Why this Liquidity Deluge? Are Europeans Meant to Swim Their Way out of the Great Recession? Fabio Sdogati 1 London, 22 March 2012 Preliminary and incomplete Prepared for the Mip Alumni London Chapter. Please do not quote without the author’s permission. 1 Department of Management, Economics and Industrial Engineering, Politecnico di Milano, [email protected]and www.scenarieconomici.com. I wish to thank Luca Macedoni, Andrea Rongone and Giacomo Saibene for very competent research assistance, as well as for the opportunity to discuss the theses put forward in this paper. Still, I am entirely responsible for any shortcomings.
Transcript
Why this Liquidity Deluge?
Are Europeans Meant to Swim Their Way out of the Great Recession?
Fabio Sdogati1 London, 22 March 2012
Preliminary and incomplete Prepared for the Mip Alumni London Chapter. Please do not quote without the author’s permission.
1 Department of Management, Economics and Industrial Engineering, Politecnico di Milano, [email protected] and www.scenarieconomici.com. I wish to thank Luca Macedoni, Andrea Rongone and Giacomo Saibene for very competent research assistance, as well as for the opportunity to discuss the theses put forward in this paper. Still, I am entirely responsible for any shortcomings.
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Summary
The current crisis was revealed to the European public on August 7, 2007. 2009 is the worst year on record. The worst so far, that is, since we know 2012 will be bad but cannot tell just how bad. Since we are among those who believe that economic policies are there to counteract crises and jump-starting the economy (any economy) is possible, in this paper we ask whether policy mixes adopted over the last four years have been effective and, if not, why that was the case. We find that, generally speaking, only in the second half of 2008 and early 2009 appropriate policy mixes were adopted by most countries, and that ever since the European policy mix has not been directed at reviving aggregate demand. To put it differently: 1. Why is such a brutal recession being forced on the European people? The evolution of the monetary-fiscal policy mix over the last four-and-one half years shows that a re-starting of the real economy was an issue in 2008, but it has never been one since. On average, European governments have been running, and pledge to run in the foreseeable future, very aggressive recessionary fiscal policies; the ECB has adopted an inadequate (from the real side of the economy point of view) monetary policy easy to a degree never seen before, despite there is abundant evidence that monetary policy is not working. 2. How will the liquidity held by financial and non-financial firms alike find its way back into the economy? I submit that the combination of immense amounts of liquidity held by banks and contractionary, debt-reducing policies are the proper policy combination to ensure that sufficient liquidity will be available to finance the coming wave of privatizations and state-owned property sales –apparently, the only way European policy makers can think their way out of the recession.
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1. Monetary and Fiscal Policy Mix, 2007-2009
It may not be irrelevant to remember that the current recession dates all the way back to the
difficulties that many commercial and investment banks were finding themselves in already in
2006. Those difficulties came to the European public’s attention on August 7, 2007, when BNP
Paribas called a press conference to announce that three among its mutual funds were no longer
solvent.2 As time went by the ‘subprime crisis’, as the problem was called in the early days,
became a ‘credit crunch’, then a ‘Great Recession’ and finally, on October 22, 2009 a ‘sovereign
debt crisis’. How did this all come to happen?3 The transition from a private debt crisis to a public
debt is not a straightforward, obvious thing to happen if one thinks, as many like to do, of market
forces leading to a new equilibrium following a given shock. What roles did policies play in the
process leading to that outcome?
When, in early August 2007, the problem was made apparent to the man in the street, the
reaction by monetary policy authorities throughout the world was generally remarkable for both
speed and size. Remarkable for the standards of the time, that is. And, in my view, appropriate.
Figure 1 documents the size of the easing when measured by discount rate intervention, while
Figure 2 when measured by the size of the central banks’ balance sheets. The Federal Reserve
started cutting its discount rate already in the Summer of 2007, followed in turn by the Bank of
England, while the European Central Bank maintained a rather less flexible monetary policy stance
all the way up to the Lehman Brothers ‘event’ in September 2008. Since then, panic started to
prevail in world financial markets and it seemed that no interest rate cut would be enough –
though we were not blessed with a compelling explanation of why such was the case. To prevent
the financial system from collapsing, the monetary authorities increased the size of their balance
sheets to an extent never seen before, nearly doubling their assets and liabilities, thus acting as a
proper lender of last resort to banks.
