Central banks’ credibility

There is no such thing as doing something you don’t believe in to gain credibility.

The blogosphere is full of articles about why Larry Summers is worse than Janet Yellen (or was it all the way around?) and I don’t intend to add to that discussion. However, it seems to me that there is a bigger question that needs answering, i.e. central banks’ credibility.

I read today a very good summary of the arguments in favour of Larry Summers, put together by Ezra Klein (who makes it painfully clear these are NOT his views). The full article is here and I’d like to quote one paragraph:

Summers is a better dove because he’s a better hawk. (…) There are two versions of this argument. One is that Yellen will tighten prematurely, because her reputation as a dove will make it harder for her to convince the market that she really will begin tightening when the time comes, and so she’ll need to move from promising future tightening to actually tightening sooner than Summers would. Another is that investors won’t trust Yellen’s promises to tighten, and so the market will lose some confidence in the Fed and a risk premium will begin building — which would be even worse than an actual tightening.

I am very sorry to say but this is ludicrous from whatever angle you look at it. Firstly, to assume that the Governor of the mightiest central bank on the planet has to do something to convince the market she means business is a joke. Secondly, to assume that Fed Chair would at some point arrive at a conclusion that policy probably needs to be tightened in, say, 6 months’ time and then go on and tighten immediately is offensive to any sort of intelligence. And thirdly, after all these years of seemingly dollar-debasing / hyperinflationary / zerohedgey policies, can anyone argue that the market would lose confidence in the Fed?

Credibility is composed of two factors: trustworthiness and expertise.

Let’s start with the expertise. I think the cornerstone of economic analysis is the data. The Federal Reserve is the central bank that brought to you FRED and is home to some of the brightest economists out there. Working papers produced by Fed staff are of sensational quality (at least the ones I’ve read) and it’s the central bank that is embracing the modern technology in full (and I don’t mean only tweeting). True, not all of the Fed’s forecasts are spot on but they are probably accurate reflection of the prevailing state of affairs and include all available and relevant information. Additionally, the Fed has been around for almost a century. In other words, the institutional memory of the Fed really should not be questioned. And again, this does not mean they’re infallible.

So then what about trustworthiness? Do I trust Janet Yellen and Larry Summers? Not particularly, no. But it is completely irrelevant. Trustworthiness in the Federal Reserve Chairman or Chairwoman extends from the trustworthiness of the institution. That’s why markets learned to trust Alan Greenspan even if he turned out to be a true maestro of destruction. Interestingly, almost two decades of his reign, which ended in peril, did not dent the Fed’s credibility. You could think that after the mess that Alan made, the frantic printing of money would have been compounded by the disillusion with the Fed’s handling of the economy… Instead, inflation remains in check (perhaps even too much) and I don’t think people have a sense of the Fed losing control. So all in all, I think the fairy tale about the market being worried about trustworthiness of either Yellen or Summers is just that – a fairy tale. Investors will trust them both because both have their own credentials and they will be running one of the best (in terms of human capital) central banks in the world.

But as I said, I don’t want to make it all about the U.S. Do you remember November 2011? The previously modestly (or would it be moderately?) known Governor of Bank of Italy Mario Draghi became the ECB Governor. At that time it was painfully obvious that the ECB had to cut interest rates and yet for some reason people thought it wouldn’t happen during the first meeting. They were saying that it would be damaging for the ECB credibility if an Italian started his tenure in Frankfurt by cutting rates thus infuriating the Germans. Silvia Wadhwa (why does she even have the right to express her own opinions?) said on the day of the meeting she would eat her hat if Draghi cut rates. And what happened? Draghi cut interest rates and… nothing. The EUR did not fall apart, inflation did not soar, the Germans didn’t go on strike. Why is that? Firstly, because the ECB is an important player in the market that makes things happen and secondly because Draghi did the right thing. Imagine how his credibility would look like if he waited a few months just to appease the Wadhwas of the world. Would he be able to play his ace of spades several months later by saying “whatever it takes”? Perhaps but credibility is not built on appeasing investors but by doing what you think is right with support of the institution behind you.

Again, I would like to stress that what I’m discussing here is the issue of credibility rather than making no mistakes. Importantly, sometimes the market goes the other way and assumes that some institutions have limitless credibility (I addressed it in my previous post “Just do as I say, don’t do as I do“) but that’s beside the point.

