The Eurozone’s policy breakthrough?

Today’s money quote, obviously, is this, from Fitch:

a ‘comprehensive solution’ to the eurozone crisis is technically and politically beyond reach.

Fitch’s view reflects the clear consensus of Anglo-American commentators. But Anglo-American commentators aren’t always right. Ezra Klein writes that the German policy establishment “remain[s] serenely confident that they will save [the Eurozone].” Note that Klein attributes this to no one in particular. He characterizes it as a view drawn from “members of Angela Merkel’s government, members of the opposition Social Democrats, industrialists, and bankers.” In other words, Klein heard this in private conversations, not market-moving public statements. Jean-Claude Junker’s famous when-it-becomes-serious-you-have-to-lie rule doesn’t apply. These are smart people who know everything we know, and they think they’ve got the situation covered.

Tyler Cowen has been emphasizing the possibility that the ECB will quietly fund sovereigns via the banking system. The ECB would lend to banks at very low rates, accepting sovereign debt as collateral. Banks would earn the spread between the yield on sovereign debt (which is currently distressed and very yieldy) and the sliver of interest demanded by the ECB. As a matter of mechanics, this plan could work. It’s the same as direct ECB lending to sovereigns, except ECB gets added security (in theory) by interposing banks as guarantors, and pays a fee for the privilege.

The Anglo-American punditosphere is unimpressed. After all, European banks are already in deep trouble because of their sovereign holdings. An article by Gareth Gore (ht Felix Salmon) quotes a senior banker:

“When investors are constantly asking what you have on your books and the board is asking you to reduce your exposure, it doesn’t really matter about the economics of the trade,” said the treasurer of one of Europe’s biggest banks. “Am I going to buy Italian bonds? No.”

That view echoes comments from UniCredit chief executive Federico Ghizzoni, who this week told reporters at a banking conference that using ECB money to buy government debt “wouldn’t be logical”. The bank had traditionally been one of the biggest buyers of Italian government bonds, with almost €50bn on its books.

Cowen responds

My view is not that banks will find the arbitrage opportunity overwhelming (that is unclear), rather my view is that public choice mechanisms will operate so that desperate governments commandeer their banks to make this move, whether the banks ideally would wish to or not.

I’m not sure that bank-mediated ECB finance is the plan, but if there is any plan at all, it is the only one I can find. And, as Cowen points out, markets seem to perceive some cause for optimism. But if this is the plan, I think Cowen is a shade off on the politics. Desperate governments can commandeer domestic banks all they want, but it is the ECB who decides to whom it will lend and against what collateral. Further, bankers’ objections are entirely irrelevant. That major banks may be, from an admittedly archaic perspective, “insolvent” is an argument for rather than against the practicality of the plan.

European banks, especially in the troubled periphery, are mortally dependent upon the ECB for liquidity and finance. These banks will acquire whatever collateral the ECB prefers to lend against. It is not a matter of trying to profit from a spread. A spread would be nice for banks, a subsidy that will help them recapitalize over time. But holding collateral the ECB wants is a matter of life-or-death for them, every day. If the ECB wants Italian bonds, they will be supplied. If the ECB prefers that Italy “face market discipline”, it can quietly hint its concern and steepen the haircuts it imposes when the country’s bonds are offered as collateral. Banks will start to divest, replacing them with whatever the ECB favors.

A lot of commentators have derided Europe’s “policy breakthrough” as just a restatement of the old stability and growth pact with some institutional changes at the margin. Talk of automatic consequences and qualified majorities may just be blah blah blah. But if European states become dependent on bank finance, they become dependent on ECB finance. The ECB would have the power to manufacture fiscal crises for a misbehaving state at will, and with marvelous deniability. Laundered through banks and then through capital markets, ECB actions would be attributed to nameless bond vigilantes rather than unelected technocrats. ECB haircuts would very quickly be self-justifying, and disentangling cause from effect would be nearly impossible as officials might privately telegraph changes before anything is put in writing. Control would be hidden as a market outcome, a fact of nature.

