November 21, 2011
Why the ECB Won't (and Shouldn't) Just Print
Over the past week, we've heard all sorts of propositions that the European Central Bank (ECB) "must" begin printing money to bail out Italy and other countries, because "there is no other option." There are three basic difficulties with this idea. The first is that ECB buying might help to address immediate liquidity issues of distressed European countries, but it would not address long-term solvency issues, and would in fact make them worse. The second is that the ECB, under existing European treaties, has no such authority, and the prohibitions against it are very explicit. Changing that would be far more difficult than many market participants seem to believe, because it would require an explicit and unanimous change in the EU Treaties that AAA rated countries such as Germany and Finland vehemently oppose. The third difficulty is that even if the ECB was to buy the debt of distressed European countries with printed money, the inflationary effects would likely be far more swift than anything we've seen in the United States. This would not "save" the euro, but would simply destroy it by other means.
Investors are not likely to be treated with a "surprise" announcement that the ECB is going to expand its purchases of distressed European debt. Any significant ECB intervention would likely follow a formal revision of EU treaties that trades greater ECB flexibility in return for more centralized fiscal control.
Let's cover these points individually.
Liquidity versus Solvency
First, it is important to keep in mind that while ECB buying of distressed European debt can address short-term liquidity problems (the need to roll over maturing debt as it comes due), it does not address the long-term solvency problems in these countries (the fact that they are mathematically unable to make good on it because the debt violates the no-Ponzi condition ).
A central bank works like this. It buys some amount of government debt, and pays for it by printing currency (or bank reserves). That initial purchase essentially represents free revenue to the government, since it gets to buy goods and services in return for costless pieces of paper, and the income from the bonds held by the central bank is transferred back to the government over time. The central bank can exchange maturing bonds new ones, or change the composition of its portfolio in other ways, but if it doesn't increase the size of its overall portfolio, no new "base money" is created.
The outstanding stock of euros was created by the ECB when it purchased a portfolio of debt issued by EU member countries. The income received on the bonds held by the European Central Bank, as well as the losses should those bonds default, is effectively "distributed" across EU members. All of the EU Treaties have a central feature - the "Principle of Proportionality" - that seeks to allocate benefits and costs proportionally among the European member states. The basic formula for each country's "share" is the average of the GDP share of each country (as a percent of total EU GDP) and the population share of each country (as a percent of total EU population). That is also the formula that is used to determine how much capital each EU country contributes to the ECB - obviously, Germany contributes the largest share.
The key problem is this. It would seem easy for the ECB to address immediate liquidity concerns by buying distressed European sovereign debt. But if the ECB buys those bonds, and they don't pay off over the long-term, the ECB will have given a fiscal subsidy to those distressed countries, and Germany will end up bearing most of the cost.
Moreover, as the president of the Federal Reserve Bank of St. Louis said in 2006, "Everyone knows that a policy of bailouts will increase their number." ECB bailouts would destroy the ECB's credibility, and without any credible way to put a hard constraint on the fiscal policies of EU member countries, would create a "moral hazard" toward even higher deficits in Europe. Having created new euros to purchase distressed sovereign debt, it would be unlikely that those new euros would ever be removed from the system.
In terms of the mix of bonds held by the ECB, a reasonable target is to hold bonds in proportion to the average of the GDP share and the population share of each EU country. Over the past two years, the composition of ECB bond holdings has increasingly deviated from proportionality, as the ECB has purchased the debt of distressed countries and has "sterilized" this intervention by selling the same value of debt of stronger countries such as Germany (sterilization ensures that no new currency is created). The deterioration in the quality of the ECB's balance sheet isn't illegal, but it does stretch the principle of proportionality unless the ECB normalizes these w eightings over time. While the shift in the composition of the ECB's asset portfolio is somewhat uncomfortable, the portfolio can still be normalized over the long-term.
On the legal front, the European System of Central Banks (ECSB), and specifically the ECB, explicitly identifies price stability as its most important objective. It can pursue other objectives in furthering other objectives of the EU, but any additional goals are secondary, and must be "without prejudice to the objective of price stability." From the Treaty on European Union:
Article 105: "The primary objective of the ESCB shall be to maintain price stability. Without prejudice to the objective of price stability, the ESCB shall support the general economic policies in the Community with a view to contributing to the achievement of the objectives of the Community as laid down in Article 2 [European economic and social progress, identity, freedom, security and justice]. The ESCB shall act in accordance with the principle of an open market economy with free competition, favouring an efficient allocation of resources, and in compliance with the principles set out in Article 4 [EU political and development guidelines provided by the European Council]."