I only ask you this. Don’t tell me that differentiating candidates should be based on what they may or may not do if and when the need to hike rates arises. Rest assured that they will do whatever they think is right and that it has more to do with the incoming data and the analysis coming from within the Fed. There is no such thing as doing something you don’t believe in to gain credibility (In fact, I like this sentence a lot so I will put it on the top)

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Just do as I say, don’t do as I do

One of the oh-so-many unintended consequences of what we’ve seen in the market for the last five years is the widespread belief that no matter what happens policy makers are in almost full control of the events. Moreover, we seem to be more willing to take their word for granted rather than analyse what they’re actually doing (which reminds me of this old Genesis song, hence also the title of the post).

Think of it.

  • If the US growth numbers turn sour, who do we think can come to save the day? Either the government with the fiscal package or, more recently, the Fed with some sort of money printing magic wand.
  • When a eurozone country gets into trouble, all the research says “if only the Troika was there to help them” or “if only Mario Draghi was not on vacation and said something about whatever it takes”.
  • Similarly, if the day of reckoning comes in India after years of screwing up the fiscal situation and very little progress on boosting competitiveness to sort out the current account (yes, that does matter), all we want is the RBI to tighten the liquidity situation to go back to normal.
  • Or when Turkey pushes the current account deficit and short term external debt to levels previously unseen in the emerging markets universe, simultaneously pumping up credit growth to very high levels and keeping negative real rates, all the JP Morgan research wishes for is for Governor Basci to sound hawkish to make it all go away. Indeed, they hiked the upper end of the interest rates corridor today and people are very happy even though it really means nothing.
  • In Egypt where the fiscal situation is completely unsustainable and people are rioting at the time when FX reserves are being depleted at a Formula I pace, many people think that the Gulf states or the IMF or some other Santa Claus can come and save the day with a simple loan. If only the government asked for it…
  • Finally, when the Governor of the National Bank of Poland categorically says that policy easing has finished at 2.5% and that he is sending a strong signal to the economy that the worst is over and therefore the economy can grow again, the market immediately takes it as a gospel even though it does sound an awful lot like my favourite Baron Munchhausen.

Trust me, I do have many more examples of when we either wish for or treat policy makers’ decisions as the ultimate solutions. Whereas if you think of it, many times it is a very twisted logic, which a friendly portfolio manager summarised as “when we turn left, a road to the left will appear”.

It didn’t use to be like this. Our faith in policy makers’ ability to reverse the course of the market has proven correct in many cases (see whatever it takes) but I think that oftentimes it’s just a reflection of the laziness of the market. After all, it’s much easier to buy bonds in Slovenia or Italy because the ECB says it will defend them rather than to look into the fundamentals. Or it’s much easier to buy the Turkish lira because the CBRT says it is hawkish rather than to think whether it’s actually true (NB it most definitely isn’t, in my opinion).

I am not denying the fact that the policy makers control developments in the very short term no matter how much you disagree with them but we need to be very careful when extrapolating that. I strongly believe that there are still things which are beyond fixing and that sometimes it really is too late. The following points are not necessarily things I am convinced about but I think you can make such counterarguments to the propositions I presented above:

  • Fed saving the day – what if the US is in the classical liquidity trap in which case without a strong fiscal stimulus you will get nowhere via QE?
  • Draghi doing whatever it takes – what if the EMU debt is actually not sustainable, in which case it’s just a matter of time before dominoes start falling? (ok, I actually don’t really agree with this one but Nouriel, Nassim and Zero would probably make that point; Also, “Zero” is the first name of Mr Hedge, right?).
  • RBI saving the rupee by squeezing front end rates to 8% – what if the awful policy mix of the recent years actually requires long term yields to increase considerably to attract any sort of interest from international investors?
  • CBRT rescuing the lira – what if we are ahead of a proper old-school funding crisis in which case the current account deficit will need to be closed in a disorderly fashion triggering a massive increase in interest rates and a huge recession?
  • Egypt bail out – what if the cost of saving Egypt is too high for anyone to bear and the country actually is unable to sustainably fund the fiscal deficit, particularly in the local market?
  • Poland recovering – what if the excessively tight monetary and fiscal policies have durably lowered the potential growth rate in Poland turning it into a country more resembling the Czech Republic (i.e. with very high savings rate and no domestic demand)?

