Europe's Big Bazooka - Round Two

As part of Europe's efforts to unfreeze the credit markets and kick-start economic growth, the ECB conducted its second round of lending to Euro zone banks on 29th February under its longer-term refinancing operation (LTRO). More than 800 banks borrowed €529.5 billion, or $713 billion, in three-year loans at the benchmark interest rate of 1% by pledging collateral, typically bonds or other liquid securities. The ECB does not disclose which banks take out loans or where the banks are based for fear of stigmatizing those banks.

In the first round in December, 523 banks borrowed €489 billion at the same terms. The increased demand in this round is a reflection of the gravity of the credit squeeze being felt by Eurozone banks. Further, relaxations in collateral requirements aimed at helping the several smaller and community banks take advantage of this credit window may also have added to the loan off-take. These banks are more likely to lend to businesses and consumers.

It is hoped that this credit infusion will help ease fears of a banking meltdown and restore market confidence. The longer tenor of the loans was intended to provide the banks with the breathing space to get things right even if the credit markets take some time to get back to normal. The challenge now will be to get these banks to start lending to businesses and consumers so that the stalled economies in many Eurozone countries can be revived. In fact, though given to banks, these liquidity infusions serve as a backdoor support to distressed sovereign bond markets. Evidence from the first round show that many banks have used atleast a part of this money to buy sovereign bonds and thereby keep borrowing costs lower for the peripheral economies.

However, though the ECB has lend more than a trillion euros over the two rounds, the actual amount of new money flowing to banks is closer to €520 billion, because many banks shifted money from shorter-term ECB loans into the three-year loans. Further, though the money injections have been substantial, it has not led to the revival of the interbank market, in which banks lend excess cash to each other for short periods. Banks have preferred to keep their excess cash in the safety of the ECB, despite the 0.25% interest rates paid by it.

Finally, there is the danger that this easy credit will only postpone the inevitable and prevent banks from taking the tough decisions required to put their house back in order. Critics argue that it will take the pressure off banks and governments to reform by providing easy credit and by also keeping down sovereign borrowing costs.

The real test of whether these policies are succeeding will be the emergence of signals that banks have started lending again to businesses and consumers. In particular, any signs of revival in the corporate bond market will be closely watched. Ultimately, given the depth of the slowdown, as reflected in the rising unemployment rates, these measures will need to restore economic growth. Robust economic growth is the only way in which these economies can pull themselves out of this crisis.

Update 1 (10/3/2012)
Greece finally managed to arm-twist its private creditors into accepting a 75% haircut on Greek government bonds. Nearly 86% of creditors accepted the deal, and the final figure is expected to be more than 95%. It had warned that without such a deal, Greece might be forced to default altogether, with no one getting paid. The outcome has enabled Greece to reduce its debt load by just over 100 billion euros, or about $132 billion. This makes it the largest private debt write-down in history.



The International Swaps and Derivatives Association ruled that the agreement was a technical default by Greece. This will enable payouts on CDS contracts that various investors had taken out on the privately held Greek debt. Around $70 billion in default swaps on that debt are outstanding, although analysts expect the net payout to end up at only $3.2 billion or so.

Now, the bulk of Athens’s 260.2 billion euros ($341 billion) in remaining government debt will now be held by the IMF, ECB and the individual European nations that have lent Greece money through the EFSF and contributed to the region’s bailout fund. This means that any further haircuts will hurt the sovereign lenders to Greece. Further, since the IMF will balk at haircuts, the bulk of any future haircuts will have to be borne by Europeans themselves. The Times writes,

As recently as 2008, virtually all of Greece’s government, or sovereign, debt was held by private sector bondholders, chiefly banks and investment funds. But as a result of Greece’s escalating debt crisis and intervention by public institutions, private creditors now hold only 27 percent of Greece’s debt.

And even after the write-down, Greece is estimated to be saddled with a debt-to-GDP ratio of 151 percent in 2012, and 149 percent in 2013. The Greek economy shrank by 7.5 percent in the fourth quarter, and its youth unemployment is at a staggering 51 percent.

