Thursday, August 16, 2012

Seeing the erred ways of my thinking... (9)

The other day I had a senior Central Bank official, a friend of the family for over 40 years, as a guest at the house. We talked about the role of the ECB. He educated me and I came away with the feeling that I had been totally wrong in my understanding of how the ECB works.

At issue was the buying of sovereign bonds on the part of the ECB.

My point all along has been that there is a huge difference between the Fed's buying Treasuries and the ECB's buying sovereign bonds of, say, Greece. When buying Treasuries, the Fed only does monetary easing; it does not acquire credit risk. When buying sovereign bonds of Greece, the ECB does monetary easing as well as acquiring credit risk. It was the latter which prompted me to conclude that the ECB should not buy sovereign bonds of problem countries.

As a reserve currency country, the US has its entire debt in a currency which it can print. Thus, there can never be the risk of non-payment. Thus, the Fed will never have to write-off Treasuries.

Greece has most of its debt in a currency (Euro) which it cannot print. Thus, there is definitely a risk on non-payment. Thus, the ECB may have to write-off Greek bonds at some point in the future. Such write-off's would trigger a recapitalization need on the part of the ECB. National Central Banks, its shareholders, would have to come up with that capital and they, in turn, would require a recapitalization from their shareholders, ultimately the tax payers of each country. At that point, the buck has stopped with the tax payers.

I was wrong!

There is absolutely no requirement on the part of the ECB to recapitalize should it end up with a negative net worth after a significant write-off of Greek bonds. There is no economic reason why the ECB could not operate with a hugely negative net worth. My friend told me that there are currently several non-Eurozone Central Banks which operate with a negative net worth. He does cede, however, that a negative net worth on the part of the ECB would cause huge political problems.

To make a provocative hypothetical case: the ECB could buy ALL sovereign bonds of EZ-countries and end up holding several trillion of them. Even if all of those sovereign bonds defaulted and would never get paid, the ECB would survive perfectly well. It would simply show a negative net worth to the tune of several trillion.

The only problem would be that the ECB, with those huge losses, could no longer finance its operating expenses out of earnings. Instead, it would require support for that from governments and that is where politicians would try to get the ECB under their direct control.

Ever since my friend left, I have pondered what he had told me. My traditional banker's brain has tremendous difficulty to understand how it could be that a borrower does not pay its debts but no one suffers a loss?

Moral of the story
One should always be prepared to re-examine one's assumptions and convictions in light of new information. I am trying hard to understand that new light!

The final question
Who in the world takes the losses when the debtors don't pay their debts?

PS: previous posts in this series: P1, P2, P3, P4, P5, P6, P7, P8.


  1. Klaus, correct me if I´m wrong, but i think the simple answer is inflation (or hyperinflation, depending on the amount of additinal printed money).

    Who pays the bill? We all in the long term.

    1. Sarcastically: inflation is not the greatest worry of mine (I have lived in Argentina with MONTHLY inflation of 25-30%! One tends to adapt to that kind of chaos). If a Central Bank has the political strength and will, it can eradicate inflation in a reasonably short period of time. Paul Volcker proved that in the 1980s when he allowed short-term interest rates to go up to 20% and more. Of course, the economic and social cost of that would be enormous which is why I doubt that Europeans would have the guts to do that.

      Seriously, if the ECB could indeed operate with a huge negative net worth allegedly forever, then it would prove that there is indeed such a thing as a free lunch. Since I have always argued the exact opposite (i. e. there is no TINSTAAFL), I find it mentally frustrating to agree to something whose sense my brain simply cannot understand.

    2. if ecb finances every 0-10 percent budget deficit and it´s no financial problem (only political), why not allow more? 20%,50%,100%? whenever a state has financial problems send the bill to super mario at ecb. a financial perpetuum mobile? this cannot work.

      such a system must collapse in the long term. how exactly is not important for this discussion.
      your TINSTAAFL theory is still correct. there is no free lunch. somebody has to pay the bill.

      what does your friend think about this?. he (central bank official) has much more knowledge about the financial system than me. but i think it does not matter for this discussion.

      i remember, when somebody argued a mechanical perpetuum mobile does exist. i said "i don´t understand all these complicated calculations and descriptions of special physical principles, but i do not have to understand them. it is sufficient to know, that the principle of conversation of energy is true and was true, so your construction cannot work!"

      so who is right?

    3. To save my friend's honor: he did not suggest to carry the negative net worth thing to the extreme. He just explained why, at this time and in his view, the buying of sovereign bonds would be recommendable. In fact, his position is that the ESM should do the buying and be given a banking license for that.

      I carried his point to the extreme for the sake of argument.

  2. "Who in the world takes the losses when the debtors don't pay their debts?"

    Let us put this the other way around: "who would suffer when the debtors pay their debts?". In this case the ECB would have to draw on those who can pay - taxpayers.

    If the ECB doesn't have to pay its debts, it will just roll along and happily accrue debts until the cows come home. Until now, the EU has shown very little economic/investment intelligence, and certainly no remorse for getting it so wrong. I would think the ECB would be happy to go along with this. After all, if you don't see that there is a problem, there isn't one.

    Oh, and it gets the German taxpayer off the hook ...

    The political problems would only come from people who have a moral stand. After all, there is only a problem if you see one.

  3. Karl Whelan wrote recently about this issue.

    1. Well, the article is one more reason why I may have to re-think the logic which has steered my banking career for 40 years...

      There is, however, one important aspect which my friend noted. What goes for the ECB does not go for national Central Banks. He said that this was overlooked at the time of the creation of the ECB.

      National Central Banks of the Eurozone CANNOT run a negative net worth because they cannot print the Euros which would be needed to stay afloat. Thus, if a NCB ever came close to having a negative net worth, the national governments would have to recapitalize them.

      Why would NCBs face the risk to run a negative net worth? Because the ECB could call for a recapitalization. One more reason that the ECB is unlikely to ever call for a major recapitalization.

  4. Like often, i appreciate your intellectual honesty. You finally recognize what many people have been claiming for a while. The main point is that a central bank is not a regular bank. Under its mission of issuing and handling the currency, It cannot comply to the same rules.

    Thus, a CB's balance sheet is not an accounting tool, this is just a macroeconomic indicator of how the economy is performing.

    "Who in the world takes the losses when the debtors don't pay their debts?"

    Wrong question. The first one to wonder is: "what (the hell) is a 'debt' ?"

    If you read David Graeber's book (Debt, the first 5,000 years), you'll find out that there is not such a debt that should always be paid back. Debt is not what we think it is (an obligation), this is more of a social contract.

    I cannot tell you much more since 1. it would require more time and 2. i still haven't finished the book; but i really recommend you to acquire it.


  5. Of course such a solution would have to be endless or to cover the trade imbalances and productivity imbalances within the EZ.