Some of those things sound less plausible than others but I guess the message is that don’t let the policy makers whisper the reality and pull the wool over your eyes. Granted, they can and should impact your trading decisions in the short-run but if the brightest and best-paid minds working in the financial industry are having problems with forecasting what is going to happen in the marketplace then how can you assume that people who – for the most part – are politicians constantly make the best possible decisions?

What I make of it all

I have given a friend a task lately to come up with a consistent theory explaining recent moves in markets. I said it could be a conspiracy theory, a preposterous theory or any-other-theory as long as it provides a consistent explanation of recent moves. His reply was “people are selling what they were very long of” but then he reflected and said that it wouldn’t be consistent with the equity rally.

While I do not aspire to give you a comprehensive explanation, I think I have one that at least I feel comfortable with. But let’s start with a snapshot of what’s going on:

  • USTs are selling off.
  • Inflation keeps surprising to the downside.
  • USD is not really rallying (except against the yen).
  • US equities are generally supported.
  • Credit is wider but not spectacularly so.
  • Implied vols are creeping higher.
  • EM bonds are under tremendous pressure and currencies are weakening.
  • Commodities had come off but have sort-of stabilised lately.

Now, it may well be the case that we’re simply experiencing a risk-off period, although I’m not sure equity and commodities markets would agree with that fully. Neither is the UST sell-off the first thing that springs to mind when discussing the dreaded risk-off.

A theory, which is a bit closer to my heart is what Paul Krugman put in his blog today but again the USD is not really rallying. Alternatively, stuff like the Mexican peso shouldn’t be under so much pressure in such a scenario, I reckon.

I see two main forces driving the market at the moment. The first one is the Bank of Japan. In my post Eddie Vedder and the Japanese carry from April 13 (USD/JPY approaching 100 ) I was being skeptical about the whole concept of yen being used to fund stuff elsewhere saying that the Japanese will probably find plenty of opportunities locally if they believe in Abenomics. However, I did also say that if anything they’d go for bonds in the US, which are looking considerably better than other global bonds on a currency-hedged basis. Similarly, if a Japanese investor wants to bet on the yen decline, then they should keep it simple and do USD/JPY rather than, say, AUD/JPY. And this is a very important point because whenever USDJPY jumps 1%, it pushes the USD index higher by almost 0.15%, thus creating the impression that the risk is off because the USD strengthens. Therefore, the previous correlation of “yen lower, risk higher” does not work like a charm anymore.

But then, if it’s just a localised intervention in USD/JPY, which has very little to do with the fundamentals in the US of A then perhaps it is safe to assume that some investors have been skewing their own USD index by buying a bit more USD against the JPY and selling the greenback against the EUR? I will explain in a second why.

A global bond investor, which has a WGBI index as a benchmark (that’s representative of around 3-4trn USD in AUM) has 23 countries to choose from. These include the bond behemoths like US, Germany, Japan or Italy but also smaller markets, mostly in Europe. And the way this investor looks at the world at the moment is as follows.

  • She just heard from Ben Bernanke that the Fed might start limiting bond purchases. Granted, this will still be an expansion of the balance sheet but at a slower pace. The investor in question will be reassured that this is not a policy mistake but rather the response to recent data when, e.g. looking at the tax receipts data (chart below):
    us_taxes
    The chart shows the annual rate of receipts of the federal government. Not only have we surpassed the pre-crisis highs in terms of revenues but also corporate income taxes are looking very healthy. And no, they are below the 2007 highs not because Apple is avoiding taxes or something but because there is a lot of tax credits originating from the crisis to work through.
  • The investor then looks at emerging markets (Mexico, Poland, Malaysia and South Africa are representing EMs in the WGBI index) and thinks that there is no way these are going to withstand the UST sell-off. Anyone who thinks otherwise is in a dreamworld in my opinion. There’s also the argument of positioning, which is very heavy.
  • Then the investor looks at her global growth/inflation forecasts and sees this big black hole between the Urals and the Atlantic Ocean, which is at a brink of deflation and already in a recession. As much as such a scenario for Europe would’ve been considered a disaster 2-3 years ago, it is now a fact of life. Please see my post Systemic ain’t what it used to be for a more detailed explanation. Suffice to say that if you have reasons to believe Bernanke when he says he will “taper” then you also should believe Mario Draghi when he says that he is prepared to do whatever it takes.
  • Meanwhile, there is a significant risk of a currency war breaking out in Asia. Yesterday the Japanese told their Korean colleagues to go and… do something about the won rather than whine over the yen depreciation. Not exactly a fantastic environment for investing in bonds over there, either.
  • So if you are a fixed-income dedicated investor then there’s really pretty much one place to be – European debt markets. To be sure, trends change and it can be reversed but if you believe in the global growth/reflation trade then probably shorting BTPs or SPGBs is not the first thing to do. In fact, under such a scenario I can very much imagine peripheral spreads tightening massively, particularly in Italy, which has now officially ceased to be a fiscal troublemaker.
  • In such a scenario EUR rallies, EGBs outperform and emerging markets closely tied to the EU (Poland, Hungary etc.) perform better than those linked to the US (Mexico). All that has indeed taken place.

