Thomas Mayer

EMU’s Stress Test

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Quarrels about the role of the ECB

The history of financial crises suggests that banking crises tend to be followed by public debt crises and eventually by sovereign default and monetization of bad (private and public) debt (see Reinhart and Rogoff’s book “This Time is Different”). Assets created during the boom under unrealistic assumptions for future returns are written off as far as possible, with the remaining parts that could not be written off without triggering a “debt deflation” passed on from private to public and eventually to central bank balance sheets. There seems to be little resistance against this process in the most affected countries, notably the US and the UK, where central bank balance sheets have already been expanded significantly. In these countries, the majority of private households—and hence voters—tend to own real assets (homes and stocks) that were to a significant part funded through borrowing. Hence, there is considerable political support for using the central banks’ balance sheets to avoid hard write-offs and defaults. Conditions are more complicated in the euro area. There, a significant number of private and public households have issued debt against future tax revenues and to fund housing investments. These entities have a strong interest in employing the central bank as a lender of last resort against troubled assets. Against this, the majority of German private households have more of their wealth invested in financial instruments and do not own their homes. In addition, public indebtedness remains manageable. Because of this and Germany’s past experience with hyperinflation, the German public strongly resists the monetary financing of private and public debt. In our view, these deep-rooted differences in interests and attitudes lie at the heart of the conflict within the ECB council about its purchase programme of EMU sovereign debt.

Against this background, financial support of troubled EMU countries by their partners and the ECB has led to serious concerns about the legitimacy of EMU especially in Germany. There, the actions by the government and the ECB have been widely regarded as a break of the promises given to the public at the beginning of EMU. In particular, the ECB’s involvement in supporting sovereign bond markets has been seen as potentially undermining the stability of the euro in the longer-term. To the extent that ECB purchases of government bonds substitute for the necessary hard fiscal adjustment to rebalance the supply of government bonds with the reduced demand of private market participants, deficits and debt levels are funded by “printing” money, which in the long run may lead to inflation. Concerns about the consequences of central bank financing of government deficits and debt has led to the resignation of two German ECB Council members and the Bundesbank’s adamant resistance against any ECB involvement in the rescue of troubled countries. Thus, the Bundesbank resists not only the continuation of the ECB’s Securities Markets Purchasing Programme but also any involvement of the ECB in “leveraging” the EFSF (e.g., by turning the EFSF into a bank with access to ECB credit). Supporters of the Bundesbank’s hard line argue that the EU Treaty requires governments, not the central bank, to ensure financial stability. Hence, it is not the ECB’s task to prevent a systemic financial crisis by intervening in government bond markets. Perhaps, the Bundesbank hopes that a hard line on bond market intervention will enforce more comprehensive and hence more credible fiscal adjustment in the troubled countries, most notably Italy. While this may be the case, there is also the considerable risk that continuous further ECB support of the Italian bond market may be necessary to avoid default of the Italian government and a global financial crisis of so far unseen proportions. Hence, despite the resistance by the Bundesbank the vast majority of ECB Council members may decide to continue the ECB’s SMP and be prepared to accumulate large amounts of Italian and other troubled countries’ debt on the ECB’s balance sheet. Should this eventually lead to inflation and a soft euro, the Bundesbank could at least tell its German audience that they opposed this policy1.

An insurance against a “soft euro”2

Perhaps the Bundesbank’s objections to government funding by the ECB are unfounded. But then again, perhaps not. In view of this uncertainty and to reassure a highly skeptical German audience and ease tensions within the ECB’s Governing Council, the German government could provide insurance against the risks and side-effects of an ECB policy of easy money and monetary government financing. How could this be done?

We believe that one possible way to insure against inflation in Germany and a potential softening of the euro is via a new type of index-linked German government security that is tied to the German price index and is thus protected against inflation in Germany and against a capital loss should a new, harder currency be introduced. With the backing of such securities German banks and insurers could then also develop investment products offering similar protection.

The German government could issue inflation-linked bonds covering the entire maturity spectrum. These bonds could be offered directly to retail investors in a similar way to federal savings notes and be made available to Germany’s financial institutions for private placements (in a similar way to the notes). On this basis, financial institutions could offer their customers savings and insurance instruments. In order to render the new instruments as secure as the government bonds issued in parallel the collateral pool could, as is usually the case with Pfandbriefe, be held as special funds, so that the investors would be protected against losses if the issuing institution were to go bankrupt. International investors could be offered German inflation-linked government paper via auction. The only differences between them and the already available inflation-linked bonds would be:

  1. The peg to the German consumer price index instead of – as has been the case until now – the Euroland index. This would protect investors against German inflation possibly being higher than the European average.
  2. Tax exemption of inflation-driven capital gains.
  3. The assurance that if a new currency were introduced in Germany, which is unlikely but is a widely-held fear, the new instruments would retain their real value when converted into this new currency, so that the investor
    would not suffer any losses on existing euro investments if the new currency were to appreciate sharply against the euro. The investments would thus be automatically converted into the new currency.

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