ECB: Assets=Liabilities

Statistics released today about the ECB balance sheet show that Euro banks have a record level of deposits at the ECB (about €500 billion). The press tends to misrepresents the meaning of these deposits. From CNBC today:

"the recent giant injection of ECB cash left banks awash with money but too scared to lend it."

and

"With total ECB lending at 664 billion euros, banks are now storing over three-quarters of money lent by the ECB at the central bank, compared to around a third after the collapse of Lehman Brothers back in late 2008."

Both statements give the impression that the size of the balance sheet of the central bank is driven by the actions of commercial banks. This is misleading. The size of the central bank balance sheet is determined by monetary policy. Monetary policy will react to economic developments, including actions of commercial banks, but at the end of the day the size of their balance sheet is mainly a decision of the central bank.

Towards the second week of December the ECB decided to increase lending to commercial banks (by making it attractive, of course). This led to an increase in the ECB balance sheet of about €250 billion between December 16 and December 23. This is associated with an increase in assets (lending to euro area credit institutions) as well as an increase in liabilities (accounting still works!). There are potentially two liabilities that could change: Banknotes in circulation (this is printing money) and deposits of commercial banks at the central bank. Currency in circulation barely changed that week, but deposits of commercial banks changed by about €200 Billion (the rest comes from other liabilities). As banks get loans from the central bank, their accounts at the central bank get credited.

Since then, not much has changed. Loans to banks remain high as well as deposits from banks. What if commercial banks start lending to the private sector, will the level of deposits at the central bank go down? Not necessarily. The only way for the level of deposits to go down is if commercial banks start paying back the loans they took from the central bank. And the central bank could always resist this move by making these loans even more attractive (this is standard monetary policy).

So it should be no surprise that deposits of commercial banks at the ECB are at a record high when the balance sheet of the ECB is at a record high (we observe the same phenomenon in the US or England). When monetary policy decides to increase its balance sheet, both the liabilities and assets have to increase. Given that central banks are not massively increasing notes in circulations, it must be the case that it is the deposits of commercial banks at the central bank the ones that are increasing.

Antonio Fatás

Bazookas, Bailouts and Fiscal Policy

As a result of the financial crisis, economic policy both in Europe and the US has been driven by announcements of plans that involved large sums of funding provided by governments to support the economy (the "bazooka" approach). It was first in the US with TARP (Troubled asset relief program) and in Europe with the EFSF (European Financial Stability Facility). In both cases we are talking about plans that amount to hundreds of billions of dollars (or euros). These large figures are seen large enough to provide support for any possible future risk, in order to provide credibility.

There is, however, a downside to this approach. Many will only remember the headline figure and will associate the number to the actual cost paid by the government (and ultimately by the tax payer). For some there is a direct association between bailout funds and taxpayer costs. And the feeling that the cost to the tax payer has been so large was partly behind the resistance to addition fiscal policy stimulus and the support that austerity received during the year 2011.

But what are the facts? Regarding TARP, the CBO (congressional budget office) regularly updates on their estimated cost to the US tax payers. Their last figures suggest that out of the original $700 billion, only $428 billion were disbursed. Most of these funds took the form of loans or investments, some of which have been paid back with a profit for the government. The estimated cost for the tax payer today is about $34 billion, a large number but far from the $700 billion that made the headlines. Most of the losses come from AIG and funds given to car manufacturers. A precise picture of the losses is below. Click on it for a larger image or you can also go directly to the source.

The same is true for the EFSF. The EFSF was established with guarantees of €780 billion and a lending capacity of €440 billion. So far it has only lent €13.5 billion and the expectation (so far) is that all this money will be paid back. But the public perception is one of large sums of transfers across Euro countries (interestingly, EU structural funds account for more than €40billion on an annual basis and agricultural funds account to €50 billion -- and these are real transfers, not loans) .

There might be some benefits to the bazooka approach to economic policy announcements in times of crisis. But there is also a need to go back ex-post and assess the actual cost of these policies. Otherwise, the headline figure is the only one that sticks in the public debate and some will equate this figure to the cost to the tax payer in an attempt to scare individuals about large governments and the use of fiscal policy.

Antonio Fatás

Financial repression German style

Last weekend I attended the American Economic Association meetings in Chicago where I had been asked to discuss a paper on historical lessons lessons on government debt reduction. The paper is written by Carmen Reinhart and Belén Sbrancia and the title is "The Liquidation of Government Debt". The paper presents a historical review of episodes where governments paid interest rates on their debt below market rates. This reduction in financial expenses can be seen as a source of revenue that can keep the debt under control or reduce it.