The desirability of an expansionary credit-driven recovery?

Even as the debate rages about how best to achieve recovery, there is the issue of what should constitute recovery. Though there cannot be much argument about the need to bring down unemployment rates to the pre-recession lows, the need to restore the other macroeconomic parameters (notably those related to financial sector and household consumption) to its pre-recession peak is questionable.

Roger Farmer, an ardent advocate of the superiority of quantitative easing over fiscal expansion and a strong believer of the self-fulfilling effect of market confidence, writes,

"Housing wealth in the US has fallen by 34% since its peak in 2006, and is still declining. The stock market fell by almost 50% from its 2007 peak and remains down by nearly a third. This enormous loss of wealth caused a large and persistent drop in consumption demand, which has led to an increase in unemployment... A quantitative-easing policy in which a central bank buys risky assets can prevent price fluctuations and restore the value of financial wealth...

My work provides a new and coherent approach to macroeconomics that explains how a lack of confidence can lead to persistent unemployment. It supports the purchase of equities by central banks to reduce asset-price volatility, restore the value of wealth, and prevent a future market crash...

The Great Recession did not turn into Great Depression II because of coordinated action by governments around the world. Although fiscal expansion may have played a role in this success, central bank intervention was the most important component by far. Quantitative easing works by increasing the value of wealth."

The underlying assumption behind Prof Farmer's hypothesis is that normalcy can be achieved only with a restoration of the pre-crisis financial asset values. The same assumption drives the logic of those advocating expansionary policies - somehow consumers will start to buy, businesses will invest, and banks will lend, thereby restoring normalcy in economic growth, and this in turn requires adequate time so that market confidence will revive and asset values will regain their old highs.

The logic behind monetary accommodation is to buy some time so that the forces of economic growth can be catalyzed into action. It is hoped that if market expectations can be shaped, it could pave the way for growth - investments, jobs, and consumption - which in turn would restore asset values to the pre-recession era standard.

Expansionary policies, especially on the monetary side - like maintaining ultra-low interest rates for an extended period of time - have the potential to generate and amplify existing distortions. One manifestation of this is the deepening divide between the bigger firms and the small and medium businesses in the US. While the former have continued to access credit at ultra-low interest rates and pile on record profits, the later have been badly squeezed in the credit markets. Risk averse banks have been wary of lending to these companies, who are the predominaty actors in creating jobs in the US economy. The result

Another example is the phenomenon of the existing TBTF institutions getting even bigger and more riskier riding on the back of the favorable policy regime. In fact, as Nassim Nicholas Taleb and Mark Spitznagel have argued persuasively in a recent article, the US Treasury and the Fed, as part of TARP and the numerous other unconventional monetary policies, have transferred an astonishing $2.2 trillion to the major American banks and this figure is estimated to reach $5 trillion by end of the decade. They write about how banks, despite their recklessness, were bailed out by the US government.

"Banks take risks, get paid for the upside, and then transfer the downside to shareholders, taxpayers, and even retirees. In order to rescue the banking system, the Federal Reserve, for example, put interest rates at artificially low levels; as was disclosed recently, it also has provided secret loans of $1.2 trillion to banks. The main effect so far has been to help bankers generate bonuses (rather than attract borrowers) by hiding exposures.

Taxpayers end up paying for these exposures, as do retirees and others who rely on returns from their savings. Moreover, low-interest-rate policies transfer inflation risk to all savers – and to future generations. Perhaps the greatest insult to taxpayers, then, is that bankers’ compensation last year was back at its pre-crisis level."

Banks benefitted immensely from the prolonged period of access to ultra-low interest rates, blanket credit guarantees, collateral standards dilution, and massive capital injections. At the height of the crisis, the Fed backstopped bank losses by becoming the lender, insurer and even purchaser (buying up illiquid and risk-filled mortgage backed securities to prevent values plummeting) for the entire financial system.

