What explains high interest rates in Europe? On creditor seniority and sovereign bond markets

Frank Westermann, Sven Steinkamp, 22 August 2012



Interest rate spreads in Europe have evolved in a way that most researchers find hard to reconcile with the underlying economic fundamentals. 

Topics: EU policies, Europe's nations and regions, Monetary policy
Tags: Bond spreads, ECB, Eurozone crisis

ECB limited and conditional lending is not 'what it takes'

Piero Ghezzi, 19 August 2012



There is broad agreement that the ECB is going to be the main actor in the potential resolution of the peripheral debt crisis. In principle, there are two avenues that the ECB could pursue in its efforts to avoid a full-blown crisis. First, it could ease monetary policy sufficiently to weaken the euro and generate inflation to facilitate growth.

Topics: EU policies, Europe's nations and regions
Tags: ECB, Eurozone crisis

ECB: No free lunch

Marco Annunziata, 14 August 2012



Disappointment in the financial markets at Draghi’s latest press conference was predictable, understandable – and misguided. You could measure it by the movement in the euro-dollar rate, with a hopeful spike quickly followed by a despondent plunge as the press conference unfolded. 

Draghi’s main messages can be summarised as follows:

Topics: Europe's nations and regions, Macroeconomic policy
Tags: ECB, eurobonds, Eurozone crisis, Italy, Spain

Thanks to the ECB

Charles Wyplosz, 30 July 2012



On Thursday, the President of the European Central Bank, Mario Draghi, created a buzz by saying that the central bank “is ready to do whatever it takes to preserve the euro. And believe me, it will be enough.” This was enough to send the euro up and bond spreads down. But what was Draghi really saying? Very smart things, in fact, for the third time.

Topics: EU policies, International finance
Tags: banking union, ECB, EU Summit, EZ crisis, lender of last resort

Trust between Eurozone leaders can create self-fulfilling positive outcomes

Paul De Grauwe interviewed by Viv Davies, 13 Jul 2012

Paul De Grauwe of the LSE talks to Viv Davies about his recent Vox column on the potentially destabilising effects of the decisions taken at the last crisis summit of Eurozone leaders. He explains how the new recapitalisation role established for the ESM is doomed to fail and how the ECB is operating on the wrong business model. They discuss how full banking union will not be possible without a degree of political union, and how trust could create self-fulfilling positive outcomes for the Eurozone. The interview was recorded in London on 10 July 2012.


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Viv Davies: Hello, and welcome to Vox Talks, a series of audio interviews with leading economists from around the world. I'm Viv Davies from the Centre for Economic Policy Research. It's the 10th of July, 2012 and I'm speaking with Professor Paul De Grauwe of the London School of Economics about his recent Vox column that describes the potentially destabilising effects of the decisions taken at the last crisis summit of Eurozone leaders. De Grauwe explains why, in his opinion, the new role established for the European Stability Mechanism is doomed to fail. He also suggests that the European Central Bank is operating on the wrong business model, and how full banking union in the Eurozone will not be possible without some degree of political union. De Grauwe maintains that only deeper trust between the Eurozone leaders will be able to create the kind of positive outcomes that will be required to save the Eurozone. I began by asking Paul how significant he thought the recent Eurozone summit had been.

Paul De Grauwe: The immediate reaction of the market was euphoric as usual. Then after a few days when everybody had become more sober, this euphoria disappeared and we saw that in fact nothing really had been solved. We thought that there would now be a mechanism that would create stability, but this appeared to be not the case, and we have to start from scratch, so to say.

Viv: Your recent Vox column focuses on the new role that's been established for the European Stability Mechanism, or the ESM, in that it will now be enabled to directly recapitalise troubled banks and to buy government bonds in the secondary markets in order to prevent further destabilising surges in bond yields such as we've currently witnessed in Spain and Italy. Yet you suggest that the ESM will not only fail to stabilise the bond markets, but the whole idea could in fact be destructive. Why is that?