The Treaty is very specific in restricting the ECB from assisting individual governments. Article 123 of the Treaty on the Functioning of the European Union prohibits the ECB from providing any type of credit facility to central governments (and specifically "any financing of the public sector's obligations vis-a-vis third parties"). That Article also effectively means that the ECB is prohibited from providing funds to "leverage" the European Financial Stability Facility (EFSF).
As a side note, it's interesting that the EFSF has many of the characteristics that the U.S. securitized mortgage market had in 2007 - attempting to provide credit to borrowers that actually weren't creditworthy, by repackaging the debt in a way that it could still get a AAA rating. The EFSF hasn't been able to issue much debt, but the debt it has been able to issue is trading at widening spreads versus German benchmark rates. The actual yields are still only in the 4% range, but the trend isn't encouraging.
Even more notably, the Greek 1-year yield hit 240% last week, with Greek debt of every maturity trading below 37% of face value, and below 28% of face value on maturities of 5 years or more. Even if you were to cut the interest and principal payments on the 5-year bond to half their stated value, the current price of the 5-year implies a yield-to-maturity of nearly 18%. This suggests a credibility problem for the widely assumed 50% writedown figure - not that any Greek debt exchange has actually even been implemented yet. We wonder where this debt is currently valued on the balance sheets of European banks. Given the nearly 40-to-1 leverage common among European banks, it appears likely that much of the European financial system will be nationalized before this is all over.
A few observers have jumped on the fact that ECB has purchased some distressed European debt as evidence that ECB bailouts must be legal since the ECB "is already doing it." This is incorrect. While there aren't tight restrictions on the composition of the portfolio of EU debt that the ECB holds, the principle of proportionality sets a soft constraint, and the prohibition against actively financing public sector obligations sets a hard one. Some observers seem to believe that getting the ECB to print money is simply a matter of getting a majority of EU countries to vote for it. Again, this is incorrect. The ECB is still required to follow the legal restrictions of the EU treaties.
On a finer point, while the Governing Council of the ECB has 15 votes, its actions require a 2/3 majority. However, the votes are allocated so that the largest 5 countries (by a weighted average of GDP share and population share) have 4 of those votes, so in effect, the smaller Member States of the EU can only override the wishes of the largest 5 countries in Europe by a supermajority 10 of their 11 votes.
In any event, t he ECB Governing Council cannot simply take decisions - even by majority vote - that violate the explicit EU rules. In fact, the ECB itself is subject to recourse for unauthorized actions. Article 340 provides that "The European Central Bank shall, in accordance with the general principles common to the laws of the Member States, make good any damage caused by it or by its servants in the performance of their duties."
Doug Huggins provides a good overview of additional legal restrictions, and legal intent, that the ECB appears to have every intent of following (see Legal Issues Involving the ECB as Sovereign Lender of Last Resort ).
Following the Rules ("Go to bed VAHN!")
We can all argue, of course, that when push comes to shove, the ECB will abandon its legal restrictions and simply start bailing countries out left and right. I doubt that this will occur, even in a crisis situation, without a formal rewriting and common approval of the EU treaties, which would be a painstaking process and would require enormous top-down controls.
Given the disregard that Ben Bernanke has shown for the restrictions of the Federal Reserve Act, it is tempting for Americans to minimize the cultural differences that keep Europeans, particularly Germans, from doing same thing. I remember being in Heidelberg in 1988 on a Sunday morning, at the crosswalk of a side street that was narrow enough to jump across if you had a good running start. There was not a single car in sight in any direction, but the traffic light showed the little red man. The people standing at that crosswalk waited a good minute until the little green man lit up before they would cross that empty street. Culturally, the respect for the rule of law, and the abhorrence of inflation, are aspects of the German mindset that are less easily shaken than Americans might believe.
My father was a strict German ("go to bed, VAHN! go to bed, TWO!..."). Once when my brothers and I were arguing, Dad decided to give us a good lesson in the value of rules, so he called out "Anarchy! Do vahtever you vahnt to do!" We immediately darted into each others' rooms and started taking stuff. That free-for-all lasted less than a gleeful minute before we were all begging him to enforce our rights.
If the ECB is to be used as a "lender of the last resort" (which is not presently one of its legally allowed roles), it is likely to gain that role only if European countries give up their ability to independently determine their own fiscal policies. Angela Merkel noted last week that Germany would be willing to cede some of its sovereignty as part of the process of creating a centralized fiscal authority that could impose budget discipline on Europe's member states. But that proposition is not very costly for Germany, which has its budget largely in order. It would represent extreme submission for less fiscally disciplined European countries, and even then, would be difficult to enforce in practice.