As the crisis expanded and the strains started showing on some of the largest financial institutions, it became increasingly evident that their failure would have catastrophic consequences on the economy. So the momentum gathered to provide all possible liquidity support and even direct bailouts, if need be, so as to contain the spread of systemic risks. The underlying premise was that it was mainly a liquidity crisis (and not a solvency one), and if the banks were given enough time, market confidence would be restored, asset values would recover, and balance sheets will be repaired.

It can be safely argued that this strategy worked, and the balance sheets of the biggest banks have recovered considerably from the depths of 2008-09. However, unfortunately, this relatively quick recovery has blanked out all institutional memory of the lessons from the sub-prime crisis. Apart from some cosmetic changes, financial markets continue merrily with limited regulation.

The same old unhealthy practices, ones that led to the build-up of systemic risks in the first place, are back along with the driving force behind these trends - distorted incentives of traders, executives and managers. Executive compensation is back to the halcyon days of the pre-crisis era. The big financial institutions have gotten bigger and enjoy the benefits of a market place where even as their smaller competitors are credit constrained, they themselves have access to capital at utlra-low rates for an extended period of time. It clearly appears as though nothing has changed, and the cycle looks set to repeat, with the markets in wait for the next bubble to inflate.

In a recent post about the Eurozone crisis, Tyler Cowen had written that though the Eurozone governments had on paper a balanced budget, their commitment to a single currency was a massive naked put, relative to their GDP, which was not internalized into the national budgets. Similarly, the growing sizes of the TBTF institutions and the resultant concentration of risks, is a very large naked put by the US government in favor of its TBTF institutions, one which is unfortunately not reflected in the US government's fiscal balance. Only when disaster strikes and the bailout checks have to be signed, the true magnitude of the fiscal commitment becomes obvious.

Finally, there is the impact of the extraordinary monetary accommodation in the US on the world economy, especially the emerging economies. The massive stocks of easy money sloshing around poses great threats to financial market stability. For a start, it can trigger off destabilising capital inflows into emerging economies and undesirable sharp currency appreciation. However, these flows can quickly reverse, leaving currencies and equity markets battered.

The aftermath of the sub-prime mortgage crisis presented a great opportunity for regulators to clamp down on the several unhealthy business practices in financial markets that were primarily responsible for the mess. However, that window of opportunity is almost gone. And more worryingly, the market conditions that has emerged in the aftermath of the crisis may be perpetuating or even amplifying many of the worst offending excesses.

We appear to have been left with the worst of all worlds. The regulators have failed to seize the opportunity. The market conditions in the aftermath of the crisis works towards making the big institutions even bigger. And amidst all this, the credit markets remain seized up and the economy continues to show no signs of any recovery.

The futility of monetary expansion

Given the strong opposition to any further expansion of its balance sheet, the US Fed has not gone ahead with a third round of quantitative easing but settled for the next best option of recalibrating its existing portfolio towards the longer end of the tenor spectrum.

The Fed's FOMC cited "significant downside risks" and announced that over the next nine months, it would sell $400 bn worth securities (treasuries and mortgage backed securities) with maturities below 3 years and purchase those with maturities longer than 6 years. With this, it hopes to twist the yield curve on longer term securities downwards without printing any more money and thereby further expanding its balance sheet.





While there is little doubt that it will have some impact in flattening the yield curve and lowering long-term rates, it is more or less certain that its impact is likely to be marginal. In fact, as witnessed by the steady flattening of the yield curve in the build up to the announcement, the markets may already have factored in its impact.

As an FT article suggested, though the lower long term rates will benefit home mortgage holders, their ability to take advantage of it remains questionable. It is estimated that about a quarter of borrowers have a mortgage worth more than their home and a half do not have the 20% of home equity needed to refinance at a lower rate. This effectively means that the two worst affected categories of mortgage holders will not be able to benefit from the flattening of the yield curve.

The lower long-term yields will also affect the profitability of banks, which traditionally borrow short-term and lend long. The flatter yield curves will dent their arbitrage margins. This will act as a further disincentive for them to lend in an uncertain economic environment.

