ECB Actions are Borne of Necessity
In recent months, both the U.S. Federal Reserve and European Central Bank (ECB) have embraced additional unconventional policy measures to address chronic problems plaguing their respective economies. While the two strategies are often conflated, the Fed and ECB are attempting to address very different problems.
Whereas the Fed is taking discretionary action to accelerate the recovery and combat chronic underemployment, the ECB has been forced to act to salvage the currency union. In many ways, the recent ECB policy actions are actually quite similar to the Fed’s initial round of quantitative easing in 2008. Just as the Fed was forced in 2008 to buy large quantities of debt issued by Fannie Mae and Freddie Mac to convince market participants that these obligations were free of credit risk, the ECB now has no choice but to stand behind the debt of “peripheral” governments.
“Credit risk” refers to the possibility that a borrower will fail to make contractually promised payments in full. The risk generally does not apply to sovereign borrowers (i.e. governments) that are able to borrow in their own currencies. No matter how indebted the government, it poses no credit risk when it borrows in a currency that it can print. In these cases, the government essentially issues interest-bearing (bonds) and non-interest-bearing liabilities (currency) and can issue more of the latter whenever necessary to avoid default. Of course, heavy reliance on money printing – debt monetization – can generate significant inflation and steep declines in the foreign exchange value of the currency, but these possibilities are analytically distinct from credit risk.
The ECB is a unique institution that controls the money supply for a confederation of economies rather than a single government. Whereas the Fed’s balance sheet consists solely of U.S. Treasury and agency (Fannie Mae and Freddie Mac) securities, the ECB’s assets are mostly loans to Eurozone banks. While these loans are often collateralized with government debt – i.e. a Spanish bank pledges a Spanish government bond as collateral for a short-term loan – the ECB has generally refrained from buying government debt directly. This arrangement creates vulnerabilities that have only recently become apparent.
First, since the ECB is not subordinate to any government, Eurozone governments’ obligations are exposed to credit risk that does not exist when a government borrows in its own currency. This creates the potential for a sovereign bankruptcy or default as occurred with Greece. Second, since the ECB is not explicitly backed by any government, its own existence depends, in large part, on its ability to maintain a positive worth. The ECB is not backed by any fiscal authority, which makes the institution much more vulnerable to losses than is the case with national central banks.
Until recently, credit markets did not differentiate between the obligations of different European governments. As shown in Chart 1, the interest rates on Spanish and German government 10-year bonds converged following the introduction of the euro and proceeded to move in lockstep until the Lehman Brothers’ bankruptcy in September 2008. Since then, yields on government bonds have diverged markedly as investors have treated each country as a stand-alone entity that is, for all practical purposes, borrowing in a different currency.
Chart 1: Changes in 10 Year Interest Rates, 2002-2012
While Treasury securities are essentially interest-bearing dollars because they are denominated in dollars that the Fed is authorized to print, the debt and mortgage-backed securities (MBS) of Fannie Mae and Freddie Mac are actually very close analogues to the debt of peripheral European governments. Just as Spanish and Italian government debt were treated as roughly equivalent to German government debt, Fannie Mae and Freddie Mac’s obligations were thought to be nearly equivalent to Treasury notes because of their special status as federal government agency securities (i.e. the “implicit guarantee”). It was not until the scale of losses at Fannie Mae and Freddie became apparent in 2008 that investors began to treat Fannie and Freddie as stand-alone entities.
Interestingly, initial efforts by the U.S. government to harden the implicit guarantee were largely unsuccessful. The rise in the yields on GSE debt and mortgage-backed securities (MBS) forced the Treasury and Federal Housing Finance Agency (FHFA) to place Fannie and Freddie into conservatorship and establish a senior preferred stock agreement to ensure both agencies maintained a positive net worth. Yet, this bailout was not sufficient to calm markets. In late November 2008 – two months after the bailout – Fannie and Freddie’s spreads relative to Treasuries reached all-time highs. It was not until the Fed announced its first round of quantitative easing that the yields on Fannie and Freddie securities returned to normal spreads versus Treasuries.
By announcing its intention to “print money” to purchase $100 billion of Fannie and Freddie debt and $500 billion of MBS, the Fed signaled to market participants that GSE obligations could be converted into dollars at par upon maturity and were thus free of credit risk. While the Treasury has been forced to inject $140 billion (net of dividends) into the GSEs since 2008, it was direct Fed purchases that convinced market participants that these securities were, like Treasuries, interest-bearing dollars. The result was significant declines in Fannie and Freddie’s borrowing costs and reduced mortgage rates.
In the middle of 2012, Eurozone officials found themselves to be in the same place as their U.S. counterparts in November 2008. Despite successive rounds of official loans and the creation of temporary (European Financial Stability Fund) and permanent (European Stability Mechanism) bailout facilities, the spreads on Spanish government debt relative to German bunds set new records in July 2012. Questions about whether the bailout funds were of sufficient size missed the point completely: market participants simply wanted to know whether the obligations of peripheral Eurozone governments were really interest-bearing euros free of credit risk.
Like the Fed, the ECB responded by announcing its intention to print money to buy the debt of peripheral governments. Unlike with the Fed’s QE, the purchases undertaken as part of this “Outright Monetary Transactions” (OMT) policy would technically be “sterilized” through the issuance of ECB bills to absorb the liquidity. However, the message sent by the policy is the exact same. From the moment the OMT policy was hinted at, peripheral government spreads have come down. As shown in Chart 2, Spanish government spreads relative to Germany have declined by more than 200 basis points since July.
Chart 2: Spanish Government 10-Year Minus German Government 10-Year Yields
The basic opposition to the OMT policy is that it creates moral hazard: lower borrowing costs reduce the incentives of overly-indebted peripheral governments to reduce budget deficits. Yet, high borrowing costs can, in and of themselves, generate death spirals that push solvent borrowers into insolvency. Whenever interest expense exceeds GDP growth by wide margins, governments have to run large primary surpluses simply to keep debt ratios stable. In this situation, a reduction in borrowing costs is necessary to make debt reduction feasible.
More significantly, the ECB had virtually no choice but to expand its balance sheet to acquire the obligations of peripheral governments because it was becoming increasingly clear that market participants – investors, depositors, creditors – doubted the permanence of the euro currency union. As shown in Chart 3, from October 2009 to July 2012, the German Bundesbank’s net creditor position with the rest of the Eurosystem – the network of national central banks that constitute the ECB – increased from €150 billion to €750 billion as depositors moved euros from accounts with Spanish, Italian, Irish, and Portuguese banks to German banks. Corporate Treasurers and cash managers were understandably concerned that a euro on deposit in Spanish banks was not the same as a euro on deposit in Germany and moved deposits accordingly. The increase in the Bundesbank’s credits was the bookkeeping manifestation of the flow of funds from peripheral banks to German banks.
Chart 3: German Bundesbank Target 2 Net Credits
Whatever the outcome of the OMT policy, the actions themselves were borne out of necessity rather than discretion. This stands in sharp contrast to the Fed’s QE3, which aims to pump liquidity into the economy in the hopes that such action will, somehow, someway, lead to faster growth and more employment opportunities. The ECB is turning the hoses on a burning building. The Fed is hoping increased water flow can overcompensate for leaky pipes.