Tyler seems to suggest that what we are seeing is an acknowledgement by the bond markets that the fundamentals in Europe are deeply off.
Kantoos – it seems – recognizes that what we are likely seeing is a run. However, the primary tool for stopping a run – lend freely against good credit – would only be applicable if Italy’s long term prospects were better. Otherwise, there are significant risks to the ECB and in turn to Germany from lending freely.
Up front, I should be fair to the readers and note that my stance on handling runs is a bit heterodox. In part, because I think what counts as good credit is incredibly nuanced and situation dependent, something the Central Bank in fact has a lot of control over. In part, because I think runs have what others might call a strong psychological component. I actually think its just profit maximizing under uncertainty, but nonetheless if you believe that the Central Bank can and will ruin you then you are not going to run. So, what the Central Bank makes you believe about its immediate response function is a big deal.
That having been said let me address the two issues.
First, for Cowen, I see a lot of evidence that the periphery in general and Italy in particular have extensive institutional and demographic problems and will suffer from sluggish growth from here forward. The extent to which this makes it impossible for Italy to service its debts is not clear. After all Italy has been stagnating for at least a decade and over most of that time its debt-to-GDP ratio was falling.
More generally the overnight rate in a currency area generally does not exceed the nominal GDP of the currency area over the long term. That would imply that as long as Italy’s growth rate was not too far below that of the Eurozone it could service this debt indefinitely.
Worse case scenario Italy needs to run something on the order of a 2% primary budget surplus.
The real issue for Italy and the periphery and why things are so difficult is that Italy as a nation – not a government – borrowed a lot of money. Now it needs to pay it back. However, the way you do that is by running a current account surplus. The way you do that is by letting your currency fall. However, the ECB will not let the Euro fall and so Italy simply cannot pay back the money it owes.
Not in the sense that it doesn’t have the money or the real resources. It doesn’t have the mechanism.
Kantoos’s point is well taken. However, there are clear mechanisms for dealing with this. He thinks my plan is too much for Europe to handle. Ok. fine.
Let the ECB stand as Lender of Last Resort for T-Bills on an issuance by issuance basis. Every time Italy comes to the well, the ECB will announce that this issuance of T-Bills will ALWAYS stand as collateral for Repurchase Agreements at Par, no matter what.
This will bring Italian or anyone else’s actual borrowing cost down. The ECB will not actually have to take any of these bonds on to its balance sheet permanently, liquidity vehicles will be provided for European banks, the Secondary market in old debt will continue to send price signals about the long term viability of the periphery and the ECB has the ability to stop guaranteeing new issues at any time.
This solves most of our immediate problems and leaves all the cards in EC and ECB hands.
We don’t need to drag the IMF into this and we don’t need to take this outside the banking sector. Anytime you start involving non-bank agencies into these matters I get nervous. I know I hate on the ECB but my wish is for them to reform and act like an activist Central Bank, not to start pulling in politicians to do work that bankers should do.
You just can’t have but so much confidence once you start turning over the operation of credit markets to politicians. This is not a jab. They have different incentives, training, views of the world. They do not value stability in the same way. And, quite frankly they are answerable to democratic processes in ways that bankers are not.
Settle it inside the Eurosystem. Settle it fast. Let markets calm. If you are worried about handing away to many cards we can always structure some type of facility that leaves the Central Bank with all the cards.
But, for God’s sake don’t let the future of the world depend on the EU member states coming to some lasting and mutually beneficial agreement. Everyone is aware that they have managed to screw-up on a colossal scale in the past. You should no confidence that they will do the right thing even after they have exhausted all other possibilities, today.
Very bad things do happen.
They very well might be happening right now.