Small businesses, the traditional engines of economic growth and job creation, especially in the aftermath of recessions, are badly credit constrained. Risk averse banks and financial institutions have been generally loath to lend to small businesses. As the plight of mortgage holders mentioned earlier shows, the battered household balance sheets have some distance to go before consumption can recover.

Most importantly, like the earlier quantitative easing programs, "operation twist" too will come up against the biggest problem facing monetary authorities and governments today - how to translate the dramatic expansion in monetary base and the resultant ultra-low long-term interest rates into increased credit ioff-take. In other words, monetary policies have not been able to make much headway with getting banks to lend, consumers to borrow, and businesses to invest. Except for a handful of the largest firms and financial institutions, credit remains squeezed.

This brings us to the fundamental issue which Paul Krugman and others have been higlighting, about the difficulty of squeezing much out of monetary policy when the economy is stuck in a liquidity trap and where aggregate demand is also in a deep slump. In a liquidity trap, since interest rates are touching the zero-bound (and therefore people do not have to sacrifice interest earnings to obtain liquidity), people are hoarding money not because of its liquidity value, but merely as a store of value. Worse still, since interest rates are close to zero, money and short-term treasuries become interchangeable and mere stores of value. This in turn means that conventional monetary policy actions that involve open market operations by swapping money for treasuries or expanding the money supply become ineffectual.

The graphic below highlights the near complete lack of responsiveness of monetary aggregates to the massive expansion in monetary base. Though the monetary base has exploded, the M2 money supply and its velocity have hardly budged, just as inflation has remained anchored to the bottom.



Clearly, as the graphic below shows, this massive infusion of money has found its way into the safety of bank's reserves.



It is amply clear that the present economic problems cannot be solved just by increasing the supply of money. Nineties Japan and Depression era US provides ample evidence of the futility of such expansion. In the circumstances, the solution lies in boosting aggregate demand. Monetary policy can only work at the margins in preventing the situation from getting worse.

"Twisting" on debt maturities as QE3?

The latest dimension to the US Federal Reserve's attempts to lower long-term interest rates through its quantitative easing (QE) program is "Operation Twist". It involves selling short-dated Treasuries (1-3 years) and buying longer-term securities (mostly 7-10 years) in an attempt to push down longer-term yields. These yields affect corporate borrowing and mortgage rates far more than short-term rates.

Hitherto, in the two rounds of QE (QE1 in 2009 was for $750bn, measured in 10-year Treasury equivalents, and QE2 in 2010 was for $412bn), lowering of long-term rates was sought to be achieved through massive purchases of long-term securities. This has involved a huge expansion of the Fed's balance sheet, though the resultant increased monetary base has been mostly confined to banks' reserves. This expansion of monetary base has generated criticism about stoking inflationary fears, weakening the dollar, and spawning other systemic distortions. It has also come in the way of another round of QE.

The new strategy avoids expanding the Fed's balance sheet and seeks to lower long-term rates by swapping short-term debt for longer-term ones. This would not involve any additional balance sheet expansion and would only cause maturity transformation of existing debt portfolio towards the longer-term. In simple terms, it would be merely re-balancing the Fed's portfolio.

It is estimated that by merely "recycling maturing bonds into longer-dated ones", $110bn would be added, and by "actively selling its portfolio of 1-3-year bonds and buying as much long paper as permitted", the Fed could achieve another $390bn. The former involving about $20 bn a month may not enthuse the markets as much as the later which could involve more than $65 bn a month. The Fed at present owns $632bn in Treasuries with a maturity of less than four years. See this Goldman estimate of Fed's possible Operation Twist strategy.



Twisting of the yield curve is not without precedents, though its impact has not been encouraging. It was first used, unsuccessfully, by the US in 1961 and then by Japan, again unsuccessfully, in the nineties. It carries with it certain clear risks. As the FT writes, it "could disrupt trading flows in the bond market, while reducing earnings for banks that borrow cheaply and invest in long-term Treasury debt". It would adversely affect the returns of institutions like insurance companies and pension funds that have large exposure to long-term debt instruments and also the net-interest margins of banks (who invest in long-term bonds).