We can't rule out more coordinated fiscal policies, but getting there will not be easy, and in any event, that step is the first thing to look for if there is any chance at all for large-scale purchases of European debt by the ECB. The level of "crisis" doesn't matter nearly to the extent that U.S. investors seem to assume. Absent fiscal coordination and an explicit change in EU treaties, it is unlikely that investors will simply wake up one day to the news that the ECB has suddenly had a change of heart and is bailing out distressed European countries.
Inflation and the value of fiat currencies
The third difficulty with large-scale ECB purchases of distressed sovereign debt is that it would have much swifter inflationary effects than anything we have seen in the United States.
Why does a fiat currency have any value at all? The answer is that the value of a fiat currency, like any other asset on the face of the earth, derives its value from the stream of benefits that it delivers to its holders over the life of the asset. Currencies get value because they serve as a means of payment and as a store of value. You can think of a dollar, for example, as throwing off a little bit of "benefit" every day to its holder, either because it is useful to that holder as a store of value, or it is useful in making a transaction (in which case, a new holder will control the remaining stream of benefits provided by the dollar).
One unit of a good provides a certain amount of benefit, or "marginal utility." One unit of a currency provides a stream of future benefits, that adds up to its own overall "marginal utility." The price of any good, in dollars, is simply the marginal utility of that good, divided by the marginal utility of a dollar. If a box of paper clips provides a total of six smiley faces of utility, and a dollar provides a total of two smiley faces of utility, a box of paper clips will trade for $3.
Value always lives at the intersection between scarcity and usefulness. What determines the overall marginal utility of the dollars in circulation? Well, if there is a great deal of financial uncertainty, so that the dollar is considered a "safe-haven," each dollar will have a little bit more value than it would otherwise. On the other hand, if the supply of dollars increases significantly, dollars are less scarce, and therefore less valuable. So credit crises tend to increase the marginal utility of dollars (as safe-havens), causing deflationary pressure on prices. Printing money reduces the marginal utility of dollars, causing upward pressure on prices. Printing money during a credit crisis - providing that people actually want to hold that currency as a safe haven - is fairly neutral for inflation.
Here's something to think about. When we look at any stream of payments, the value is based on the whole long-term stream, not just the benefits received in the first few years. Those of you that are familiar with the dividend discount model, for example, know that the bulk of the "value" of a stock is not in the near-term cash flows the stock will throw off in the first few years, but in the very long-term "tail" of those cash flows (or equivalently, the terminal value expected in a buyout). Well, the same is true for a currency. Even if the Federal Reserve creates a massive amount of currency, it will not be inflationary provided people are absolutely convinced that the dollars will only hang around for a short period of time. If they ever become convinced that the new dollars are permanent (and especially if there is not an ongoing credit crisis to create safe-haven demand), the marginal value of each individual dollar would decline, and inflationary pressures would emerge.
From this perspective, it should be clear why the Federal Reserve's tripling of its balance sheet has not resulted in near-term inflation. There is significant demand for the U.S. dollar as a safe-haven currency, the creation of dollars is still viewed as temporary, even though the Treasury is still bailing out Fannie and Freddie in order to make the mortgage securities held by the Fed whole. The problem for the Fed will emerge in the back half of this decade if (and I suspect when) it becomes clear that there is no easy way for the Fed to disgorge its balance sheet without causing disruptions in an economy where the U.S. debt/GDP ratio will then be well above 100%. At that point, the dollars that the Fed has created may be looked upon as more permanent than the markets bargained for, and we are likely to see inflationary pressures. For now, however, we continue to expect only modest near-term inflationary effects from the Fed's actions, despite being reckless and misguided in a broader sense.
Against this backdrop, consider a situation where the European Central Bank begins to print new euros in order to purchase the debt of distressed European countries that are deeply indebted and likely to become more so (barring a major restructuring of their existing obligations). In this case, would people be likely to view the newly created euros as temporary or permanent? Would people be likely to seek the euro as a "safe haven," or would they seek the relative safety of some other currency? For my part, I am convinced that a move to buy distressed European debt by creating euros would be seen as permanent money creation, and that far from seeing any safe-haven demand for euros, we would instead see a flight from the euro. As a result, European inflation would predictably accelerate.
