Why the ECB Should Buy American

Jeffrey Frankel

MAR 13, 2014

Newsart for Why the ECB Should Buy American


CAMBRIDGE The European Central Bank needs to ease monetary policy further. Eurozone-wide inflation, at 0.8%, is below the target of “close to 2%,” and unemployment in most countries remains high. Under current conditions, it is hard for the periphery countries to reduce their costs to internationally competitive levels, as they need to do. If inflation in the eurozone as a whole is below 1%, the periphery countries are condemned to suffer painful deflation.

The question is how the ECB can ease policy, given that short-term interest rates are already close to zero. Most of the talk in Europe concerns proposals to undertake quantitative easing (QE), following the path taken by the US Federal Reserve and the Bank of Japan. This would mean expanding the money supply by buying member countries’ government bonds – a realization of ECB President Mario Draghi’s outright monetary transactionsscheme, announced in August 2012 in the midst of growing uncertainty about the euro’s future (but never used since then).

But QE would present a problem for the ECB that the Fed and other central banks do not face. The eurozone has no centrally issued and traded Eurobond that the central bank could buy. (And the time to create such a bond has not yet come.) By purchasing bonds of member countries, the ECB would be taking implicit positions on their individual creditworthiness.

That idea is not popular with the eurozone’s creditor countries. In Germany, ECB purchases of bonds issued by Greece and other periphery countries are widely thought to constitute monetary financing of profligate governments, in violation of the treaty under which the ECB was established. The German Constitutional Court believes that the OMT scheme exceeds the ECB’s mandate, though it has temporarily tossed that political hot potato to the European Court of Justice.

The legal obstacle is not merely an inconvenience; it also represents a valid economic concern about the moral hazard that ECB bailouts present for members’ fiscal policies in the long term. That moral hazard – a subsidy for fiscal irresponsibility – was among the origins of the Greek crisis in the first place.

Fortunately, interest rates on Greek and other periphery-country debt have fallen sharply over the last two years. Since he took the helm at the ECB, Draghi has brilliantly walked the fine line required to “do whatever it takes” to keep the eurozone intact. (After all, there would be little point in upholding pristine principles if doing so resulted in a breakup, and fiscal austerity alone was never going to return the periphery countries to sustainable debt paths.) At the moment, there is no need to support periphery-country bonds, especially if it would flirt with illegality.

What, then, should the ECB buy if it is to expand the monetary base? For several reasons, it should buy US treasury securities. In other words, it should go back to intervening in the foreign-exchange market.

For starters, there would be no legal obstacles. Operations in the foreign-exchange market are well within the ECB’s remit. Moreover, they do not pose moral-hazard issues (unless one thinks of the long-term moral hazard that the “exorbitant privilege” of printing the world’s international currency creates for US fiscal policy). Finally, ECB purchases of dollars would help push down the euro’s exchange rate against the dollar.

Such foreign-exchange operations among G-7 central banks have fallen into disuse in recent years, partly owing to the theory that they do not affect exchange rates except when they change money supplies. But in this case we are talking about an ECB purchase of dollars that would change the euro money supply. The increase in the supply of euros would naturally lower their price. Monetary expansion that depreciates the currency is more effective than monetary expansion that does not, especially when, as is the case now, there is very little scope for pushing short-term interest rates much lower.

Depreciation of the euro would be the best medicine for restoring international price competitiveness to the periphery countries and reviving their export sectors. Of course, they would devalue on their own had they not given up their currencies for the euro ten years before the crisis (and if it were not for their euro-denominated debt). If abandoning the euro is not the answer, depreciation by the entire eurozone is.

The euro’s exchange rate has held up remarkably during the four years of crisis. Indeed, the currency appreciated further when the ECB declined to undertake any monetary stimulus at its March 6 meeting. Thus, the euro could afford to weaken substantially. Even Germans might warm up to easy money if it meant more exports.

Central banks should and do choose their monetary policies primarily to serve their own economies’ interests. But proposals to coordinate policies internationally for mutual benefit are fair. Raghuram Rajan, the governor of the Reserve Bank of India, has recently called for the advanced economies’ central banks to take emerging-market countries’ interests into account via international cooperation.

ECB foreign-exchange intervention would fare well in this regard. This year, the emerging economies are worried about a tightening of global monetary policy, not the policy loosening that three years ago fueled talk of “currency wars.” As the Fed tapers its purchases of long-term assets, including US treasury securities, it is a perfect time for the ECB to step in and buy some itself.