Paul: It has to do with the following. ESM, the European Stability Mechanism, now has resources approximating 500 billion euros. The debt total of government bonds issued by Italy is close to 2,000. Add to that about 800 billion of Spain, and then your other possible countries and you see immediately that the ESM doesn't have enough resources to make it possible to stabilise the bond markets, right? If one of these countries gets into trouble, it's clear that the ESM doesn't have the money to provide stability. In fact it's worse because, given its limited resources, once it starts intervening investors will immediately see that its resources are depleted. It will start buying, say, Italian government bonds and at the end of the day you look at the balance sheet of the ESM and you'll see there's less left over for further interventions tomorrow. As a result, investors will anticipate the moment where the ESM runs out of resources.

That will be the moment where the ESM cannot intervene anymore and bond prices start declining again. But investors are rational beings, and they will put that to the present and they will therefore have a very strong incentive to sell immediately. As soon as the ESM starts intervening, this will signal to the market that it's time to intervene because they already anticipate that the ESM will be running out of resources and will have to stop that intervention.

It's extremely destabilising. This phenomenon is well known for people who know the literature, for example, about foreign exchange markets and fixed exchange rates that have the same instability feature.

Viv: Paul Krugman wrote about this.

Paul: Paul Krugman has a classic paper. Obstfeld later, also. Another type of crisis model for the foreign exchange market. These people don't seem to learn from what we know.

Viv: Given that Germany won't accept the idea of a Eurozone bond or some other form of debt mutualisation, and that the ECB isn't prepared to directly purchase government bonds, does this mean there's no alternative for countries like Spain and Italy other than to leave the Eurozone?

Paul: Well, if we stay in a situation where these countries like Germany and others, it's not only Germany. Holland and Finland are of the same idea if that goes on, then at some point Spain and Italy will have no other option. They will not accept to be driven into default. Sovereign nations that do not want to do that, will not want to be pushed by financial markets. Then the only option will be to leave the Eurozone, yeah. But that will of course be in an environment of violent instability that I hope we can avoid.

Viv: Of course. You maintain that the ECB is operating on the wrong business model. Can you elaborate a little on that for us?

Paul: Yes, ECB is concerned mainly with its balance sheet. It wants to avoid making losses. It wants to have positive equity. That's an overriding concern of the ECB. But that's wrong for a central bank to have as a primary concern. The primary concern of a central bank should be to maintain financial stability. That's why we need a central bank, to maintain financial stability. Capitalism is often gripped by booms and busts, and financial markets are then very unstable. The banking sector can become very unstable. We need an institution that is primarily concerned with financial stability, not with an institution that doesn't want to make losses. Because these two concerns conflict with each other. When the central bank has to intervene to maintain financial stability, it runs the risk of making losses.

It buys bonds, and it is possible that it will make losses. Not necessarily, but it's possible. If it is too much concerned about avoiding losses, it will not be prepared to buy the bonds in the markets, and as a result fail to maintain stability. Another example, the ECB after having bought Italian and Spanish government bonds, came out saying, "We want seniority on these bonds." Now, the effect of this is that the others, the private holders of these bonds say, "But now we have become junior, so the risk for us has increased," and they sell the bonds.

Here you have a central bank that is overly concerned about its balance sheet, does things that destabilise the financial markets. A central bank has to keep in mind that what it should do is to maintain financial stability. If that leads to losses, so be it. In fact, a central bank can make unlimited losses. Unlimited in the sense that it should not be such that it destroys price stability, because that's another objective.

That's the limit that the central bank should keep in mind, but we are so far from this today. The risk of inflation that the central bank surely should not be concerned today about potential losses.

Viv: The last time we spoke, you mentioned the matter of moral hazard when the ECB are lending. Could expand on that for us?