2 Of course, the American public had been made aware of the situation already in the Spring when, for instance, Bear Sterns difficulties were the talk of the day. 3 I shall not be dwelling with the origins of the crisis, it being a subject amply treated in the literature. I will restrict myself to mentioning the coincidence that may be said to have constituted an excellent culture for the following four ‘causes’ to produce the crisis: 1. The growing reliance of the US Federal deficit on Chinese (most emerging economies, really) financing, circa 1994-2007; 2. Progressive deregulation of the banking industry all the way to total abolition of the remaining rules in late 1999; 3. Rampant financial innovation procedures (also known as ‘financial engineering’) not submitted to screening by the regulator –and not ‘submitted-but-not-understood’, as some would have it, circa 1985-to date; 4. The expansionary monetary policy initially adopted to counteract the 2000-2001 ‘dotcom crisis’ first and the 9/11 shock after that.
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Figure 1. Discount rates of three major central banks, Jan 2007 – Jan 2009 (monthly averages)
Source: Federal Reserve, European Central Bank, Bank of England
Figure 2. Total assets/liabilities of three major central banks, Jan 2007–Dec 2009
Source: Federal Reserve, European Central Bank, Bank of England
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Indeed, that was good policy making. When, for whatever reason, banks begin refusing
each other liquidity, the immediate duty of the lender of last resort is to supply liquidity to prevent
the interbank market from suddenly drying up, interrupting thus the flow of funds from lender to
borrower. There were ample and abundant discussions about the size of the intervention, its forms
(a very technical issue, a fact which did not deter most commentators from contributing views of
their own), even its timing, but the substance and the policy objective was never really discussed:
banks had to be ‘saved’.4
It is remarkable that vis-à-vis such important, frequent, and widespread injections of
liquidity, relatively few were the vestals of monetary orthodoxy who raised the issue that monetary
expansions would be inflationary –in the long run, of course. The Financial Times itself,
traditionally an alert guardian of such orthodoxy, abandoned the traditional caution. But, we were
writing already at the time, inflation was nowhere to be seen, nor would it be seen for a long while
–a prophecy that, four years hence, we are still proud of.
Thus, many were those who believed that an aggressively expansionary monetary policy
could be sufficient to save the banking industry; yet, it was looking like everybody believed that an
impending, already perfectly foreseeable recession could be defeated, and growth returned to,
only with the adoption of expansionary fiscal policies. How did that idea spring to life, how did the
world move from a monetary policy-only approach to a dual approach?
Over the second half of 2007 the ultimate objective of the authorities was to save the
financial system no matter what, using the guns of monetary expansions. But, not very
surprisingly, the real economy was beginning to show sign of growing weakness: lenders were
suspicious of all types of risk and, progressively, they began withdrawing financing not just from
one another, but from the real economy as well. Thus, signs of slowing economic activity were
surfacing already at the end of 2007 (Figure 3).
4 It is true, however, that in the US a movement appeared to be getting traction which was harshly criticizing such a goal which, it submitted, would have been more appropriate to substitute for with a ‘save the mortgage holders’ one. In other words, a movement thinking that priority ought to be given to the real economy, rather than to the financial superstructure. Nothing of the sort was taking place in Europe.