The bottom line is this, the call for massive ECB purchases of distressed European sovereign debt is not simply a call for a liquidity-providing intervention, but is an attempt to address a solvency issue. Liquidity issues can often be addressed through temporary increases in the stock of money, but to address solvency issues, you have to print permanent money. A memorable instance of permanent money creation as a means of financing budget deficits was in 1922, when Germany (saddled with war reparation obligations that violated the no-Ponzi condition, and responding to an invasion of the Ruhr by France and Belgium), began printing money in order to keep paying striking workers in the Ruhr even though they were not producing goods and services. The shift to printing money triggered an immediate flight away from the German mark. The resulting hyperinflation is well-remembered by the German people even if the rest of the world has forgotten.
There are strong legal restrictions among the EU nations against solvency operations by the ECB, and even if one believes that this is inevitable, the chance of the ECB deciding to abandon EU Treaties on its own is zero, in my view. The main thing to look for, if the ECB is to expand its purchases of distressed European debt, would be a solid effort to impose centralized control on the fiscal policies of the individual European member states. This will be a painstaking process, subject to unanimous approval by EU member states. But I strongly doubt that we will see significant ECB intervention without a formal revision of EU treaties that trades greater ECB flexibility in return for more centralized fiscal control.
Meanwhile, it is helpful to remember that the average maturity of European government debt is only about 7 years. If attempts at centralized fiscal control fail in Europe, I suspect that the best way to address the problems of peripheral European countries (which have structural, not temporary fiscal issues) will be for these countries to extricate themselves from the euro as their existing bonds mature, by issuing new debt that is convertible into their own currencies (which would require a higher yield for the conversion privilege, and would lower but not eliminate the default premium). If these countries solve their problems, no conversion would be necessary. Otherwise, they would eventually proceed with a combination of restructuring, fiscal reform, and devaluation to restore their individual economic competitiveness.
As of last week, the Market Climate for stocks remained unfavorable, with valuations still rich (though slightly improved, raising our 10-year S&P 500 total return projection to about 5% annually) and an overall ensemble of conditions (including market action, sentiment, economic factors, and other evidence) best characterized as a "whipsaw trap." Historically, these conditions cluster with other periods that have featured failure-prone rallies in what have ultimately turned out to be negative market conditions. As I noted a few weeks ago, about 30% of the observations in this historical bucket have ultimately enjoyed positive follow-through, so while Strategic Growth and Strategic International remain tightly hedged here, we are open to evidence of any shift in market conditions. Despite conditions that continue to suggest a high risk of oncoming recession, the market has periodically been able to mount intermediate term advances even in the face of hostile economic conditions. My sense is that we're already past such an advance here, but if the evidence shifts, we're open to removing a portion of our hedges to establish a modestly constructive position. Most likely, the opportunity to remove a significant portion of our hedges will emerge at much lower valuations, but as usual, we'll align ourselves with the evidence as it emerges. For now, we remain strongly defensive.
In bonds, yields have retreated back to the 2% level on the 10-year bond, and Strategic Total Return continues to carry a moderate duration of about 3 years in Treasury notes. The Fund continues to carry about 20% of assets in precious metals shares. It's notable that the ratio of spot gold to the XAU remains near record highs, while the ratio of spot gold to the HUI is only about 20% above its historical median. The difference is that the HUI focuses on producers that do not hedge their gold exposure beyond 1.5 years, and those stocks have run up much more strongly with spot gold. The danger here is that while we expect gold prices to remain generally elevated in the coming years, the HUI in my view requires a very strong opinion on a further advance. The following chart shows the general relationship between the gold/XAU ratio (left scale) and the annual gain in the XAU over the following 3 years (right scale). My impression is that the implication of this chart is probably too optimistic, owing to the unusual strength in spot gold, but clearly, the high gold/XAU ratio weighs as a generally favorable consideration for gold stocks here.
That said, given that the U.S. dollar is rising on safe-haven demand, and my own view that the ECB is far less likely to launch bailouts than investors seem to believe, we are more comfortable holding a mix of companies rather than focusing strictly on unhedged producers. In other words, the XAU is priced in a way that suggests that gold mining is an undervalued business, but we have less faith that gold prices themselves are impervious to a correction.
It is important to recognize that precious metals shares can be very volatile, so it is essential to limit exposure to a level that can tolerate that volatility. Also, a high gold/XAU ratio is not in itself enough to warrant a significant exposure to precious metals shares - the relationship isn't tight enough to rule out large periodic selloffs in the stocks, even when that ratio is elevated. Part of our exposure here is also driven by factors such as downward pressure on real interest rates (falling nominal Treasury yields coupled with still-upward pressure on inflation and generally weak economic evidence). As usual, we will shift our exposure as those factors change. For now, a 20% exposure to precious metals shares in Strategic Total Return remains appropriately constructive, in my view.
Wishing you a happy Thanksgiving.
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