I would like to spend a second on the EUR here. In one of my recent discussions with long-term investors an interesting theme started taking shape – what if Europe is about to experience what Japan had experienced in the last two decades but in a very short period of time, say 1-2 years? The current account is very positive, the appetite for debt is relatively strong and domestic demand will stay very sluggish but at the same the ECB won’t go “full monty” on printing. Unless it is forced to do so, of course, like it recently happened in Japan. What if the balance of payments forces coupled by the fact that virtually every major trading partner of the Eurozone is printing money push EUR to some ridiculously high levels before the pressure on the ECB is so strong that it can’t resist it anymore? So yes, the EUR would eventually crash but there would be a lot of stop losses beforehand.

I will be very honest – I am really struggling to get a good feel on the market at the moment. There are bond markets that I still like a lot, e.g. Italy, CEE or Russia but I think one needs to have something to offset the long rates exposure (my suggestion – Turkey). I generally think emerging markets in the EU should outperform Latam and Asia due to proximity to the deflationary vortex but moves have been quite brutal there, too. On the FX, if what I wrote is correct then the theme from the beginning of the year, i.e. being long EUR/MXN, EUR/RUB or EUR/MYR should work out really nicely.

And yes, I know this post would’ve been nice to have two weeks ago but this is what I make of it all anyway.

What the central bank giveth, only the central bank taketh away

When I first started working at a bank they told me to do liquidity forecasts for the money market desk. It was a relatively simple, yet educational exercise. I would look at a given month and put together a table of cash inflows to and outflows from the system. For example, when there would be a bond redemption or a coupon payment, it would mean an increase in liquidity. Conversely, if the finance ministry were to issue bonds, it would drain some money from the system. These were just daily moves in liquidity but they were absolutely key for the money market rates. Believe me, you don’t want to make a mistake when doing that…

But the thing is that this was just forecasting of changes in maturity of money in the system. After all, the mere fact that the finance ministry pays out a coupon doesn’t mean that there is more money in the system. The finance ministry cannot print money so they would simply move it from their account to the accounts of bond holders. On that day overnight rates would normally drop but the system would balance itself quite quickly.

Fast forward to more interesting (aka post-Lehman) times. The central banks around the world have been printing money at a spectacular pace and many agree (myself included) that quite a few of developed economies are in the liquidity trap. Naturally, the increase in central banks’ balance sheets has led to a significant build up in excess liquidity, which – as we know all too well – usually ends up back at the central bank’s deposit facility. This is beginning to raise concerns in both developed and emerging economies. Let me give you three examples from recent weeks in the European Union (in order of appearance):

  • Hungary’s central bank is planning to limit banks’ access to the two-week NBH bills (open market operations). More details can be found here. NBH Governor Matolcsy is quite angry that the central bank needs to pay banks for the liquidity they park in this facility. He is pointing in the direction of foreign banks (I explained the mechanism in the post entitled The Invisible Carry), but we can assume this will eventually be extended.
  • Last week, Mario Draghi said the central bank was open to negative rates on the deposit facility.
  • This week, Nationa Bank of Poland’s Governor Marek Belka said that banks had too easy lives because they were parking PLN140bn using weekly open market operations and earning the repo rate without any problems.

Many commentators and indeed the central bankers themselves have been mentioning that the idea behind those measures is to make the banks lend more. It is often claimed that the liquidity in the banking system should be helping the economy recover, instead of making banks money. But this is a very simplistic approach to how banks operate.

Let’s say that a banking system has excess liquidity of 1,000bn (never mind how it got to that state). This money is kept at the central bank in weekly open market operations and earns 0.05%. Let’s then assume that the central bank slashes this rate to -1%. What happens?