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Figure 3. Real GDP growth rate, quarter by quarter, from 2Q07 to 3Q08, in France, UK, Italy, and the US
Source: OECD and U.S. Bureau of Economic Analysis
It is at this point in time that we saw the emergence of a rather unusual form of
cooperation between the Us Treasury and the Fed as, beginning in the early Spring of 2008
straight, pure expansionary monetary policy was being gradually accompanied by increasing doses
of fiscal policies. But it was a rather ‘strange’ form of fiscal policy, bearing little or no resemblance
to what we were (and still are) accustomed to encountering in macroeconomics textbook: in short,
public spending was not aimed at stimulating demand for goods and services, that is, aimed at
anti-cyclical expansions of the orthodox Keynesian brand. Rather, the Treasury, with the support
of the Fed, was asking Congress funding to buy, and/or salvage, and/or subsidize, and/or
nationalize financial firms: Why some of those firms were made fail, while others were nationalized
and others still made be bought by other financials was, and still is, a much debated issue, but it is
one of scarce relevance for our purposes. What matters here is that the couple Bernanke-Fed and
Paulson-Treasury was breaking one the most treasured (!) pillars of economic policy doctrine, that
of the independence of the two authorities from one another. Forms of intervention were
increasingly innovative and unorthodox. We witnessed all manner of free-market-rules being
disposed of in no time: the sale of Bear Sterns and Merrill Lynch, basically managed by the
Government; the same Government’s refusal to adopt a similar, if not identical, solution for
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Lehman Brothers; and then again the end of investment banks, the nationalization of AIG. And, to
top it all, we saw a central bank actually acting as the lender of last resort to investment banks
and accept toxic assets as a collateral. A world came to an end.
How effective was this ‘policy mix’? Well, if we judge it from the point of view of the all-
important question on the table -that is, was it able to insulate real economic activity from the
financial (lack of) one?, the answer is a resounding no. 2008 is the year when all the pieces for a
Great Recession are getting together. And, obviously, 2008 is the time when governments all over
adopt proper expansionary fiscal policies to counteract the negative cycle started by the credit
crunch (Figure 4).
Figure 4. 2008 fiscal stimuli enacted to counter the crisis and public deficits 2009 and 2010 (% of GDP)
Sources: Gallagher, Kevin P., et al., Survey of Stimulus and IMF Rescue Plans During the Global Financial Crisis; and IMF, WEO Database, April 2010.
Notice that in 2008 there is no talking of excessive public deficits or debts: private (read
banks) debts are the issue. Vis-à-vis the need to intervene in order to stave off what was feared
would be a worldwide recession, the virtues of laissez faire are forgotten everywhere. More
cautious than it needs be on the basis of facts are the governments of Europe, though not
cautious enough to satisfy the remaining (at the time) few vestals of fiscal austerity; in short, the
perception that the world economy is running a great danger is spreading fast.
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It is in November 2008 that the Chinese government adopts deficit-spending policies for a
total amount of $586 Bln, a whoppy 16% of GDP. And the Us? Many will remember that in
November 2008 President Obama had won the presidential elections, but had not taken office yet;
thus, Bush was the president in charge, but he could not very well ask Congress for deficit
spending authorizations two months before his mandate was up. Thus, it will be only in February
2009, right after the new president will have taken office, that Congress authorizes a $787 Bln
deficit for fiscal 2009, a modest (!) 5,6% of GDP5. Thus, it would appear as though in the first half
of 2009 very few were those clamoring against governments engaged in deficit spending as
opposed to those ‘balanced budget’ policies they had been favoring for years. Again, the Financial
Times was maintaining that, sooner or later, the world should go back to more traditional budget
policies but, please, not yet, or the very mild recovery we were witnessing would risk being
chocked.
And what about monetary expansions? Had they been replaced by deficit spending? Not at
all. On November 6, 2008 I wrote a piece I titled “Why this Liquidity Deluge?”
(www.scenarieconomici.com). It was a time that the press had dubbed ‘The great expansion’: the
Bank of England had just cut its official bank rate by a virtually unprecedented 150 (one hundred
and fifty!) basis points; the Swiss National Bank had followed shortly thereafter with a ‘modest’ 50
bp cut; and even the ECB followed suit with a 50 bp cut of its own main refinancing rate. Why all
the easing? Still, fifteen months after that seventh of August 2007? And with all the evidence one
might ever desire there to show that easing did nothing for real activity?
Lovers of the theory according to which monetary expansions are the next best things to
miracles when it comes to re-starting an economy chocked by the worst credit crunch on record
will, of course, reject the relevance of those questions on the basis of the following line: if credit
doesn’t get to the shop floor, obviously it is because it is too expensive. And the more
sophisticated among them will add that it is the real interest rate that matters, that is, current
nominal interest rates deflated, or inflated, inflated (by some sort of) rational-expectation-
generated expected inflation rate. While it is our deep-seated belief that numbers prove little
when they are not asked a specific question, let us take a look at the evolution of the balance
sheets of the three major central banks (Figures from 5.1.1 to 5.3.2).