Operationally, I don’t see why the plan can’t work. I dislike it, both because I dislike the policies I suspect ECB would enforce (austerity and internal devaluation) and because it is profoundly undemocratic. Democracy is really the main obstacle, though the plan gains some immunity from the fact that politicians who try to call it out would quickly be labeled conspiracy nuts.

p.s. If you haven’t seen Ashwin Parameswaran’s democratic twist on the putative Euroarbitrage, do check that out.

FD: I hold a short position in long-term US Treasuries, and via that, I attribute some personal discomfort to Euro-uncertainty. I’m not sure how or whether this affects my views, but I thought I’d confess that my holdings have focused my mind.

Update History:

  • 17-Dec-2011, 3:15 a.m. EST: Minor edits: “hint that its concern“, “Banks will start to divest, and purchase replacing them with whatever the ECB favors.”, “imposes when Italian the country’s bonds” Italicized “blah blah blah”.

36 Responses to “The Eurozone’s policy breakthrough?”

  1. D writes:

    “The ECB would lend to banks at very low rates, accepting sovereign debt as collateral. Banks would earn the spread between the yield on sovereign debt (which is currently distressed and very yieldy) and the sliver of interest demanded by the ECB.”

    Correct me if I’m way off, but this sounds like a variation of QE in America. Instead of outright exchange of treasuries for dollars, this is just the exchange of almost interest free loans (cash) for sovereign debt. Best case scenario is this inflationary tactic balances out the deflationary austerity/deleveraging and we all live happily ever after. Worst case scenario we get the worst of both worlds: outrageous asset prices and high unemployment. Here’s hoping we muddle through, Japan style.

  2. “I hold a short position in long-term US Treasuries…” You win the prize for the full disclosure sentence requiring the most thought I’ve seen in quite some time.

  3. Fed Up writes:

    I’d like to know if central banks and commercial banks are nothing more than glorified hedge funds. Thoughts?

  4. Fed Up writes:

    What happens if this starts occurring?

    ‘Tempers are fraying in austerity-racked Portugal. A top socialist politician was taped at a party dinner calling for diplomatic warfare against the EU’s northern powers and issuing threats of debt default.

    “We have an atomic bomb that we can use in the face of the Germans and the French: this atomic bomb is simply that we won’t pay,” said Pedro Nuno Santos, vice-president of the Socialist Party in the parliament.

    “Debt is our only weapon and we must use it to impose better conditions, because recession itself is what is stopping us complying with the (EU-IMF Troika) accord. We should make the legs of the German bankers tremble,” he said.’

  5. “European banks, especially in the troubled periphery, are mortally dependent upon the ECB for liquidity and finance. These banks will acquire whatever collateral the ECB prefers to lend against.”

    The EU needs liquidity, let them have liquidity! At this point it’s harmless, like a cigarette to a man facing the firing squad.

    The EU needs liquidity but the Germans need the associated liabilities to reside somewhere besides Germany. Everyone else in Europe is broke so they are SOL.

    I’ve seen this, we can call it the ‘Tuesday proposal’ elsewhere — Reuters and Business Insider and Zero Hedge. It’s fine, there is liquidity with a bond short-squeeze built into it. The ECB could make money! Peripheral bond rates will plummet. Then what? With 2% Italian 10yrs do the Italians embrace austerity? How is that going to work? Send in the Wehrmacht?

    Nobody has a plan. Sorry, you can’t sell me on a German plan b/c there is no German plan only lurching from crisis to crisis with zero understanding of what is taking place.

    There is still no non-German fiscal counterpart to the ECB so what comes next is the denial from the Bundesbank or German finance minister. Afterward comes more stress and the ECB prints anyway. This is the euro Gotterdammerung … the EU throws in the towel because there is nothing to lose. They print or the euro dies, no matter what eh ‘pros’ in Berlin think or want.

    If the ECB prints now there is no dramatic swan song, the euro has a few more months. At some point the central bank magic fails. It has to because central banks don’t make monetary policy any more, the value of money is set by hundreds of millions of motorists around the world trading currency for a valuable physical good on demand. What is being posed about the euro are existential questions, such as what in Europe replaces it when it finally collapses? The dollar?