Some banks may conclude that using the central bank is not a very smart thing to do anymore and will go and buy, say, 3-month TBills. But who will they buy them from? Finance ministry? Ok, but then what will the finance ministry do with the money it gets from the bank? It will pay teachers’ salaries (among others, of course). What will the teachers do? They will keep it on their bank accounts, which means the money will have returned to the system and we’re back at square one, but with one happy finance minister who just sold some TBills.

Other banks will conclude that maybe they will take the money they’d normally put at the central bank, swap it into another currency, eg the USD and buy some USD-denominated assets with it. The price of USD in the swap market will increase (and the price of the local currency will decline) but ultimately the money won’t disappear and will return to the central bank. The process will, however, lower fx swap rates.

Perhaps there will be one bank whose CEO will feel patriotic and will want to lend money to “hard-working entrepreneurs up and down the country”. Why the decline of deposit rate by 105bp would persuade her to do that is beyond me, but we can make such an assumption. So if this bank lends some money for the new investment project, then the company in question will spend the money and the money will… come back to the system! At the end of the day, there will still be 1,000bn sitting with the central bank. Just at a different price.

I don’t question the fact that such a move will persuade banks to search for higher-yielding assets, ie loans but what I’m trying to explain is that the liquidity in the banking system is like a hot potato. The central bank controls how much money there is in the system (using various ways, eg printing money, changing the reserve requirement etc) and the market only needs to decide the price of this money. The only way that lowering rates to the negative territory impacts the amount of cash in the system is because the central bank will be returning 99% of the money placed in it back to banks. But then which of the major central banks could even contemplate shrinking its balance sheet at the time when the global economy remains exceptionally fragile?

What I think discussions like the ones taking place in Europe will lead to is significant re-pricing of interbank rates (BOR-OIS spreads could decline massively as banks start passing on the potato) and an increased demand for government or quasi-government bonds by banks’ assets and liabilities management desks (ALMs). Perhaps this is the point of the whole exercise. Then again, isn’t it yet another version of crowding out and actually forcing banks to play the carry in government bond markets? Hard to see how that should please politicians but perhaps this is the only path to rejuvenate the credit action. I really don’t like growth implications of such a process. Unless of course the ultimate beneficiaries, ie the governments, use the extra demand for their papers to increase public spending… But I will spare you, Dear Reader, yet another discussion about consequences of austerity. There’s this chap in the US who does that several times a day.

 

Forget Apple, Slovenia was the real deal

All that matters for the US media is the stock market. Just take a look at the TOP category in Bloomberg or tune into CNBC for… well… as long as you can bear it. And of course many put the “=” sign between the US equities and Apple. Therefore, last week’s premier issue of Apple bonds grabbed all the headlines. Granted, it was a bond, not a stock but it’s Apple so it can still rule the global economic reports. But honestly, in the greater scheme of things this issue had really zero relevance for anything. Yeah, probably the PIMCOs of the world decided to park some cash there expecting that high outstanding value would boost liquidity in the secondary market. Plus, there were some comments about Apple’s tax bill but that’s about it.

I think something considerably more important happened in the small European country of Slovenia.

slovenia_apple

After several days of roadshowing, the troubled Slovenia decided to open books for 5 and 10y bonds on Tuesday (30 April). Given that in the previous weeks peripheral bond markets rallied like mad, it wasn’t too heroic to assume that the book-building would be quite quick. Indeed, in the early afternoon books exceeded USD10bn (I guess Slovenia wanted to sell something around 2-3bn) and then reached a quarter of what Apple managed to get in its book building. If I were to take a cheap shot I would say that Slovenia’s GDP is almost 10 times smaller than Apple’s market capitalisation* but I won’t.

And then the lightning struck. Moody’s informed the government of an impending downgrade, which has led to a subsequent suspension of the whole issuance process. I honesty can’t recall the last time a rating agency would do such a thing after the roadshow and during book-building but that’s beside the point. That evening, Moody’s (which already was the most bearish agency on Slovenia) downgraded the country by two notches to junk AND maintained the negative outlook. This created a whopping four-notch difference between them and both Fitch and S&P (A-). The justification of the decision was appalling. Particularly the point about “uncertain funding prospects”. I actually do understand why Moody’s did what it did – they must have assumed that the Dijsselbloem Rule (a.k.a. The Template) means that Slovenia will fall down at the first stumbling point. But they weren’t brave enough to put that in writing and instead chose a set of phony arguments.