5 While the Chinese government has chosen to aim most of expenditures to infrastructure and their maintenance, the Us government’s deficit is made up of smaller revenues and larger expenditures, a fact which well reflects the balance of power in the Us Congress at the time.
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Figure 5.1.1. European Central Bank, Total Assets, 8 March 2006 – 7 March 2012 (billions of euro)
Source: European Central Bank (Note: MPOs=Monetary Policy Operations, which include MROs and LTROs)
Other assets General government debt denominated in euro Securities of euro area residents denominated in euro Other claims on euro area credit institutions Lending to euro area credit institutions related to MPOs Claims on non-euro area residents denominated in euro Claims on euro area residents denominated in foreign currency Claims on non-euro area residents denominated in foreign currency Gold
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Figure 5.1.2. European Central Bank, Total Liabilities, 8 March 2006 – 7 March 2012 (billions of euro)
Source: European Central Bank (Note: MPOs=Monetary Policy Operations, which include MROs and LTROs)
Capital and reserves Revaluation accounts Other liabilities Counterpart of SDRs allocated by the IMF Liabilities to non-euro area residents, in foreign currency Liabilities to euro area residents, in foreign currency Liabilities to non-euro area residents, in euro Liabilities to other euro area residents, in euro Debt certificates issued Other liabilities to euro area credit institutions Liabilities to euro area credit institutions related to MPOs Banknotes in circulation
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Figure 5.2.1. Federal Reserve Bank, Total Assets, 8 March 2006 – 7 March 2012 (billions of dollars)
Source: Federal Reserve
Figure 5.2.2. Federal Reserve Bank, Total Liabilities, 8 March 2006 – 7 March 2012 (billions of dollars)
Reserve balance with Federal Reserve Banks Other liabilities and capital Funds from AIG, held as agent Deposits with F.R. banks, other than reserve balance Treasury cash holdings Reserve repurchase agreement Currency in circulation
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Figure 5.3.1. Bank of England, Total Assets, 7 June 2006 – 7 March 2012 (billions of sterling)
Source: Bank of England
Figure 5.3.2. Bank of England, Total Liabilities, 7 June 2006 – 7 March 2012 (billions of sterling)
Other assets Standing facility assets Bonds and other securities acquired via market transactions Ways and Means advances to HM government Long-term sterling reverse repo
Notes in circulation Reserve balances Short-term open market operations Standing facility deposits Foreign currency public securities issued Cash ratio deposits Other liabilities
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It is easy to see that liquidity injected into the system has increased systematically, though not at
uniform rates over different sub-periods; it has increased systematically, though not in a visibly
internationally coordinated manner; it has increate systematically, even though the ‘monetary’
policy tools differ from central bank to central bank.
On the assets side: the ECB, abruptly increased its holding of securities and lending to
credit market institutions just after the collapse of Lehman. Similar procedures were also adopted
by the Federal Reserve, which increased its credits against depository institutions (mainly
consisting of both Us Treasury securities and mortgage-backed securities), and by the Bank of
England, which hugely increased its ‘other assets’ holding (consisting of loans to its subsidiary
company, the Bank of England Asset Purchase Facility Fund, the operational arm of the Bank of
England that purchase securities on the financial markets on its behalf).
On the liability side: it is impressive how sharp the increase in reserve balances held at all
the three major central banks by commercial banks has been. By definition, the reserves balances
constitute the monetary base (M0 or narrow money) – a high quality liquid asset for commercial
banks to hold – that can be used by commercial banks to make payments and issue credit to their
customers. However, it seems that commercial banks are not at all increasing their reserve holding
so as to extend credit to the economic system; in fact, reserve holding are mainly seen as a safe
asset whose major value is to provide liquidity in case of need.