The paper focuses on periods where real interest rates on government debt were negative which were common in the pre-1980 period. Here is a chart from their paper

They refer to the pre-1980 period as the era of "financial repression" because on average real interest rates were negative driven by the behavior during the 1945-1955 period and the early 70s. Financial repression comes from two sources: financial market regulation (e.g. ceilings on interest rates, legal conditions that favor government debt holdings by institutional investors) and surprises in inflation. The early years of the sample are characterized by capital controls and strong regulations on interest rates. The real negative interest rates of the early 70's are more driven by inflation being higher than expectations  (although controls on capital flows and distortions on interest rates were also present).

A quick calculation shows the importance of this channel during the 1945-1980 period. For example, for the US and UK economies, negative real interest rates allowed a reduction of government debt equivalent to about 2-3% of GDP per year. This is a large amount compared to their ratios of taxes to GDP (this amounts to 14% of the average tax revenues for the US during these years). What this suggests is that the reduction in government debt that advanced economies witnessed in the post-second world war period was partly driven by unusually low (even negative) real interest rates.

The authors argue that we might see something similar going forward. A combination of financial repression (regulation, moral suasion) and inflation could produce negative real interest rates.

Today, the German government issued for the first time debt with a negative (nominal!) yield. This is not financial repression as the authors of the paper describe it. It is more about risk aversion, flight to quality and a reaction of what is happening in other Euro countries, but it has the same effect on the German government. It finances its debt at negative real interest rate (this is one of the benefits of the Euro for the German economy...). Same is true for the US government where over the last years nominal yields have been close to zero while inflation remained positive. Of course, not all governments (Greece, Italy or Spain) are as lucky and can benefit from fear and perceptions of risk, their real interest rates remain positive and high.

Antonio Fatás

Learning from 2011, hoping for a better 2012.

Here is a summary of two very interesting articles that look back at the economic developments in 2011, what we have learned and what to look forward in 2012.

Charles Wyplosz looks at the Eurozone crisis and how it deepened during the second half of 2011. He asks the question of why governments, the European Commission and the ECB do not seem to learn from their mistakes. He suggests several hypothesis:

1. ignorance and lack of understanding
2. the obsession of the French President and the German Chancellor to find a political solution
3. the "quasi-religious" beliefs at the ECB on economic policy options
4. the crisis as a strategic option chosen by the ECB and some countries to teach a lesson to those who misbehave

Number 4 is what Charles Wyplosz calls the "kind interpretation" of the crisis. I am afraid that the other explanations matter as well. Lack of understanding of the economics behind the crisis. an obsession with certain standard recipes (austerity and confidence) as well as the belief that it is all about politics were behind the lack of a proper response to the events in the second half of the year.

Olivier Blanchard, Economic Counsellor at the IMF, summarizes four lessons ("hard truths") from 2011. The article not only provides some great insights about the year but it also offers a very honest and fresh view on some of the hard lessons that policy makers and academics have learned. He stresses something that rarely gets attention in academic research: the importance of multiple equilibria and self-fulfilling crises of confidence. Quoting from the article:

Multiple equilibria are not new. We have known for a long time about self-fulfilling bank runs; this is why deposit insurance was created... And we learned early on in the crisis that wholesale funding could have the same effects, and that runs could affect banks and non-banks alike. This is what led central banks to provide liquidity to a much larger set of financial institutions.

What has become clearer this year is that liquidity problems, and associated runs, can also affect governments. 

Right or wrong, conceptual frames change with events. And once they have changed, there is no going back. For example, nothing much happened in Italy over the summer. But, once Italy was perceived as at risk, this perception did not go away. And perceptions matter: once the “real money’’ investors have left a market, they do not come back overnight.
A further example: not much happened to change the economic situation in the Euro zone in the second half of the year. But once markets and commentators started to mention the possible breakup of Euro, the perception remained and it also will not easily go away.  Many financial investors are busy constructing strategies in case it happens.

Perceptions matter and, what it worse, once they are formed, it is hard to influenced them.

Olivier Blanchard also discusses what he calls the "schizophrenic" reaction of financial markets towards fiscal policy. In his words:

They (financial markets) react positively to news of fiscal consolidation, but then react negatively later, when consolidation leads to lower growth—which it often does. Some preliminary estimates that the IMF is working on suggest that it does not take large multipliers for the joint effects of fiscal consolidation and the implied lower growth to lead in the end to an increase, not a decrease, in risk spreads on government bonds.  To the extent that governments feel they have to respond to markets, they may be induced to consolidate too fast, even from the narrow point of view of debt sustainability.

This was one of the most interesting developments during the second half of 2011. The notion that austerity was going to help governments address their imbalances lost support during the sumer (because of the evidence) and led to a situation where governments had no good options. If they promised a quick adjustment they would be penalized for the negative growth consequences that they would cause; but if they did not adjust they would be penalized because of their lack of discipline.

So now it is time to digest all the 2011 lessons and have a better 2012. As Olivier Blanchard says in his last comment "The alternative is just too unattractive".

Antonio Fatás

Debt does not matter. Spending and taxes do.