Anyway, May 1st followed and the book reopened for bids only on Thursday. In the meantime, it was interesting to see what happened in the secondary market: the existing Sloven22 USD bonds got given on Tuesday at 99.00, they were sold just below 98.00 on Wednesday and by the time the books restarted they were firmly on their way towards par. I know markets don’t care about ratings these days but this was a pretty extreme vote of no-confidence for Moody’s.

I took advantage of the fact that May 1st is a holiday across Europe and had a few meetings with fund managers here in London. All of them were telling me the same thing, i.e. that they hope that the downgrade would cheapen the deal by at least 10bp. They “hoped” but didn’t really think that would happen. This sharply contrasts with some analysts’ comments who said that the downgrade could cost Slovenia around 100bp (i.e. from 6 to 7% in yield). Imagine that – some people seriously thought Slovenia would have to pay more than Rwanda (no disrespect, of course).

Then the big day came – books reopened, bids were even stronger than during the first attempt and Slovenia sold 3.5bn worth of 5 and 10y bonds. On Friday, the new Sloven23s traded up by more than 4 points, which means yield fell by more than 50bp from the 6% the government paid. A fairy tale ending.

So why do I think this event was so important? Because it shows how different the perception of European sovereign risk is. I wrote a few times about it (see here and here) partly making fun of people who thought that Slovenia would be the next Cyprus. Now, don’t get me wrong, I don’t think that Slovenia is out of the woods yet. In fact, the 3.5bn cash injection could make the government less eager to push for necessary reforms (for details, do check an excellent summary of a great paper by @GoodRichWatts which can be found here). But the emotional reaction to the Cyprus debacle was ridiculed by the market. In other words, just because something happened in one part of the Eurozone, it doesn’t mean that there will be an impending domino effect, or an outright tsunami.

Perhaps issues from both Apple and Slovenia have only proved that investors will buy anything that yields. But I strongly believe that in the case of Slovenia we got something much more important in terms of where the crisis in the Eurozone is headed. If you want to be short Europe, feel free to do that but better check whether your story holds first and don’t count on panic spreading quickly.

* Comparing a country’s GDP with a company’s market capitalisation is ridiculous, though because one is flow and the other one is stock. But this sort of comparison is what would get me quoted on Bloomberg so I couldn’t resist. For the record, if you wanted to compare a country’s GDP to anything from the corporate finance world it should rather be sales, in which case Slovenia is a third of Apple.

Abolish deposit insurance, please

This crises has taken its toll on livelihoods of many people. But it’s also making otherwise reasonable and balanced investors lose the plot and move from investing to preaching.

I have found myself in a surprising situation lately – I inadvertently became the only person on my twitter feed who does not condemn Jeroen Dijsselbloem. Now, I like being controversial like the next man (anyone who ever tried to talk to me about Hungary can testify that) but this time around I have had to endure more abuses than normally.

I am sure many of you still have in mind “the Cyprus debacle”. If not, please start with an excellent piece from Joseph Cotterill entitled “A stupid idea whose time had to come” and work your way through links. The title of Joe’s piece has stuck in my mind ever since and I finally have a few moments to explain why.

To be sure, I do not contest the fact that the EU outdid itself and managed to make their communication even muddier than usual. But this is now behind us and we should focus on the essence rather than on the way the package was announced. I may have mentioned that in the old days I was quite involved in Iceland’s banking crisis of 2008. And I have always claimed that – despite a few minor hiccups on the way – letting the big banks default and closing the capital account was the right thing to do. I think there are many similarities between Iceland and Cyprus and that’s why I believe that bailing-in the (foreign to a large extent) depositors was the correct course of action. I mean of course the final solution, not the initial idea of not sparing smaller deposits, which was plain ridiculous. Yet, ever since the announcement I had to argue with people who were throwing all sort of populist arguments and who went into great length in finding ways to insult Jeroen Dijsselbloem. Jeroen Dijsselbloem who is a politician trying – like all of them – to get reelected and who understands that top priority in a support package for any country must include ways to prevent citizens of core European nations from revolting.

But instead of spending time explaining why I think the Cyprus solution was a correct one*, I thought I would touch on a somewhat more medium term issue, which is deposit insurance. This is because I think the debate in Europe whether to centralise the deposit insurance scheme or keep it on the national level is a wrong kind of discussion. I think that we should begin to discuss whether one of the lessons from the crisis shouldn’t be to cancel deposit insurance altogether.