2. Monetary and Fiscal Policy Mix, 2009-2012
Let me risk being perceived as repetitious and say, once again, that only four years ago there was
no ‘sovereign debt crisis’. The economic policy issue was easy to identify and easy to deal with:
there was a credit crunch, everybody was suffering, financial and non-financial activities alike, and
the priority was to keep ‘the markets’ liquid. Unlike now, there was not a damn government
sucking in all that ‘capital’ and letting nothing available for businesses! So, perhaps back then one
was justified asking why liquidity was not trickling down to the real economy. But today?
Well, today things are different, today we have sovereign debts. Excessive ones. So says
Fitch on October 22 2009, apropos the Greek government. And so we will be told time and again
by the likes of Fitch about Portugal, Ireland, Spain, Italy, Austria….. well, yes, with time we will be
revealed that even the Austrian government is not immaculate!
Which amounts to saying that at least since October 2009 aggressively expansionary monetary
policies are finally fully justified. Banks are happy, and especially so since the end of 2011: three
years scot-free to play with one trillion € is no minor deal; governments are happy: banks are
buying government debt again and bond-to-bond spreads are coming down –yet a little bit of help
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to make servicing the debt in the future a little bit less traumatic for the most–aggressively
attacked governments; the ECB ought to be happy: its reputation re-established, its ability to ferry
the banking industry to at least early 2015 asserted6.
Let us simply ask: a dramatically expansionary policy justified relative to what end?
There is an old-honored question a certain part of the economics profession often asks of itself
which goes something like ‘You can bring the horse to the water, but you cannot force it to drink
it.’ In other words, why this deluge of liquidity, given the credit crunch is there for the better part
of five years now? Things must have gone wrong somewhere, if the assertion one hears from the
‘chattering classes’7 nowadays is: ‘there is a lot of water out there, but none of it safe to drink’.
To see the point, let us just remember that central banks inject into ‘the system’ not just
any water, but rather the water itself. Which can be absorbed by the system of commercial banks
and financial intermediaries in general and nobody else: manufacturers are not invited into open
market operations, nor are housewives, barbers or engineering consulting firms. And it is not a
matter of dispute that banks have been drinking every last drop of liquidity central banks have
thrown at them, all the way up to the latest, so-called ‘Long Term Refinancing Operations’, a
February 29 ECB handout of half a trillion € at the comfortable rate of 1%. What is the reason for
LTROs?
6 I will let it slide that the European monetary authorities did not (or pretended not to, we will never know) recognize that there was not such a thing as a ‘Greek crisis’ and went at it with an all-wrong attitude –cautious, prudent, maybe-we-will-buy-government-bonds-but-maybe-we-won’t; and that we had to wait over two years before we could see the ECB move massively and decisively, the way a central bank ought to. 7 In current times, the expression is a Paul Krugman’s favorite. I rather like it myself.
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Figure 6. Discount rates of three major central banks, Jan 2009 – Feb 2012 (monthly averages)
Source: Federal Reserve, European Central Bank, Bank of England
Simple enough. Despite the results of so-called ‘stress tests’, by which we mean a rather naïve
attempt to throw smoke at the public’s eyes, in 2011 doubts began to arise about the stability of
the European banking system8. Those doubts were expressed on August the 27th by IMF president
Christine Lagarde, then at the Jackson Hole meeting, who called for urgent actions on European
banks9. Why were European banks insufficiently capitalized?
One may speculate that the reason is the lack of a TARP-equivalent program in the
Eurozone: while in the United States banks and insurance companies were being sold and
nationalized, and junk assets were absorbed as collateral by the Federal Reserve and the Federal
Government, such policies were not implemented in Europe. When Angela Merkel stated that each
European national government should guarantee its national financial system on its own, she was
8 Due to a growing lack of confidence in banks, many large firms even began holding their liquidity directly at the ECB See, for an instance, the 20 September 2011 Financial Times, http://www.ft.com/intl/cms/s/0/dca4cc08-e096-11e0-bd01 -00144feabdc0.html#ixzz1YUzw1qPr 9 http://www.ft.com/intl/cms/s/0/9f857244-d0d0-11e0-8891-0144feab49a.html#axzz1oWYuvGDI
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revealing that without a European government no TARP was available. Indeed, one crucial feature
of the TARP had been its flexibility, which made it unsuitable for the rigid European Central Bank10.
