I have received a lot of E-mails over the weekend about a paper released by the CEPR Policy Portal VOX (June 20, 2015) – Can central banks avoid sovereign debt crises? – which purports to provide “new evidence” to support the conclusion that “the ability of the central bank to avert a debt self-fulfilling debt crisis is limited”. It is another one of those mainstream attempts to brush away reality and draw logical conclusions from a flawed analytical framework. When one digs a bit the conclusion withers on the vine of a stylised economic model that leaves out significant features of the monetary system – such as for starters, a currency-issuing government can never go broke in terms of the liabilities its issues in its own currency. All the smoke and mirrors of stylised New Keynesian mathematical models cannot render that reality false.In other words, the paper and the lineage of papers it draws upon should be disregarded by anyone who desires to understand how the monetary system operates and the capacity and opportunities that the currency-issuing government (including its central bank) has within that system.



The motivation for the VOX article is the observation that “the sovereign debt crisis that has impacted European periphery countries since 2010” has arisen because of “self-fulfilling sentiments”.

What does the jargon mean? Self-fulfilling expectations simply means if people believe something will happen and act accordingly then their actions drive the belief to realisation.

In this context, the authors claim that:

If market participants believe that sovereign default of a country is more likely, they demand higher spreads, which over time raises the debt level and thus makes eventual default more likely.

Applied to the Eurozone situation since the onset of the crisis, it is difficult to disagree with the contention.

Bond spreads (between the ailing nations and the German bund) have variously widened over this period as the bond markets feared an exit was coming or some default was imminent.

But as the authors note, the same dynamics have not been observed outside of the Eurozone and they cite sources that attribute this “to the fact that the highly indebted non-Eurozone countries have their own currency”.

There is no rocket-science involved there.

They also recognise that the Eurozone spreads declined rapidly “since mid-2012” when there was “a change in ECB policy towards explicit backing of periphery government debt”.

They should have actually realised that the ECB saved the Eurozone from collapsing much earlier than mid-2012.

When the Greek government effectively lost access to the private bond markets in early 2010, it was almost certain that they would have to default on their maturing liabilities and exit the Eurozone.

The fears were that the Greece exit would be the first domino of several to fall.

Further, given the exposure of the big French and German private banks to Greek government debt and the linkages between these banks and other banks throughout the European financial system, it was also considered likely that a default would trigger a general financial collapse.

There were mixed views on this among the political elites in Europe.

While the doomsday claims about the consequences of a Greek exit were nonsense (and remain so today) and designed to advance the neo-liberal agenda of the elites, there is no doubt that the integrity of the Eurozone was under threat in early 2010 as the Greek government approached insolvency.

Moreover, the bailout programs that we being discussed were never going to be sufficient to ensure Greece or any other nation remained solvent.

Given the structure of the monetary system, it was obvious that a major ‘fiscal-like’ intervention was going to be required to keep the nations solvent in the face of growing private bond market uncertainty and withdrawal.

But while the ratings agencies, whose behaviour leading up the GFC had been exposed as incompetent and corrupt by US Congressional hearings, were circling with downgrades and issuing all manner of spurious briefings about likely insolvency to investors, it became obvious in May 2010 that the ECB would use its ‘currency issuing’ capacity to ensure no Member State became insolvent.

Effectively, a massive ‘fiscal operation’ was introduced, seemingly in violation of the Treaty rules. But, without any doubt, it saved the Eurozone – for the time being.

On May 14, 2010, the ECB established its Securities Markets Program (SMP), which opened the possibility that the ECB and the national central banks could:

… conduct outright interventions in the euro area public and private debt securities markets.

See – Decision of the European Central Bank of 14 May 2010 establishing a securities markets programme.

[Full reference: European Central Bank (ECB) (2010b) ‘Decision of the European Central Bank of 14 May 2010 establishing a securities markets programme’, Official Journal of the European Union, L 124/8, May 20, 2010]

What did that decision mean. It was central bank-speak for buying government bonds in the so-called secondary bond market in exchange for euros, that they created out of ‘thin air’.

Government bonds are issued to selective tender in the primary bond market and then traded freely among speculators and others in the secondary bond market.