Please bear with me before you click the unsubscribe/unfollow button.

Deposit insurance was introduced in the US in 1933 (earlier it was created in Czechoslovakia). The idea was to restore faith in the financial system and get banks to lend more. This was the idea whose time had to come. And it wasn’t stupid at the time but rather necessary. Since then a lot of things have changed, though. For starters, the world has seen a remarkable ascent of investment banks, which have benefited quite a bit from deposit insurance. This was at times coupled by quite a bit of recklessness in the way banks’ balance sheets were used and this is now widely recognised. Perhaps all-too widely.

Think about it – we just witnessed a full-blown bank holiday in a country which is relatively small but which was in the spotlight for at least a fortnight. During that time I even recall one of the macro tourists hedge fund guys who said that the best thing to do at the moment was to put live cameras in front of banks in Milan and Madrid because “the end is nigh”. Of course none of that happened and we probably need to entertain the idea that people in the street are not completely dumb, as difficult as it may sound…

But why didn’t we have a run on other European banks? I think most of the Europeans understood that the bail-in in Cyprus was due to the fact that there was a lot of foreign and most probably dirty money there. Heck, even the average person in Cyprus seems to have comprehended that problems at Laiki were pretty specific to Laiki. True, the capital account remains shut and it will probably stay like that for a while but it’s really not a big deal in the greater scheme of things.

When I first tweeted about the idea of abolishing deposit insurance, the replies I received pointed out that it could topple the whole financial system. There is some truth in it. After all, if the deposit insurance was to be abolished as of tomorrow, many people would probably go to ATMs “just in case”. But let’s try and work out the logistics of the issue. First of all, most European countries guarantee deposits up to €100k in full. This seems to be working even though there are quite a few governments who could not possibly meet this obligation if required, just like Cyprus. So it’s one of those barrier-type option hedging products that stops working precisely when you need it. Another question is why 100k? It’s a round number and nothing else, because the average deposit is way below that level. And if that’s the case then would it change much if we reduced the limit to 99,999.99€? With the exception of the holier-than-thou folk in the media who would immolate over the concept, probably not much.

Let’s take it a step further. What if Europe announced the following:

  1. As of January 1, 2014, all the countries within the Eurozone will be jointly responsible for insuring any deposit up to 100,000€.
  2. Starting from January 1, 2015 the limit will go down by 10,000€ every year until it goes down to zero on January 1, 2024, after which no deposit will be guaranteed by any Member State.
  3. (repetition) Governments and national central banks of Member States will irrevocably guarantee the insurance with their full faith and credit until January 1, 2024.

I would argue that the average person in the street would probably be interested to browse through front pages of various newspapers which would be “shocked and dismayed” but since they don’t have anything close to 100,000€, they would probably only calculate when their savings could potentially become vulnerable. What would be far more interesting is the reaction of banks. After all, even in core countries like Germany, the Netherlands or France “some banks are better than others”. There’s no need to point them out – they are perfectly aware of their own situation. After such a change in the system they would know they have several years to build up the sufficient capital buffer and to improve their books or else… In other words, Europe wouldn’t place those institutions under an imminent threat of a rapid deposit withdrawal but would send a strong signal that the clock is (slowly) ticking. Sure, there would probably be some turbulence in the cost of bank funding but I don’t believe that would be fatal. Simultaneously, the banks would have to voluntarily cut their riskiest and most balance sheet consuming operations in trading. No need for financial transaction tax, bonus caps or short-sale bans.

I know that what I described may sound a bit like science fiction but we have just gone through something that was seemingly unthinkable only a few months ago, i.e. haircutting desposits and shutting the capital account within the Eurozone. And guess what – not much has happened. So instead of throwing calumnies at Jeroen Dijsselbloem consider that if we stop here then it will mean that we (Europe) have just sent a signal to people that they can keep money in however crappy bank they want as long as it’s less than 100,000€. Alternatively, we could give the banks’ customers and the banks themselves a friendly nudge with a not-too-close deadline and let the market forces work their magic. Remember, systemic ain’t what it used to be. Let’s take advantage of that.

* By the way, don’t even try to assume that I think every single country in trouble should be dealt with in the same way as Cyprus.

Baron Münchhausen and spreads in Europe

Hieronymus Carl Friedrich von Münchhausen is known for telling the story that he pulled himself (and the horse he was sitting on) out of the swamp by his own hair.

