fight for financial stability as the Fed, the Bank of Japan, or the Bank of England.

    Also his proposal of an interest rate cap for Eurozone government bonds deserves to be supported as it would give some urgently needed breathing space to hard fighting Eurozone periphery countries.

    But ultimately credit and debt (money matter and antimatter) will be destroyed when debtors can’t pay off the principal (see Minsky’s speculative and Ponzi finance). What is proposed at this site (Michael Hudson, Yves Smith) are modes of debt destruction which don’t once again redistribute wealth from bottom to top, only to extend the weak economy.

    Some ‘euthanasia of the cumulative oppressive power of the capitalist to exploit the scarcity-value of capital’ (Keynes) should be unavoidable, as a lot of accumulated financial wealth no longer serves a social function.

    1. Jim

      The reason for ECB inaction lies in your comment.

      The US, Japan and the UK are sovereign countries, currency issuers.

      There is no United States of Europe. Why is that so difficult for people to comprehend.

      Unless, gerold k.b. weber, you expect a United States of Euorpe to be the endgame, complete with one team representing the United States of Europe in the Olympics and World Cup.

      If so, I would appreciate those proponents of ECB action to plainly state that they believe this, that they no longer believe in the sovereignty of the nations comprising the Eurozone.

      Also, I’d like to add that the UK has become the premier nation of the continent of Europe, largely because of Thatcher’s refusal to cede monetary sovereignty. Five years ago, who would have believed that the UK ranks above Germany in intl prestige?

      1. gerold k.b. weber


        I believe that even in the case of a United States of Europe (USE) we might have an ECB which operates differently than the Fed, BoJ, and BoE and has less power to fight the crisis.

        De Grauwe’s analysis helped me to understand some positions which are taken by Eurozone central bankers. As a citizen of one Eurozone country (Austria) I think we need to assess in a self-critical way the modus operandi of our central bank, independent of the question of a USE which per se will solve nothing.

        De Grauwe’s contribution fits exactly in that category, IMHO.

    2. Yves Smith Post author

      Um, you seem to miss that extinguishing or renegotiating debt DOES amount to wealth redistribution.

      1. gerold k.b. weber

        No, I don’t miss that. And I wrote that at this site (nakedcapitalism) modes of debt destruction were proposed which don’t redestribute wealth from bottom to top, like Michael Hudson’s call for a ‘debt jubilee’, or your call for more debt restructurings and writedowns for US mortgage debt. From my point of view such proposals should be supported.

        This is also the case for proposals by Steve Keen and Steve Randy Waldman to create money per citizen to pay off private or sovereign debt. I like them both, as they are effective and arguably comply with distributive justice.

        It would be interesting to have a more systematic discussion by which means certain types of debt could and should be extinguished or at least relieved, to get a better understanding of the pros and cons of varying proposals.

        Such a discussion should include debt-to-equity conversion for ‘casino debt’ of financial institutions, and Eurozone sovereign debt.

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