    The ECB can print but that has to be part one of a big plan where the Europeans get serious about exiting their waste-based economy. That means killing consumption across the board.

    Since nobody TALKS about a waste-based economy, the ECB just holds off annihilation for a short interval. Can the banks buy more time? Germany can ‘pass’ as Japan, the rest of the EU cannot. Deflation in the EU will (is) crushing.

    If you look at the European problems as having to do with the juncture of liquidity shortages morphing into solvency erosion, playing games with rate arbitrage makes sense. If you see past the money to the big picture you can see Europe and the rest of the West mired in an energy shortage hidden behind the scrim of debt. Puny real EU ‘output’ — what exists minus the debt impulse — cannot afford harder-to-extract energy supplies.

    Bottom line is the entire enterprise is insolvent and the credit acting to ration energy demand has more or less played out. What comes after is the end of economics which cannot and never has anywhere allocated shortages, this dirty task is left to the police. Europe is at the doorstep of actual physical shortages as the crude price drops below the level needed to bring forward new supply. How close? Right now, within $3- 5 per barrel!

    Central banks can’t fix that. Only thing that can is fierce, determined conservation, a reduction in EU fuel consumption to about 1/3 of current levels with more stringent cuts to come.

    Otherwise, the result is what is already being seen, conservation by other means, the end of the automobile in Europe.

    The sooner the better …

  6. Jonas writes:

    What you have is cognitive dissonance between (German) ideology and (crushing debt burden) reality. Even Anglo Saxon commentators would recognize the problem as (mostly) solved if the ECB came out and openly supported the sovereign debts. The backdoor solution is just a way to hide and rationalize away the dissonance. I’d rather they use hypocrisy to shield their discomfort than continue denial.

    Looking forward, the ECB is going to continue to push austerity as a matter of ideology, but it’s not going to be as strong pressure as the current push that’s amplified by panic. I do agree that it’s going to be a very “managed” form of capitalism, which the continental Europeans have always liked anyway.

  7. charles writes:

    It looks like we are coming back to the basics…

    “Let me issue and control a nation’s money and I care not who writes its laws.”
    – Mayer Amschel Rothschild

    When the “conspiracy nuts” seems to be the sanest people in the room, you start to be very worried indeed. Very dangerous game indeed.

  8. […] The Eurozone’s policy breakthrough? – interfluidity […]

  9. […] The Eurozone’s policy breakthrough? […]

  10. Nick Rowe writes:

    Normally, I would think that the lender of last resort has to be a big player, because only a big player can solve a coordination problem and make the switch to the good equilibrium. I’m having difficulty getting my head around the idea that the big player (the ECB) can farm out the LOLR job to a lot of little players (the banks).

  11. Becky Hargrove writes:

    Re: Your short position. You make me feel a bit less crazy for always thinking about what could be done solution wise, should the burdens on money simply become too heavy.

  12. David Pearson writes:

    The “ECB indirect funding of sovereigns through banks” thesis may contain a misunderstanding of central bank operations.

    Banks don’t need additional funding commitments from the ECB to buy sovereign bonds. They ALWAYS have unlimited access to reserves at any given policy rate under an overnight rate-targeting regime. The way it works: banks load up on Italian bonds at auction; the system is short reserves to cover the resulting deposits created; the banks compete with each other to borrow reserves; the rate on reserves rises; the ECB supplies reserves to keep the rate at target. The supply of reserves is thus always perfectly elastic at any given policy rate. Banks are never reserve-constrained in extending credit.

    The above regime did not change recently. What has changed is that the ECB is supplying not just overnight reserves but longer maturities as well: now up to three years. If the rate on these reserves is fixed, this is tantamount to committing to leave the overnight rate unchanged for three years, which is a significant commitment. I’m not sure whether these reserves have a fixed or floating rate, but I would be interested to find out. If not, then the three-year money changes nothing, as banks have access to unlimited reserves anyway.

  13. Steve Roth writes:

    What Ryan said. I’ve read the FD three times and am still wondering how your wondering should affect my wondering. ;-)

    Thanks for a very clarifying post. I think I get it.