But even if one were to assume that all was well with European banks and a European
TARP was not needed, the sovereign debt crisis certainly did not help. With the price of Greek,
Irish and Portuguese debt constantly, wildly falling, the asset value of European banks was
necessarily plunging11. Troubled bank balance sheets caused another credit crunch, leading (again)
to no financing for either firms or governments. On the Financial Times Opinion page, an
interesting discussion in favor of a “European” TARP was shaping up12.
The ECB kicked in, though a little late, by cutting the interest rate for main refinancing
operations by 25 bp on November 9th, 2011, and by another 25 bp on December 14th, 2011, thus
bringing it again to the historically lowest level of one-percent (Figure 6). Still, these cuts just
outweighed the raise of 50 bp that had been adopted a few months earlier, when the April 13th 25
bp increase and that of July 13th of July, a time when Mr. Trichet was expressing his concern about
the increasing inflation (?!). Rampaging unemployment being not, of course, an ECB’s concern.
On December 21st and on February 29th, the European Central Bank implemented two
extraordinary Long Term Refinancing Operations (LTRO), lending circa 1 trillion of euro for three
years at 1% rate, which are being used by banks to finance the purchase of own government
paper. Since then, the total assets (and liabilities) of the ECB reached the astonishing amount of 3
Tln €, circa 31% of Euro area GDP, surpassing the size of the balance sheet of the Federal
Reserve, which is ‘only’ just below $ 3 Tln, or about 25% of Us GDP. Loans? Not yet.
The ECB refinancing rate cuts in late Fall 2011 were hailed as a relief for the banking
system, but still they were not enough. Even the ‘quantitative easing’ of the ECB, the LTROs,
seems to be not enough — at least for the real side of the economy. In fact, the growth of broad
money is still sluggish, as measured by M2 (Figure 7), which measures the supply of credit to
businesses and consumers and captures the amount of money in circulation. Only in the Us the
growth rate in the money supply is increasing since the beginning of 2011. Instead, in the United
Kingdom as well as in the Euro area, the growth rate of M2 is either stagnant or negative. In other
10 See Gillian Tett on the FT, 6 October 2011, http://www.ft.com/intl/cms/s/0/0a8aaeb0-f034-11e0-977b-00144feab49a.html#axzz1oWYuvGDI 11 And there is a lot of mystery around the house of cards built around those bonds. (What with Greek paper, CDSs on Greek paper…). 12 Roger Altman on the 11 October 2011 Financial Times, http://blogs.ft.com/the-a-list/2011/10/11/americas-blueprint-for-saving-europes-banks/#axzz1oWYtNSn3)
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words, in the Euro area, the increase in money, as measured by M2, is barely enough to keep up
with the inflation rate — while GDP growth in real terms is worrisomely sluggish.
Figure 7. M2 money supply, year-to-year percentage change (end of period), Jan 2007 – Jan 2012
Source: Federal Reserve, European Central Bank, Bank of England
So the question arises: the less the real horse drinks, the more water we throw at the
financial one. Why?
It is being said that Mr. Draghi, ECB president, is a really devilish fellow, for it would appear
that he found the way to have the Bank be lender of last resort to national governments without
looking it: who could blame the ECB if national commercial banks, large and small, employ the
money doled out by the Bank to buy their own government’s debt –especially when those
governments are in some debt-related trouble and, anyway, the ‘investment’ carries a handsome
spread over the cost of borrowing?
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Figure 8. Access to ECB’s December 2011 LTRO’s by Main Country’s banks
Source: European Central Bank
Figure 9. Average interest rate on 10-years sovereign bonds and ECB main refinancing rate, December 2011
Source: European Central Bank, Bloomberg
We do not know, of course, whether such is the intent of the ECB’s Governing Council. But we
know for sure that it is the intent of banks’. Let us look at central banks’ balance sheets once
again: what has changed so dramatically in the world economy since 2007 to force such dramatic
swelling of the liquidity-to-gdp ratios?