Paul Krugman makes the point that government debt matters less than most people think because in some cases we simply owe money to ourselves. He is right and what he has in mind is the notion that government debt is (in many countries) mostly held domestically. Japan is an extreme case where more than 90% of the government debt is held by its nationals but even in the US the majority of government debt is held by US citizens or institutions. For some it is debt but for others it is an asset, they cancel out from a national point of view.

We can think of an extreme case where government bonds are held by all taxpayers in proportion to their income - in a way that mimics tax rates. In that case, government debt is not imposing a future burden on anyone, it simply cancels out with the assets that all investors/taxpayers have.

How do future generations enter into this analysis? What if we try to pass the bill to future generations? Let's start with the case of a closed economy/system. In a closed system (the world, no international trade or capital flows) the debt that the current generation has will end up in the hands of the future generation in one of two ways: either it gets simply passed to the next generation as a bequest or, alternatively, the current generation could try to sell their assets and spend all their wealth if they do not want to leave a bequest to their children. But the debt must be bought by someone. And given that this is a closed economy, it can only be bought by the future generations. In both cases the bond holders are also the taxpayers.

If we bring other countries into the picture then the analysis is different. The government debt that other countries hold is a claim on our current and future income and as such it is a financial burden that either the current generation or the future one will have to pay for. But Krugman's point, which is correct, is that many make the mistake of assuming that government debt is equivalent to external debt and they overestimate the burden that it imposes on a country.

Let's go back to the case of a closed economy: is it really true that debt does not matter? Not quite, because there are distributional issues of two types: first there is no perfect match between bond holders and taxpayers so it is not quite true that we owe money to ourselves. Some citizens owe money to others. The second distributional issue is about generations and here we need to go back to the example above to understand how difficult the analysis can get. The best way to understand the argument is to stop talking about debt and talk about spending and taxes, which is what really matters. A government spends some income today (builds a road, provides health services to the population). It decides not to tax anyone but instead it issues debt bought by the current generation. The government decides that it will only pay back the debt in the future when it raise taxes on the next generation, not the current one. Are we passing a burden to the next generation? It all depends on what the current generation does. If they decide to spend all their income and leave no bequests for their children then the answer is a clear yes. The current generation enjoyed services that they did not pay for themselves and did not compensate the next generation in any way for the future taxes they will have to pay. Just to be clear, the future generation will be holding the debt that the previous generation sold to them when they were spending their inheritance, but this is not a transfer of resources, the asset was sold at market price. So the fact that in the future bondholders are also the taxpayers does not mean that we are not passing a burden to the next generation.

There is a second scenario where there is no burden passed to the next generation. It can be that the current generation is responsible, understands that the government is asking future generations to pay for the goods and services that they enjoyed and they decide to leave a larger-than-planned bequest to their children so that they have resources to pay for all the taxes (you can think about the bequest being the government debt itself). In this case no burden is passed to the next generation.

This simple example (*) makes it clear that answering the question of what distributional impact government debt has across generations requires an understanding of the patterns of spending, taxes and saving of different generations. What matters is not debt but who enjoys the spending that the government does and who pays for it. Debt is just a vehicle that can be used to transfer resources across different individuals or generations. Debt is not a problem, the problem, from a generational point of view, is the potential mismatch between spending and taxes (even if future taxpayers are also the holders of government bonds when they are paid back).

Antonio Fatás


(*) The example ignores many issues: the type of goods government buy, the possibility of default, the possibility of crowding out (government bonds displacing other forms of saving),...

Running out of words?

The Euro crisis is stretching for such a long period of time that it is difficult to know what is news and what is not. Yields go up and then they go down. The ECB is buying bonds or maybe they are not.

Today there was yet another auction of Spanish government bonds and CNBC must have run out of words to describe what happened. See below the description of the news as it appeared on their web site (should we interpret the fact that there was no second paragraph planned as good news?)

Antonio Fatás

The discipline of Financial Markets

John Kay writes an interesting article on the FT today about the limited effect of fiscal rules on fiscal discipline. This is related to out last blog entry and I agree with most of his arguments although I am less pessimistic, there are some fiscal rules that work better than others. What I found surprising is one of the last sentences in his article (a sentence that was highlighted in the title of the article):

Financial markets are an effective discipline on profligate individuals and states because markets cannot easily be bullied or lobbied, and their threat to make the cost of funds prohibitive is effective. 

Financial markets are NOT effective when it comes to providing discipline to governments. Yes, occassionally they do bring governments down and they push governments that misbehave towards default, but they do so in the last minute. They are completely absent in the years where discipline could really matter, when things go well and governments should work hard at generating a large surplus. This is the experience of European countries since the launch of the Euro when all governments were seen as identical and their bonds were priced as risk-free assets. Where was the discipline of financial markets then?

Antonio Fatás