  14. OGT writes:

    Michael Pettis, an Anglo Saxon comentator by way of Spain, points out that there have been a number of currency unions in history, and they all failed. So if we’re going to apply Baye’s theorem, we have to recognize that the base rate for survival is pretty low to begin with. Add on that the Euro is not a particularly well designed currency area economically and politically, then the private confidence of German officials probably doesn’t move the probability of success very much.

  15. Ashwin writes:


    The rate is not fixed, it is an average of the main refinancing rate throughout the tenor of the long-term repo. The key commitment is not the rate, it is the collateral acceptance requirements. Once it is repoed, it stays put for the term. Rolling the short-term refinancing operations always carries with it the risk that the collateral doesn’t meet the ECB criteria either due to a change in criteria or due to a deterioration in the collateral. This isn’t really an arbitrage but it is a significant change at the margin which is what you’re seeing play out in the markets especially at the short end of the govt bond yield curve.

    Steve – you said “That major banks may be, from an admittedly archaic perspective, “insolvent” is an argument for rather than against the practicality of the plan.” That is the key point which I’ve not seen anyone else point out. The “ideal” short-term situation for this plan to work is for your banks to essentially be insolvent or at least insolvent if the respective govt defaults. If as a bank CEO you deem your equity to be essentially worthless, then you might as well just load up on your govt’s debt. The govt can then use the money raised to recapitalise the banks. Rinse and repeat.

    The worst case is ironically if your banks are not so closely tied to the state and not so worthless. At the risk of constructing an alternate history, I would wager that if the UK had entered the Euro in 1999 it would be in a worse situation than Italy is in right now – just because of its relatively global and oligopolistic banking sector.

  16. vjk writes:

    Nick @ 10:

    In the EMU, the LOLR role is left to the home CB who performs this function via Emergency Liquidity Assistance (ELA). So, it is a specific NCB that is on hook and will bear possible losses. The ECB does not have ability to offer the LOLR assistance.

  17. David Pearson writes:

    I’m not sure easing the collateral rules is that helpful to the “Sarkozy” trade. Sovereign bonds are already accepted as collateral, and the smaller banks that the collateral easing was aimed at are not big buyers of sovereign debt. Further, in a scenario where the ECB stops accepting Italian debt as collateral, the LTRO program would only be marginally helpful in saving individual banks: they would effectively be bankrupt. Its not clear to me how the new program and easing of collateral rule assisted the short end of the curb this week.

  18. Blankfiend writes:

    I’ve been thinking a lot about this topic as well, and am glad to see you address it. I have posted a review and rebuttal of your post on my blog, if you are interested.

  19. […] 3. How the “Sarko trade” is bailing out Spain, and Interfluidity on same general topic. […]

  20. vjk writes:


    You wrote: “European banks, especially in the troubled periphery, are mortally dependent upon the ECB for liquidity and finance. These banks will acquire whatever collateral the ECB prefers to lend against.”

    Not sure what the ECB has got to do with the price of fish except approving eligible collateral. Whether or not lend against such collateral, in an emergency, is at the sole discretion of the respective NCB who will bear possible losses to the extent of its capital and potential national treasury participation as happened for example with Dexia. Therefore, if anybody is “mortally dependent”, then it is on the domestic NCB’s willingness to come to rescue, not the ECB’s.

    Now, other EMU members may be willing to come up with some rescue package, but again the package would be a separate story altogether.

  21. Ashwin writes:

    David – if as a bank, I fund my sovereign bonds through the usual short-term repo and 3 months later, the bonds get downgraded significantly and the ECB changes its mind about continuing to finance them, then I have a problem. Obviously if the sovereign defaults, then I have a problem in both regimes. But if I can stomach the MtM volatility and believe the commitment that there will be no default till the maturity of the bond then ‘at the margin’, the economics have got better.

  22. Yancey Ward writes:

    Everyone still pretending no one has to recognize a loss. It is all coming apart.

  23. Doc Merlin writes:

    You can’t stomach the volatility as you are required to mark to market. The question is if governments are willing to look the other way and pretend that banks aren’t cheating on the capitalization rules.