Paul: Well, when the central bank, when the ECB buys government bonds, for example, it alleviates the pressure of the governments. For example, the Italian government. This may lead to moral hazard in that the Italian government may then feel a little more relaxed. And then, not as much pressure to reduce deficits and debt levels. So that's the moral hazard problem that arises each time the central bank exerts its lender of last resort activity. The same is true for banks. When the ECB provides liquidity to banks, it also leads to moral hazard and the risk, therefore, the banks will take too much risk. That is certainly a problem. There is no doubt about this. The central bank, in times of crisis, must provide the liquidity. Others should then take care of moral hazard issues.

The way we did with it in banks is to say, "Well, you have supervisor regulators that try to limit the risk that banks can take. It's not easy, but this should be other institutions than the provider of liquidity. The one that provides liquidity should not try to solve two problems, namely liquidity crisis and a moral hazard problem. It's like the fireman that is at the same time the policeman.

The fireman that arrives at a burning house has to extinguish the fire, and should not try to be the policeman at the same time that is trying to catch the guilty. If he does that, he will not be a good fireman. The same is true for a central bank and also with respect to government bond markets when a central bank buys these government bonds, it provides the liquidity, it creates moral hazard. We should have another mechanism that deals with the potential moral hazard risk that is created by these liquidity interventions. That's also not easy, but that's the way we should do it.

Viv: Do you think full banking union in Europe will ever be possible without political union?

Paul: No. The banking union always implies some political union, not necessarily a full scale political union, but some. Let me give you an example. If banking union also implies that we will have a deposit insurance mechanism that is organised at the European level, in normal times the funding of this insurance mechanism can be provided by the banks that participate in all this. In crisis times, this funding is usually insufficient. As a result, you need a backstop that has to be some European institution then with the power to tax, and to make sure that the system can be kept. That requires some political union.

Viv: The immediate and most pressing problem in the Eurozone has been described recently as being a mix of excessive debt, failing banks, and uncompetitive economies causing a lack of access to financial markets. In addition, unemployment at over 11% is at the highest it's ever been in the Eurozone. Do you think we're moving any closer towards resolving these core problems?

Paul: Well, not really. I'm not very optimistic after all we have seen and the failure to act quite often, also propensity to decide the wrong things. It doesn't look like today we are in the process of solving these problems. We have not set up a mechanism that makes it possible for countries that are pushed into a corner by financial markets and are driven into insolvency to help them out. In addition, macroeconomic policies continue to be deflationary, where we put excessive austerity in some, especially southern European countries, without any compensating macroeconomics stimulus elsewhere. All this makes it very difficult to resolve these problems. Sometimes I am despairing, but I'm trying to convince myself that maybe at some point we will be able to resolve this.

Viv: What would be your immediate advice to the Eurozone leaders right now, Paul?

Paul: The basic requirement is that trust is to be established, because it seems to me that we are failing to come up with the right decisions because there is so much distrust. I see how the Finns, for example now, just a few days after the previous summit meeting. Distrust suddenly come up so much that they come back on these decisions. The Dutch do the same things. Everybody distrusts everybody. That makes it extremely difficult to come to the right decisions. All I can advise them is to tell them, well, start trusting each other. And then, this may even work in a self fulfilling way. Trust has this characteristic of creating self fulfilling positive outcomes. But unfortunately, we are now more in a bad equilibrium, where distrust is taking over, leading us into bad equilibrium.

Viv: Paul de Grauwe, thanks very much.

Topics: EU policies, Europe's nations and regions
Tags: ECB, European Stability Mechanism, Eurozone crisis

The tragic error of excessive austerity

Richard Layard interviewed by Viv Davies, 6 Jul 2012

Richard Layard of the LSE talks to Viv Davies about his and Paul Krugman’s recently published ‘Manifesto for Economic Sense’, which aims to generate a movement of economists who are prepared to speak out against policies they know to be wrong - the excessive austerity of current fiscal policies. They discuss the role of the ECB as lender of last resort and whether the current bank-led capitalist culture can ever be changed. The interview was recorded in London on 5 July 2012.