The SMP also permitted the ECB to buy private debt in both primary and secondary markets. To understand this more fully, the decision meant that private bond investors (including private banks) could off-load distressed state debt onto the ECB.

The action also meant that the ECB was able to control the yields on the debt because by pushing up the demand for the debt, its price rose and so the fixed interest rates attached to the debt fell as the face value increased.

Competitive tenders then would ensure any further primary issues would be at the rate the ECB deemed appropriate (that is, low).

The following graph shows the history of the SMP program, which was formally replaced on September 6, 2012 when the ECB introduced the ‘Outright Monetary Transactions (OMT)’ program.

The bars show the weekly debt purchases while the line shows the cumulative asset holdings associated with the program (in billion of euros).

Clearly the ECB accelerated their purchases at times when the difference between the yields on some Member State government bonds against the benchmark bond, the German bund (the ‘spreads’) were widening significantly.

The initial spike from May 2011 was associated with the escalation in spreads on bonds issued by Greece, Ireland, Portugal and Spain.

The second, larger acquisitions began in August 2011 and were mostly associated with the sharp rise in the spread on Italian government bonds, which went from 1.5 percentage points in April 2011 to a peak of 5.2 percentage points in November 2011.

The large-scale ECB buying stabilised the spreads by the end of 2011. Given the size and importance of the Italian economy to Europe, the ECB was clearly not going to allow the Italian spreads to rise as quickly or as far as the Greek spreads had risen.

Of-course, the later bailouts effectively allowed the Greek government to ignore the bond markets, which meant that the size of the spreads were moot anyway.

After the SMP was launched, a number of ECB’s official members gave speeches claiming that the program was just part of the normal weekly central bank liquidity management operations which was spin in the extreme.

Of course, they were trying to disabuse any notion that the ECB was funding government deficits. This was to quell criticisms, from the likes of the Bundesbank and others, that the program contravened Article 123 of the Treaty of the European Union.

Whatever spin one wants to put on the SMP, it was unambiguously a fiscal bailout package. The SMP amounted to the central bank ensuring that troubled governments could continue to function (albeit under the strain of austerity) rather than collapse into insolvency.

Whether it breached Article 123 is moot but largely irrelevant.

The SMP reality was that the ECB was bailing out governments by buying their debt and eliminating the risk of insolvency.

The SMP demonstrated that the ECB was caught in a bind. It repeatedly claimed that it was not responsible for resolving the crisis but, at the same time, it realised that as the currency-issuer, it was the only EMU institution that had the capacity to provide resolution.

The SMP saved the Eurozone from breakup.

So unlike the VOX author’s contention it was not the 2012 “whatever it takes” announcement by ECB boss Mario Draghi that saved the day. That was just a more explicit recognition of what they had been doing since May 2010 – using its currency issuing capacity to ensure no government became insolvent.

The VOX authors note that:

While it is certainly possible for a central bank to adopt a policy that avoids a self-fulfilling default equilibrium, such a policy needs to be credible. If it is credible, it would not even be necessary to actually implement the policy.

This is now mainstream economist-speak. Credibility has nothing to do with the capacity of the central bank to eliminate the risk of government insolvency.

Whether the private bond markets believe that the central bank has that capacity is irrelevant. They soon see it in the trading realities of the secondary bond markets when they keep getting outbid for bonds by the central bank that always has a superior purchasing capacity.

They see it when yields that they would like to rise (to reflect risk or greed) stay low because the central bank demonstrates its unflinching commitment to control rates – as it only can in a modern monetary system.

So belief soon adjusts to reality. Remember that in a fiat currency system with no convertibility (into gold etc) and no fixed exchange rate arrangements in place, it is the currency issuer that is in ‘charge’ not the bond market dealers.

The latter are supplicants at best, beggars who want their dose of corporate welfare. They have no power against the currency issuer.

Please read my blog – Who is in charge? – for more discussion on this point.

In a sort of begrudging way the VOX authors acknowledge all that but then bring in the usual neo-liberal scaremongering by saying:

A central bank could always surprise debt holders by creating inflation or could buy large amounts of government debt by printing money. But how high should inflation be? And how easy is to create surprise inflation when prices are rigid? If the required inflation is too high, investors will not believe in such a commitment and the ‘bad’ equilibrium could not be avoided. In the end, this is a quantitative question that requires a reasonably realistic model.