Jeffrey Frankel, a professor at Harvard University's Kennedy School of Government, previously served as a member of President Bill Clinton’s Council of Economic Advisers. He directs the Program in International Finance and Macroeconomics at the US National Bureau of Economic Research, where he is a member of the Business Cycle Dating Committee, the official US arbiter of recession and recovery.


Russia counts cost as West tightens sanctions noose

The West has threatened visa bans and an asset freeze on individuals unless Russia steps back from the brink on the annexation of Crimea

By Ambrose Evans-Pritchard

8:48PM GMT 13 Mar 2014
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Russian President Vladimir Putin addresses the media at the end of an EU-Russia summit, at the European Council building in Brussels
Angela Merkel said Vladimir Putin was becoming hard to reason with after her latest telephone conversation Photo: AP

Russia risks a wave of capital flight and a shattering economic crisis as the West prepares a package of sanctions over the seizure of Crimea.

German Chancellor Angela Merkel spelled out the danger for Russia in a speech that silenced pro-Kremlin voices in her own coalition and left no doubt that Europe is now fully behind the US on punitive measures.

“If Russia continues on its course of the past weeks, that will not only be a great catastrophe for Ukraine. It will cause massive damage to Russia, both economically and politically,” she said. “None of us wants it to come to this, but we are determined to act. Let me be absolutely clear; the territorial integrity of Ukraine is not up for discussion.”

The West has threatened visa bans and an asset freeze on individuals as early as Monday unless Russia steps back from the brink on the annexation of Crimea. This now looks certain since Russian troops are continuing to dig in across the peninsula before this Sunday’s vote on secession. “It can get ugly fast if the wrong choices are made, and it can get ugly in multiple directions,” said John Kerry, US Secretary of State.

The US and the EU will escalate to “additional and far-reachingmeasures if the picture deteriorates, a likely outcome since Ukraine’s premier Arseniy Yatsenyuk has vowed to resist any loss of sovereign soil.

Russia has threatened to retaliate with “symmetrical sanctions” but Tim Ash, from Standard Bank, said it is a one-sided contest that Moscow cannot win. Russia is facing the entire West. Its economy is already very weak and this could end up being as bad as 2008-2009, when GDP contracted by 9pc,” he said.

Russia cannot suspend oil and gas exports without cutting off its own source of foreign revenue. Any such move would destroy its credibility as a supplier of energy, accelerating Europe’s long-term switch to other sources.

Russian companies have $653bn (£392bn) of foreign dollar debt, and must roll over roughly $150bn this year. Yields on five-year bonds have already spiked 200 basis points, even for blue-chip firms. The rouble has fallen 11pc this year after dropping 8pc last year, making dollar debts harder to repay. “It is going to be very difficult to roll over these bonds, and it will be at much higher cost,” said Mr Ash.

Capital flight reached $63bn last year. Former finance minister Alexei Kudrin said this could reach $50bn a quarter as the crisis deepens. The central bank has already raised interest rates sharply to stem outflows, pushing the economy into recession.

Russia has $480bn of foreign reserves but these cannot easily be used in a downturn since it entails monetary tightening. The Kremlin caused a drastic fall in the money supply and a banking crisis when it ran down reserves by $200bn after the Lehman crisis.

Standard Bank said Washington is determined to make Russia pay for tearing up the post-Cold War settlement and undermining the architecture of nuclear non-proliferation. It is drawing up stealth sanctions to freeze Russia out of global finance.

These will be spearheaded by the US Securities and Exchange Commission, which will enforce compliance of the Foreign Corrupt Practices Act. The next step is to place Russia on the “grey list” for money laundering. “This would prevent global banks from dealing with Russian counterparts. Washington is tightening the noose. No bank is going to mess with the SEC,” said Mr Ash.

Chris Weafer, from the Moscow-based group Macro Advisory, said the Russian elites are becoming extremely nervous” but it is a two-way risk. There could be contagion back into the West

There are a lot of things Russia can do short of the nuclear option of cutting off gas. It could ban exports of titanium, inflicting severe disruption on Airbus and Boeing,” he said. Both jet makers rely on titanium supplies from the Russia firm VSMPO-Avisma.

Russia could cut off 2.5m barrels a day of refined products such as diesel that are hard for Europe to replace since it has run down its refineries,” he said.

Germany is in an awkward position since it exports $50bn of cars, machinery and industrial goods to Russia each year. There are 6,200 German companies in the country with vast sunk costs. Last year alone they invested $105bn. Germany’s trade group BDA said a tit-for-tat sanctions war would be “painful” for Germany but “life-threatening” for Russia.