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Viv Davies:  Hello, and welcome to Vox Talks, a series of audio interviews with leading economists from around the world. I'm Viv Davies from the Centre for Economic Policy Research. It's the 5th of July, 2012, and I'm speaking with Professor Lord Richard Layard, founder and emeritus professor of the Centre for Economic Performance at the London School of Economics. We discuss his recently published Manifesto for Sound Economics, written with Paul Krugman, which aims to generate a movement of economists who are prepared to speak out against policies they know to be wrong.

Professor Layard briefly summarises the manifesto and what he considers to be the errors that have taken root in public consciousness and which have provided support for the excessive austerity of current fiscal policies in many countries.

We also discuss the role of the European Central Bank as a lender of last resort, and whether the current bank-led capitalist culture will ever be changed. I began the interview by asking Lord Layard to summarise why he thought the manifesto needed to be written.

Richard Layard:  Well, I think the majority of economists probably disagree with what is presently going on, and in particular with the assertion that the only way to get growth is to take extra action to reduce public deficits. That, of course, is getting things the wrong way round, because the deficits are not because of low growth; it's the low growth that's the cause of the deficits. We have these deficits, but not because there was irresponsible public borrowing back in 2007, because there was excessive private borrowing and lending, which led to the bust, which lead to reduced private spending. Then the reduced private spending led to reduced tax receipts, and so the lower taxes which are causing the deficits in the public finances.

So when you've got a reduction in private spending, the last thing you want to have is simultaneously a reduction in public spending, thereby cutting the total level of activity in the economy. And you don't want to have, equally, big tax rises reducing private spending.

And what is remarkable is that there is no evidence that doing these things ‑‑ which every country is being told they have to do ‑‑ will produce the growth which people assert is going to be the result. So the IMF in its latest economic outlook has a wonderful chapter where they look at 183 episodes in the past where countries have taken discretionary action to reduce their deficits, and they show that in the vast majority of cases, this led not to faster growth but to slower growth, which is what, of course, the ordinary economics textbook for a depression economy would lead you to expect.

There's another issue. If we slow growth in this way, we're having a bad effect on the future path of deficits. We're going to have higher deficits further into the future, and there's a strong argument put forward by Larry Sumners and Brad DeLong in Brookings papers that if you increase the deficit in the short run, this would have the effect of stopping unemployment becoming endemic, and thereby making it easier to have higher growth in the medium term, and therefore lower deficits in the medium term, which would more than offset the slightly higher deficits you have in the short term.

So, really, just to go on trying to cut deficits in the short term is a very counterproductive policy.

Viv:  The manifesto presents two counterarguments to your proposal. A confidence argument in that austerity increases confidence and the prospects of recovery, et cetera, and a structural argument against expanding demand in that output is constrained on the supply side by structural imbalances in the economy. Could you elaborate a little on these arguments and how you counter them in the manifesto?

Richard:  Well, the confidence argument says that if you increase the deficit, this will raise interest rates, and that will produce lower growth. There really isn't any evidence of that in the conditions we're now in. We would have significantly higher interest rates if we had a higher deficit. Because just look around. You see absolutely massive deficits in the US, Britain and Japan, and you see almost the lowest interest rates that we've ever seen. So it's just not a reasonable spectre to be raising. In fact, the confidence argument is obviously failing, because you can see that businesses are not feeling confident because of the deficit reduction policies. They're feeling, "Oh my god, where is the demand going to come from?"

This deficit reduction policy is just going to impose low growth on our countries for some years. We're not going to invest because we can't see the market. So the confidence argument isn't working. The structural argument is also invalid, because suppose that we were being inhibited from expanding aggregate demand because there were some sectors that were already operating at full capacity.

Then we would have to see some sectors operating at full capacity. We don't see that, we see in most the countries, we see excess capacity and unemployment in every part of the economy, and higher unemployment in every occupation.

It's not a plausible argument, the structural one. It was used during the Great Depression, and lo and behold when people said the American economy can't produce any more, suddenly there was the Japanese threat and from 1940 to 1942 the US GDP rose by 20%. It had been limited by demand rather than by supply.