Italy 25%
Spain 16%
France 14%
Ireland 13%
Greece 11%
Germany 7%
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Figure 10. Monetary base (M0) to GDP ratio, percentage of GDP, quarterly data, 2006Q2 – 2011Q3
Sources: European Central Bank, Federal Reserve, Bank of England, Eurostat, Bureau of Economic Analysis
Risk aversion, I am being told. The age of trust is behind us, I am informed, and risk aversion is all
the rage. Possible, I say. I cannot prove the contrary –but neither can those who put the story
forward either. So, I tell my own story. A story that, I like to think, squares with data.
3. Liquidity, Anyone? A Tale of 2012-2015
One reads (reputable) newspapers, and one finds that of lately the two most serious questions
being asked are: how will banks find a way to return it to the ECB, once time’s up in late 2014-
early 2015? And again: what will the liquidity in the system used for, especially if no recovery
takes place? Let us take these two questions seriously.
Consider that, come March 2015, LTROs will get to their maturity and commercial banks
will have to return the liquidity to the ECB. In a March 6, 2012 Patrick Jenkins, FT’s banking editor,
also wonders about what will happen to the € 1 Tln at the end of 2014-beginning of 2015:
“The most basic worry, voiced of late by the Bundesbank and Standard Chartered, is that three years hence banks will find they are hooked on the LTRO drug. To have €1tn of bank
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2010
Q1
2009
Q4
2009
Q3
2009
Q2
2009
Q1
2008
Q4
2008
Q3
2008
Q2
2008
Q1
2007
Q4
2007
Q3
2007
Q2
2007
Q1
2006
Q4
2006
Q3
2006
Q2
Eurozone US UK
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funding all maturing within barely two months in late 2014/early 2015 risks triggering panic. Even if the eurozone economy has recovered by then, it is questionable whether commercial markets would ever have the appetite to buy that quantity of bank bonds in such a short space of time.”13
Well, it seems a legitimate concern. Of course the issue of bank bonds is not meant to repay the
LTRO to the ECB, but rather to cover the credit the LTRO drug will (?) finance. Should we be
scared of that? In fact, we should not, as I am going to maintain. To understand why, it is
necessary to conceive what could happen between now and the end of 2014. LTRO’s were meant
to supply liquidity to banks. What for? Well, for whatever they like, this being a market economy.
And what do they like it for? Ever since 2007 the answer is one: to allow themselves sufficient time
to clean up their own balance sheets. How much time is “sufficient time”? We don’t know for sure,
it may be 2 to 10 more years. While waiting for the end of deleveraging, what will banks do? Let
us look at three different scenarios.
In the gloomiest scenario, we have years of economic stagnation ahead of us. Then, banks
will simply park some of the liquidity provided by the ECB in their reserve accounts at the ECB, at
a 0.75% loss (this is the case of 388-out-of-529 € Bln supplied last February, the 29th). In addition,
commercial banks will purchase (own) government bonds using the remaining liquidity, turn a
decent profit in the process by carry trading on the spread between the refinancing rate and
sovereign debt interests –even though nothing that would look seriously interesting in the normal
running of a bank– until they will simply sell the government paper they just bought and use the
proceedings to satisfy the ECB. To sum up, banks should not have any liquidity problem after
returning the liquidity to the ECB in late 2014. Moreover, the ECB will (of course) stand ready with
another LTRO, though probably smaller in size and/or shorter in maturity, should financial
difficulties emerge.
Imagine now a second scenario, characterized by a miraculous turn of the real economy,
businesses booming, unemployment falling, so that firms and households alike will be ‘less risky’
and worth lending to again. Will commercial banks be able to give back the liquidity they were
given by the ECB to the same ECB? If economic recovery is on the way, they (the banks) will be
there. And they will turn a profit large enough to comfortably clean up their balance sheets. At
that point, the major concern of the ECB will be to limit the growth of credit or, put in other terms,
13 I find it heartening that Mr. Jenkins appears to be as skeptical as I am about a spontaneous recovery taking place in Europe before 2015.