Finally, it also increases the long-term interest rate risk in the Fed's portfolio, which could, at certain point, constrain the Fed's policy making freedom. Fed would then effectively become a player in the bond markets. And there also exists the probability of making considerable losses when the Fed exits from its current accommodatary stance. It is also being argued that speculation of Operation Twist has already been priced into long-term yields and not much will be achieved with the actual operations.

Update 1 (22/9/2011)

The Fed announces that it would invest $400 billion in long-term Treasury securities over the next nine months, using money raised by selling its holdings of short-term federal debt, in an attempt to drive down interest rates on mortgage loans, corporate bonds and other forms of credit. With this, the Fed hopes to drive down rates not by expanding its portfolio, as it has done twice in recent years, but by shifting its money into riskier long-term investments.

The Fed has amassed more than $1.6 trillion of federal debt. It said that by June 2012 it would sell $400 billion in securities with remaining maturities of less than three years and buy roughly the same amount in securities with maturities longer than six years. It said the result would shift the average maturity of its holdings to 100 months, or more than eight years, from the current average of 75 months, or just over six years.

Lower interest rates so far had not produced the full measure of predicted benefits because lending standards remained unusually strict. Most outstanding mortgages still carry interest rates above 5 percent, despite the availability of lower rates, because it remains difficult to refinance. Tough lending standards are likely to limit the benefits from lowering interest rates. Loans already are cheap, but they are also hard to get.

Impact of QE2

The second round of quantitative easing (QE 2) in the US by the Fed, involving $600 billion in Treasury-bond purchases over the past eight months, came to an end on 30th June. However, the Fed will not start exiting from its expansionary policy and will remain committed to holding its balance sheet at its present size by among other things, reinvesting the proceeds of any securities that mature while in their possession.

At first reading, in terms of its direct objectives, the QE 2 was a success - interest rates on long-term securities and corporate bonds declined, asset values rose, dollar depreciated, and deflation worries abated without igniting undue inflationary pressures. However, in terms of achieving its final outcomes, its impact was less obvious - corporate spending remains depressed, consumer and business confidence is still weak, and economic growth and unemployment are dismal. The WSJ has an excellent graphic that captures these trends.

Like other interventions during this crisis, QE 2 too faces questions about its effectiveness. Critics point to the persistent recessionary conditions to claim that monetary expansion did not succeed. Its supporters argue that QE 2 backstopped the economy from slipping further, and claim that the situation would have been much worse without QE 2. They also point out that the recovery has not been strong because the monetary expansion was itself inadequate.

Mostly Economics points to an excellent presentation by James Bullard, President of the St Louis Fed, who illustrates graphically how events unfolded after Ben Bernanke's Jackson Hole speech in August 2010 - expected inflation rose, dollar depreciated, real interest rates declines, and equity prices rose. See also this from a St Louis Fed seminar on quantitative easing.

In any case, it can be safely argued that the QE 2 program atleast prevented the economy from getting worser and may also have set the economy on the recovery path, both of which would have not been possible without monetary expansion.

More on macroeconomic policy arguments during the Great Recession

The Great Recession has become a fertile ground for considerable analysis of the prevailing conventional wisdom macroeconomic policies. The relative merits of contractionary and expansionary monetary and fiscal policies are at the heart of all ideological battles.

Conservatives fret at the inflationary effects of expansionary conventional (zero-bound interest rates) and unconventional (quantitative easing) monetary policies and call for tightening monetary policy or atleast oppose any further monetary expansion. They also point to the unsustainable public debt and fiscal deficit and argue any fiscal expansion. Some even argue that all this is crowding out private spending, despite the overwhelming evidence of massive idling resources and capacity in the US economy. Their general belief is that hard money and sound government finances are necessary for a robust recovery to take hold.

Paul Krugman has been the strongest proponent of the view that when faced with a liquidity trap, increases in the monetary base (which includes bank reserves as well as currency) doesn’t cause inflation, or even a rise in broader definitions of the money supply. Faced with a recession and the zero-bound, businesses postpone investments and consumers their spending, thereby forcing banks to hold on to their reserves. This propensity to hold on to reserves is amplified by the fact that under such conditions, cash and T-Bills become near perfect substitutes, and the Fed cannot therefore expand M2.