Igor Rudensky, head of the Duma’s Economics Committee, said sanctions will boomerang. “They are a double-edged sword, and Western states should be very careful,” he said.

With emotions running high, it is impossible to know whether Russia will act in its own economic self-interest or choose to bring the temple crashing down on everybody’s heads. Mrs Merkel said Vladimir Putin was becoming hard to reason with after her latest telephone conversation. “He is in his own world,” she said. 


March 16, 2014 3:14 pm

Europe should say no to a flawed banking union

To sacrifice important principles and hope for the best is not a sensible idea

©Ralph Orlowski/Bloomberg News


There are two classes of compromise in political life. In the first, your ultimate aim is sweeping change, such as switching the side of the road on which your country drives; but, in the name of expediency, you sacrifice important principles and gradually try to phase in the new rules. This is deadly.

The other involves settling for as much as you can get even when it is less than you want. This is not great either. But often it is good enough to leave everyone a little better off.

The art of the second kind of compromise has been the essence of political life in the EU. The proposed legislation on banking union, however, is not of that kind. I have been hesitating to make this call but I now believe that it would be best for the EU and the eurozone if this legislation were ditched altogether.

The matter is now in the hands of the European parliament. A deadline for a compromise in the negotiations between finance ministers and parliamentary representatives is approaching fast. The parliamentarians should simply say no to the proposals and walk away.

At issue is new legislation that would give regulators the power to close down a bank or force it to seek new capital. In December finance ministers agreed this so-called single resolution mechanism. Parliament and the ministers have since been locked in negotiations, but have made little progress. European agreements always look impossible five minutes before a breakthrough. But this time, the distance between the two sides is especially large.

Under the deal agreed in December, member states would build up a resolution fund over 10 years, covering about 1 per cent of all insured deposits, which amount to about €55bn. If a bank needs bailing out in the meantime, member states and the fund will jointly foot the bill according to an agreed schedule. At Germany’s insistence, the fund itself will be incorporated under a separate intergovernmental agreement. It cannot borrow money from the European Stability Mechanism, the rescue umbrella.

A decision to close down a bank has to be agreed over a weekend, while the markets are closed, to avoid creating panic. Under the proposed regime, agreement would be needed from all of the following institutions: the European Commission; the Council of Ministers; the European Central Bank; the supervisory board of the Single Supervisory Mechanism, the new bank supervisor; the executive board of the Single Resolution Mechanism, and its plenary council. I might have forgotten one or two.

The European parliament has drawn five red lines: the ECB should have the final say about whether a bank fails; resolution decisions should be taken without political interference; there should be no new inter-governmental legislation; the fund should be replenished more quickly; and, most importantly, governments should jointly commit to pay up themselves if the fund’s resources prove inadequate.

Step back from this technical debate for a moment and recall why the eurozone needs a banking union in the first place: to prevent doubts about the solvency of national governments from undermining confidence in their banks. Unless the resolution fund has the backstop of further European funding, that cannot happen.

A bad banking union is worse than none. Some advocates miscalculated because they thought of it as a cheap alternative to a fiscal union. But cheap it is not. On my own calculations, the European banking sector needs to raise its capital by at least €1tn. I arrive at this number by looking at the total size of all banking sector assets, making a rough guess of the losses to expect in a large financial crisis, and knocking off the bit absorbed by existing capital. Of course, this is very rough but it gives you an order of magnitude.

A detailed study by financial economists Viral Acharya and Sascha Steffen came up with an estimate of €510bn-€770bn for the shortfall. But this range relates to only 109 banks out of the 128 that would be subject to ECB supervision. I doubt the ECB will come up with a number anywhere near this high. It would require lots of public money. The EU is not prepared for that.

What is the alternative? My suggestion is that the legislation should be dropped for now. Policy makers should start from scratch after the elections in Maypossibly without Germany. This could be done under EU law, under a procedure called enhanced co-operation.

The Germans have adopted a take-it-or-leave-it stance in the negotiations. Banking union, to put it mildly, is not a German priority. Berlin wants neither to pay for the closure of foreign banks nor to allow foreigners to close their banks themselves. If a smaller banking union can be made to work, Germany may join eventually.

That carries risks of its own. But it would at least be a start. It would be the second type of compromise, not great but good enough. Otherwise, we will end up letting the lorries drive on the wrong side of the road.


Copyright The Financial Times Limited 2014.