Which explains why inflation is so ‘high’ (not) in the US, Japan, etc as the balance sheets of the central banks have grown in multiples since the crisis.

Please read the following blogs – Building bank reserves will not expand credit and Building bank reserves is not inflationary – for further discussion.

Once again, the capacity of the central bank to eliminate the possibility of a “bad equilibrium” (which means a government not being able to borrow from the private markets sufficient funds to cover its deficit), is not dependent in any way on whether private bond investers believe anything.

It is also not a “a quantitative question that requires a reasonably realistic model” at all. The most realistic model is known in fine detail. It is the real world of currency issuers.

In that world, if a central bank acts according to its capacity the corresponding government or in the Eurozone, governments – can never go broke. No analytical model – New Keynesian – or otherwise is required to establish that fact.

Of course, that reality escapes the authors who had been reading a paper – Slow Moving Debt Crises – by two US-located academics.

The paper is an example of GIGO – garbage in, garbage out.

It aims to explore “What circumstances or policies leave sovereign borrowers at the mercy of self-fulfilling increases in interest rates”.

I wouldn’t bother reading (or attempting to read) it if you like to spend your time productively. Unfortunately, as an academic I have to waste time reading things like this – it is part of the job. Experience means I minimise the time wasted though which was not the case when I started out – a lost ‘youth’.

Their New Keynesian ‘model’ invokes all sorts of assumptions to make the mathematics tractable and to establish their prior ideological position that “slow moving crises” can “be avoided … whenever debt is low enough”.

Maybe they should stop squiggling for a while and wonder about Japan!

Many of their assumptions are just conveniences rather than an attempt to capture reality. For example, they say “making fiscal policy endogenous is desirable, it may be difficult to capture in stylized optimization problems a number of constraints and biases coming from the political process.”

In other words, the real world is too difficult for the type of mathematical tools and framework they are trapped within.

Essentially, the paper constructs the government as a beggar who has to rely on the private bond investors for money and “default occurs only if the surplus and potential borrowing are insufficient to refinance outstanding debt.”

They squiggle away for page after page defining things such as “maximal debt capacity” which really just result in some expression that says the government will default when some condition is met.

They never once ask the question: What are the capacities of a sovereign, currency-issuing government?

If they did, and could answer the question properly, they would realise their efforts were a waste of time.

This is worse than digging holes and then filling them in again by way of productive work effort.

But after 44 tortured pages they get to their conclusion that “Our results highlight the importance of fiscal policy rules and debt maturity in determining whether the economy is safe from the threat of crises.”

Yes, in the land of never never which bears no relation to the real world that we all live in and in which currency issuing governments can never go broke irrespective of the level of debt they are carrying or the size of their deficits.

But the VOX authors use this ‘model’ as their starting point, which means their end point becomes irrelevant too.

Their New Keynesian model ends up with very high inflation as the central bank goes on a bond buying spree. Once again, they should look around and attempt to understand recent history.

They should also understand that building reserves in the banking system is not an inflationary act. If it was, Japan would be following Zimbabwe down the drain – and would have done so before Zimbabwe led the way.

Reality has a way of enforcing us to ask questions about the type of frameworks and the predictions forthcoming from those frameworks.

There is nothing worthy in the New Keynesian frameworks. They failed to foresee the crisis and more extreme versions led to the belief that the business cycle was dead!

Conclusion

So their substantive conclusion:

The ECB would be powerless if there were a broad sovereign debt crisis across the Eurozone, in the same way that the Fed or Bank of Japan would be powerless to credibly avoid a self-fulfilling debt crisis in their countries.

Is plainly false.

The ECB could buy all the government debt issued and could then announce that it would credit the various treasury accounts with funds to match the deficits at will.

The inflation risk would result not from the ECB monetary operation but from the public spending growth if it exceeded the real capacity of the economy to produce goods and services in response.

But if these nations were already at full employment – then there would be no reason to expand the deficits anyway and the existing fiscal parameters would be deemed appropriate.

That is, that spending growth would, in conjunction with the non-government spending growth be sufficient to productively deploy all the available productive resources.

That is enough for today!

(c) Copyright 2015 William Mitchell. All Rights Reserved.