This reference was the first thing that came to my mind after seeing this and this post on Paul Krugman’s blog. After the whole bunch of swearwords, that is.

In the first one he argues that France has finally joined the club of ultra-sovereign countries, i.e. countries who can do whatever they please and yet get away with it because bond yields remain remarkably low. The second one uses “research” material from VoxEU entitled Panic-driven austerity in the Eurozone and its implications. There are five charts in it which I would like to discuss before circling back to Krugman’s thesis about French bonds.

Chart 1. Austerity measures and spreads in 2011.

 

degrauwe_fig1

 

In this chart the author argues that the higher the spread, the bigger the austerity that was subsequently applied. Well if it isn’t remarkable – so they’re telling us the higher the increase in credit spread in 2011, the bigger the adjustment had to be? Brilliant. But let’s say it’s an introductory statement just to warm us up.

Chart 2. Change in spreads vs. initial spreads

degrauwe_fig2

Now this is epic. The Baron Münchhausen argument. It basically says that the the higher the initial spread, the bigger the subsequent decline. A few things about that. Firstly, absent of a total collapse of the eurozone, how else should this chart look like? Secondly, using the same weight for the spread on tiny Portugal and Greece as Spain or Italy is just skewing the results. Thirdly, I don’t think that using the decline in percentage points as dependent variable is kosher because spreads can’t go negative and so 50bp for France is something completely different to 50bp for Portugal. Finally, I seriously wonder if the fit would be so bombastic if they removed Portugal and Greece – those dots at the beginning seem close to the best-fit line but I have a sneaky feeling that this is mostly because of the scale.

Chart 3. Change in debt-to-GDP ratio vs. spreads since 2012Q2

degrauwe_fig3

 

First of all, this is just plain wrong from the econometric point of view. What is this -0.6747 factor in the equation? It means that if there is no change in debt/GDP then spread will fall on average by 67bp. So 10 years of unchanged debt and spread falls by almost 700bp? No, friends, such results should be deemed “inconclusive” and there shouldn’t be any downward sloping line here. But if you want the line then have a look what it would imply if debt levels fell. Spreads would increase… Brilliant. Finally, assuming no lags or anything is just ridiculous.

Figure 4. Austerity and GDP growth 2011-2012  <– this one I actually have no problems with. Stating the obvious, but so be it.

Figure 5. Austerity and increases in debt-to-GDP ratios

degrauwe_fig5

 

This one says that austerity increases debt to GDP. A lot has been said on the subject and in the short run it is very difficult to argue with that. One could make an argument that without austerity debt/GDP would’ve increased even more because of super-high borrowing costs but let’s not go there here.

Wait a second though. So if austerity increases debt to GDP and we “know” from (ridiculous) Chart 3 that higher debt to GDP is associated with a decline in credit spread then isn’t austerity leading to lower spreads? Alternatively, if we interpret Chart 3 as the lack of relationship then shouldn’t we also conclude that austerity has no impact on credit spreads?

If the author’s only intention was to show that the ECB was instrumental in narrowing the spreads then fair enough. But the analysis provided is weak to say the least.

And this brings us back to Paul Krugman. Because if he believes in what De Grauwe wrote, i.e. that the reduction in spreads was the function of how high the spreads went in the first place then why has France rallied so much? Similarly, why would it rally if austerity worsens things so much?

Oh, I know why. Blame the markets (both ways).

First De Grauwe:

Since the start of the debt crisis financial markets have provided wrong signals; led by fear and panic, they pushed the spreads to artificially high levels and forced cash-strapped nations into intense austerity that produced great suffering.

Then Krugman:

Markets have concluded that the ECB will not, cannot, let France run out of money; without France there is no euro left. So for France the ECB is unambiguously willing to play a proper lender of last resort function, providing

If one wants to make an argument that OMT has led to significant tightening of credit spreads in the eurozone, we really don’t need working papers – a tweet will do. But for crying out loud do not mix austerity with that. Especially as austerity and OMT were completely coincidental. And if you do have to mix austerity into all this then make a little bit of effort to make a consistent and mathematically correct set of arguments. And make up your mind, Mr. Krugman. Either austerity is bad and ultimately keeps debt to GDP high and thus credit risk elevated in which case you need to rethink France. Or austerity sometimes makes sense in which case… well… you need to rethink a hell of a lot of things.

Otherwise your story is not far from what Baron Münchhausen – amusing and entertaining but ultimately ridiculous.