  24. JP Koning writes:

    I think the ECB’s policy change is designed to stop the intra-European bank run currently in effect, and not to support various governments. The arbitrage bit that Cowen is writing about is either a red herring or simply incidental.

    Because of the Eoro area clearing & settlement mechanism, banks subject to capital flight need to submit collateral to their NCB on a continuing basis to deal with a bank run.

    By lending settlement balances for three years and, more importantly, accepting lower quality ABS and bank loans as collateral, the ECB is committing NCBs to averting all degrees of bank runs from member banks. Hopefully this flexing of its muscles is enough to stop the run.

  25. vjk writes:


    :By lending settlement balances for three years”

    Not sure where the three year loan program information came from.
    Could you provide a reference ?

  26. […] Steve Randy Waldman, “But if European states become dependent on bank finance, they become dependent on ECB finance.”  (interfluidity) […]

  27. David Pearson writes:

    It is difficult to conceive of a scenario where the ECB stops accepting a country’s sovereign bond as collateral and the sovereign does not immediately default.

  28. jsn writes:

    I find the section of this: just before the “The Long March of the Euro Communist Economies” subtitle very interesting in this light.

    What it proposes is the mechanism you are analyzing is in fact a lever to break up the EU over time: for a period the ECB makes clear through its activity it wants national banks to purchase local government debts. After a while national banks and national exposures begin to correspond as the cross border links are unwound through this policy stance whereby the ECB actually pays banks to load up local and sell of cross border debts.

    Once French banks hold mostly French debt, Italian banks Italian debt etc., presumably German banks will be left with mostly German debt and can finally be done with the French, Italians, Spaniards and all the other Europeans they feel superior to . Maybe at that point they’ll willing to let German wages float to support German consumption. Or maybe they’ll start looking for “lebensraum” again, who knows? But the policy does appear to afford this possibility which will have the affect of encouraging it.

  29. Ashwin writes:

    David – It’s not just a binary decision, the ECB could just increase the haircuts on all govt bonds for example. My point is just that at the margin, this increased certainty does have some impact, combined with the explicit commitment that private creditor participation in haircuts a la Greece is not on the table any more (which is as important as the 3-yr repo IMO).

    If you want a really good example of bust banks buying bust govt debt try Greece which is funding short-term paper at 5% while the same paper trades at 100% and above yields in the secondary market.

  30. […] A novel take on the “Sarkozy trade” […]

  31. […] The Eurozone’s policy breakthrough? El autor recorre y vincula a las opiniones encontradas en el blogosferio acerca de cuán eficaz puede ser el nuevo pacto fiscal en la zona del euro para resolver la crisis (el consenso es que poco o cero). […]

  32. Pepijn writes:

    There’s another option: a government could nationalize a bank, and then have it draw ECB liquidity giving its bonds in collateral. Certainly in countries like Greece i see this happening. They’ll do anything to stave off difficult times for the electorate. Spoke to a Greek this weekend and she said that now people are being advised not to pay the new property tax, as no-one will pay it and for sure the government will change its mind.

    The point is: the above scheme amounts to nothing less then having direct access to the ECB printing press for the Greek souvereign. Will they exploit this opportunity? No doubt they will!

  33. […] Argument in favor: Steve Randy Waldman on why we should prefer the ECB to have less power. read article Let’s play the fun income-gap game again and take a look at some unfortunately […]

  34. Phil Koop writes:

    “These are smart people who know everything we know, and they think they’ve got the situation covered.”

    If only life were like that! Human nature is such that we all do the majority of our reasoning from our conclusions. What we think of as reasoning is mostly rationalization, and the cleverer the person, the more difficult to overturn the rationalization. It is all too easy for stupid and ill-informed person to be right where a smart and well-informed one is wrong, when the former is less biased.

  35. vlade writes:

    Where does a long-term repo end and a QE start?

  36. […] directly translate into higher borrowing costs for the government. As the excellent Steve Waldman points out: The ECB would have the power to manufacture fiscal crises for a misbehaving state at will, and […]