Viv:  Within a European context, would you be in favour of the ECB acting as lender of last resort to European banks?

Richard:  Well, the European problem is a different one. I perhaps should have referred to it when we were talking about interest rates, because of course European interest rates in many countries are very high. But this is not because these countries were irresponsible in their budgetary policy in 2007. We had falling debt income ratios in Spain and Italy and some other countries in 2007. Even now, Spain and Italy have lower deficits than the US, Britain and Japan, even though they also have higher interest rates.

It's just not the case that the interest rates are caused by those deficits so much as the fact that the countries of Spain and Italy do not have a central bank behind them that will fund their deficits, whereas Britain, Japan and the States do have a central bank behind them that would in the last resort fund these deficits.

So we have to have institutional reform in Europe, and we have to have some system whereby ultimately the central bank will not only be a lender of last resort to European banks but also a funder of governments on certain conditions, of course, and that's why we have to have these much more strict arrangements for European supervision of budget deficits in the different member countries.

Viv:  So it's clear then that the global financial crisis wasn't a blip on the landscape, but what you're advocating calls for a radical and very significant cultural and political shift. Do you think banks, businesses and governments are ready and prepared to go that far? Will they ever be?

Richard:  Well, I think the public is going to demand it. And I think there are sort of very specific reasons relating to this crisis which are going to lead to much greater regulation of banks, and hopefully more government activism in getting us out of the recession. But I also think actually that there will be and needs to be a big cultural change in a different capacity. I've been a co‑founder of something called "Action for Happiness," which is a movement to encourage people, in fact all the members pledge to try to create more happiness in the world and less misery. To lead a moral life in everything they're doing, including their work life.

And I don't think we want people working in businesses unless they think that what they're doing is socially useful. I think we've got to get back to that kind of concept of a life that is dedicated to the common good in some way or other, and not simply dependent on self‑interest.

Viv:  So finally, how would you like to see economists respond to your manifesto?

Richard:  Well, I want everybody to get up and shout and write articles, send off letters, organise meetings and make sure that we stop proceeding in this way, which is bringing in so much misery to our people.

Viv:  Lord Layard, thanks very much for taking the time to talk to us today.


Topics: Global crisis
Tags: austerity, ECB, fiscal policy

The tragedy of the commons at the European Central Bank and the next rescue

Aaron Tornell, Frank Westermann, 22 June 2012



The late, great scholar of crises, Rudi Dornbusch, put it aptly: “In a very rich country you can afford to do very bad things for very, very long.” (Dornbusch and Fischer 2003). The Eurozone is in the process of finding out just how long “very, very long” means.

Topics: EU institutions
Tags: ECB, EFSF, Eurozone crisis

Is LTRO QE in disguise?

Jean Pisani-Ferry, Guntram Wolff, 3 May 2012



With the launching of the three-year longer-term refinancing operations (LTROs) in December 2011, the Eurosystem has entered new territory (see Wyplosz 2012).

Topics: Macroeconomic policy
Tags: Bank of England, ECB, Fed, monetary policy

The ECB’s proportionate response to the Eurozone crisis

Bernard Delbecque, 4 April 2012



When the Eurozone crisis worsened during the summer of last year, a number of experts proposed to appoint the ECB as a lender of last resort in the government bond markets to make these markets less prone to liquidity crises and contagion, and to prevent the weakest Eurozone countries from being pushed into a self-fulfilling debt crisis (see

Topics: EU policies, Macroeconomic policy
Tags: ECB, LTROs, monetary policy

ECB inflation-fighting powers remain intact

Christian Thimann, 30 March 2012



In a recent Vox column, Aaron Tornell and Frank Westermann (2012) argue that with the conduct of three-year liquidity operations, the ECB has “hit a limit in its ability to prevent an acceleration of inflation”.

Topics: EU policies, Europe's nations and regions, Monetary policy
Tags: ECB, Eurozone crisis, inflation

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