Krugman points to the evidence from old and recent history to highlight this. At the onset of the Great Depression, though the Fed expanded the monetary base considerably (admittedly this may have been smaller than was required), it did not result in the expected increase in money supply and inflation remained muted.



Much the same happened in Japan. Despite a dramatic expansion in the monetary base by the Bank of Japan, prices kept falling.



Since the beginning of the Great Recession, the US Federal Reserve has been quick in dramatically expanding its balance sheet and increasing the monetary base. The result - M2 money supply and consumer prices have hardly budged.



However, even among those who favor monetary expansion, there is one group who argue that the Federal Reserve could have done more to avert a deep recession in 2008 and 2009 if it had indulged in much more aggressive monetary expansion. Scott Sumner, David Beckworth and others argue that the central bank using monetary policy tools can do more, even when faced with a zero-bound in interest rates, to stimulate aggregate demand and expand the economy.

They advocate setting an explicit nominal GDP target (or nominal GDP growth path) to shape future market expectations about current and future nominal spending and thereby boost economic growth or prevent aggregate demand crashes. This, they argue, can be done by purchasing assets other than Treasury Bills, like longer-term securities, to lower long-term rates and thereby incentivize investment and consumption spending so as to reach the nominal GDP target. David Beckworth writes,

"Set an explicit nominal GDP level target so that expectations are appropriately shaped. If such a rule were adopted expectations of current and future nominal spending would be anchored around the level target... Even if a spending crash did occur the catch-up growth needed to return nominal spending to its level target would most likely imply an expected path of short-term real interest rates consistent with restoring full employment...

if the monetary base and t-bills became perfect substitutes because the 0% bound is reached the Fed should buy longer-term treasuries or foreign exchange... The 0% bond for us really is not a big deal, but simply an artifact of monetary policy using a short-term interest rate as the targeted instrument."

As David Beckworth acknowledges, this understanding is not that different operationally than a New Keynesian invoking a higher inflation target to lower the expected path of real interest rates or the portfolio channel to drive down the term premium on long-term bonds.

Paul Krugman points to evidence from Japan to question the quasi monetarist position on the utility of monetary policy during such liquidity trap crises. In this context, he also draws attention to the views of the late Milton Friedman who had advocated that the central banks push more reserves into the banking system through monetary expansion. In fact, Friedman had famously blamed the Fed's unwillingness to indulge in sufficient monetary expansion as the major contributor towards the Great Depression.

However, unlike the Fed in the 1930s, the Bank of Japan indluged in massive monetary expansion. However, this did not result in the expected rapid growth in the money supply or monetary base.



Paul Krugman concludes that "in the face of a really big shock, which pushes the economy into a liquidity trap, the central bank can’t prevent a depression". In the circumstances, the only option left is fiscal policy. Here Krugman points to the critical role that the government borrowing and spending played in making up for the steep decline in private consumption.



Update 1 (28/10/2011)

FT Aplhaville points to a Goldman report which advocates nominal GDP targeting for the US.

"For the US, we advocated a shift to nominal GDP targeting, backed up with asset purchases, as the best of these options if further easing is needed. We think nominal GDP targeting probably provides the best way of communicating a credible intention to deliver a more aggressive easing without taking risks on long-term inflation. First, the framework is simple and transparent and avoids the complications of choosing a particular price index. Second, it deals directly with the problem of large excess capacity in the economy and focuses on a variable that is more directly linked to the ability to cope with debt contracts that were mostly made on the assumption that nominal income would be much higher than it currently is. Extending the price level trend for the US or UK would not deliver as strong a case for easing (and in the UK may argue for tighter policy). Third, it does not focus directly on generating inflation, which may make it more palatable to the public, or on the exchange rate, which could raise international tension. Fourth, it defines a clear exit strategy for policy and so minimises the risk of runaway inflation. Other policy options meet some of these criteria, but we think overall score less well."