Some financial engineering proposals to uplift Eurozone

As Europe struggles to provide some comprehensive solution to ease its crisis (actually there is nothing like a solution for Europe), some economists keep trying.

Here  is Thomas Philippon and Christian Hellwig suggesting the need to launch Eurobills not Eurobonds. They say Eurobonds which don’t really solve the moral hazard problem as once again Germans will pay for Greece’s adventures. Eurobills are bonds less than 1 year and help resolve liquidity crisis when they occur. The governments should give up issuing short term bills and will incentivise them to issue more longer term debt.

The key idea is to prevent self-fulfilling liquidity runs and the negative feedback between sovereign and banking crises, while minimising the risk of moral hazard. The first point to emphasise is that our proposal is not a substitute for improved economic governance and fiscal discipline.

It is complementary to these measures. Indeed, by making access to Eurobills conditional on sound long-term fiscal policy, our proposal strengthens the existing framework. Second, Eurobills would replace existing short-term debts, and not expand the overall amount of short-term debt.

The specific number of 10% of GDP is based on the US market. US Treasury Bills, whose maturity is less than a year, represent about 10% of US GDP. It is important that countries give up their right to issue short-term debt. This is, in our view, the only credible way to make Eurobills effectively senior to all other liabilities that countries issue. Eurobills would cover the maturity range from one month to one year, and individual countries would only be able to issue maturities beyond two years.

Our proposal would incentivise countries to issue more long-term debt. In addition, to the extent that Eurobills improve financial stability, they will make it cheaper for countries to borrow long

For Eurobills they propose setting a Debt Management Office which manages the whole issuance business.

In another proposal, Illian Mihiv points to what new can ECB  do? He looks at an older proposal from Willem Buiter (how much I miss his blogposts for really maverick solutions). He says all central banks have this thing called seignorage where they can print money without any cost:

The standard view on ECB is that they have to print money in order to buy bonds of governments in trouble like Greece, Italy, Portugal, etc. But there is another thing that they can do. About 18 months ago, the chief economist of Citigroup, Willem Buiter, wrote an article in which he noted that the ECB can use its future profits to stop the acceleration of these negative dynamics on the bonds market. According to his estimates, the ECB has a “non-inflationary loss absorption capacity of … at least €2.4trn and more likely over €3.4trn.” In other words, the ECB can put credibly on the market a firewall of over €2.4 trillion. Certainly this ought to stop the ever-increasing yields on Spanish and Italian debt from rising further.

How does this work? Central banks run very profitable operations – they issue pieces of paper that we call money on which they pay us no interest. With the printed money they buy interest-bearing securities like government bonds. Because of the interest rate differential between the 0% rate on currency and the yield on bonds, central banks generate profits every year. Well, the actual calculation of the profit (seigniorage) is a bit more complicated (see Buiter’s article), but the mechanics are not changed much. This profit is generated even if inflation is 2% (ECB’s mandate).

Hmmm. So bringing future profits forward and helping the markets:

One way to imagine Buiter’s proposal is the following: Suppose that the ECB issues bonds worth €2.4 trillion (note that they do NOT print money equal to €2.4 trillion). These bonds would most likely have a yield close to the yield on German bonds (2.6% for 30-year bonds) because one can expect that if the euro is alive, the ECB will be mechanically generating this revenue from their activities. After issuing these bonds, the ECB can make an announcement that for countries which are solvent when the yield is 5%, they will not allow these yields to go above 5% (one can adjust the numbers for the state of the cycle, but the idea is that they restrict the yields from increasing due to the lack of confidence). If yields are above 5%, they buy the bonds with the revenue generated through their own issue. If this announcement happens, and if the ECB just starts with some symbolic purchases, yields will go down quite rapidly and yields on Italian debt for example will return to sustainable levels.

Notice that if the ECB has to buy the bonds, then they will be generating yet another profit stream from the difference between their 30-year bond (at 2.6%) and the Italian yield (currently at 6.5%). But even if Italy fails and does not repay the bonds bought by the ECB, the ECB can fully absorb the loss. This is why Buiter calls this quantity the “non-inflationary loss-absorbing capacity” of the ECB.

Is there any magic or a free lunch here? Not really. The seigniorage of central banks has to be transferred by law to the governments of the euro zone. So, effectively what the ECB does is that it takes future government revenues and puts them today to create a firewall. They can commit to having this revenue in the future because of the nature of their operations. Governments – even though they are the eventual recipients of this flow – cannot commit today because the markets do not trust them anymore. The essential role played by the ECB in this case is to put the certain revenue stream on the table and to tell the markets – this future revenues will be used to absorb losses or to repay debt and not for other spending. It is quite likely that they will never have to buy even one government bond out of this facility.

What caused the crisis are also being seen as solutions of the crisis…


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