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to avoid inflation and another financial or real estate bubble. So yes, there could be a problem in
reimbursing the liquidity provided by the ECB by the end of the three years grace period – a
problem of cutting too much (circa 1 Tln €) the credit supply and in turn hamper economic growth.
Still, if we really believe that this will be the future concern of the ECB (and we do not), we should
also take into account that the ECB can drain liquidity from the system using other instruments:
the LTRO amounts to only one third of the total liquidity available to the commercial banks. That
is, the ECB could drain liquidity from the system by gradually reducing the liquidity provided
through its Main Refinancing Operations, something it does on a weekly and monthly basis. So, no
big reimbursement shocks will take place in late 2014 or early 2015.
Yet: how plausible is such a growth scenario, given that fiscal austerity is the rule of the
day? Economic theory teaches us not to expect extraordinary rates of economic growth while
government spending is shrinking and unemployment is high. How long can we live in such a
scenario? The latest forecasts by OECD and IMF report that there is little reason to believe that
Europe will get out of its ‘mild recession’ before 2014. And the so-called ‘debt-reducing strategy’?
Well, things do not look good on that front either. Let us play with an example.
The Italian government has a debt amounting to roughly 2 Tln €, which amounts to about
120% of gdp. If one is to take deliberations at the European level seriously, as I do, such ratio will
have to be about 60% in 2032. True, text language is not really strict and allowances will be
made. So, suppose we are talking about shaving off only one fourth of the debt. Assuming that
the recession we are witnessing were an IMF-OECD invention and that income is, and will be,
stable (that is, assuming economic theory is wrong and debt reductions are not contractionary),
we are talking about reducing debt by around € 25 Bln / year for twenty consecutive years. Which,
to put it differently, implies a budget surplus of the same amount.
Of course, this is not a path any government can follow. So, there is only one way I can
see that can ensure that debt reduction will be down to the intended size: privatizations. I am not
talking, of course, of ridiculous ideas such as the sale of former army barraks or bit and pieces of
formerly state-owned stretches of beaches. I am talking about the real thing, those ‘items’ that are
at once big and bulky and unprofitable (as of now): public utilities; health care; public transport.
And so on.
And who can afford those ‘items’? Well, maybe the banks, that could have found a less
risky asset to invest on than private firms are.
And so we have the third scenario, which I strongly believe to be a plausible one. This
scenario is characterized by two main features. On the real side of the economy, we have
governments cutting public debt, mostly through privatizations. On the financial side of the
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economy, banks hold plenty of liquidity that will not be lent to firms. It is not hard to imagine
commercial banks lending money to some private agents to buy, for instance, public utilities. And
the money is provided by the LTRO, waiting for profitable investments.
Will the engagement of commercial banks in the privatization process of European public
utilities, health care, etc., create some financial trouble in 2015? The answer is no. Again, the ECB
could inject additional liquidity, or the economy could recover so that banks could easily find
liquidity on the market.
But, even in a scenario were the reimbursement of the LTRO could trigger a reduction in
credit availability, banks would have the solution for any liquidity problem. What is the solution?
Issuing secured bonds, secured, of course, by public utilities.
4. Final Remarks
Let us go on our way to something that may resemble a conclusion.
The original question was: why so much liquidity, given that we have a large record of ineffective
monetary expansions? Ever since 2007 the answer is one: to allow sufficient time for banks to
clean up their balance sheets. How much time is “sufficient time”? We don’t know for sure, though
some scholars estimate that past deleveragings have taken on average seven years.
Is the European economy going to start growing again in the meanwhile? Current forecasts
deny that possibility. And so does economic theory, to the extent that monetary easing is the only
policy being implemented. Actually, when one takes the current policy stance announced by
European institutions and leaders, fiscal policy is going to be aggressively contractionary, the
reason being that (most) national governments are supposed to get rid of consistent shares of
outstanding debts.
For countries whose level of debt-to-gdp exceeds 60%, such a policy line cannot be
pursued running a twenty-year string of budget surpluses generated through spending cuts and
higher fiscal revenues. It is necessary that government receipts be fattened by higher non-tax
incomes.
Whether an intended policy or not, a string of privatizations is in the cards. And the liquidity
