Political leaders in the Euro zone make its central bank buy more government bonds adding to the dangers going forwards

After the Euro zone denominated proceedings of most of last week we turned on Friday to a major update on the state of the US economy as we were due figures on both employment (non-farm payrolls)  and unemployment. These figures turned out to be disappointing but in the current market sentiment which seems to find a reason for an equity market improvement regardless of what is happening saw the disappointing numbers as something likely to cause yet more monetary easing/stimulus measures from the US Federal Reserve. Accordingly after struggling initially the US Dow Jones equity index closed up 19 points which meant that it has risen around 370 points in three days. Other markets have also rallied over these past few days leading to some interesting implications.

Here we have seen some quite strong moves. If we start with the crude oil price we have seen a powerful move to new highs for 2010 which are also the highest price for crude oil for over 2 years. This morning the price of a barrel of West Texas Intermediate crude oil has touched US $89.75. There have been various influences on its rise. Rising equity markets are often associated with rising oil prices, the weather in much of Europe (the UK included!) is very cold, and there was an interview with Ben Bernanke the Chairman of the US Federal Reserve which I will discuss later. If we look back to the beginnings of 2009 then the price of a barrel of crude oil was in the low thirties. However back in May this year we saw a more recent low of US $64 per barrel of oil. So in the following seven months the price has risen by some US $25 per barrel or nearly 40%. Also if we think back to then one of the influences on a falling oil price was the Euro zone crisis of the time whereas now we find a Euro zone crisis associated with rising oil prices.

There are always many explanations for a rise in the price of gold. However one of them is concerns over inflationary trends and the correlated debasement of fiat money. As we can see from the oil price there are inflationary trends around and this is likely to have been an influence in the rise of the gold price. After the jobs figures on Friday the gold price shot up by more than US $20 per ounce virtually in a straight line and is now priced at US $1412 per ounce for yet another new high when it touched US $1418 per ounce earlier today.

After such moves for both one can probably expect something of a retracement in the short-term but it is plain that at this time there are concerns about inflationary trends in the world. Unfortunately conventional economic theory may struggle to pick this up as many economists base their thinking on core inflation which excludes food and energy.

The US unemployment and employment or non-farm payroll numbers

The headline figures came as something of a shock as according to the US Bureau of Labor Statistics we got.

The unemployment rate edged up to 9.8 percent in November, and nonfarm payroll employment was little changed (+39,000),

So we opened with two negatives as the unemployment rate rose by 0.2% and the level of employment creation was much lower than hoped for. If we continue with the report there were unfortunately other concerning numbers.

1. The Employment-Population ratio declined to 58.2% in November and accordingly went back to the low levels of  2009.

2. The Labor Force Participation Rate was steady at 64.5% in November (blue line). There had been hopes of an improvement towards what is regarded as more normal levels somewhere in the region of 66 to 67%.

3. The number of long-term unemployed is rising again which is concerning as it had previously show signs that it had peaked. But the number of workers  who have been unemployed for more than 6 months and still want a job rose to 6,313,000 workers in November up from 6,206,000 in October.

It was not all bad news as the numbers of workers forced to cut their hours or work part-time fell to 8,972,000 which meant that the wider measure of unemployment or U-6 stayed at 17%. However this is a very high level. There were also revisions to October and September jobs figures which made them slightly better and average hourly earnings edged up. However these were unable to fully offset the weaker components of the figures and leave us with a completely different feeling to the October figures where employment creation appeared to be much stronger.

Comment

Care is always required because the non-farm payroll component of these figures is notoriously volatile but these figures leave quite a different impression to those for October. One matter that does appear clear is that the US economy is growing but if we look at the last few months figures it is not growing quickly enough to improve the unemployment picture and indeed it looks as though unemployment is in danger of rising again. This poses a  policy problem for the US Federal Reserve or central bank.

An Interview with the Chairman of the US Federal Reserve

In an interesting coincidence of timing the Chairman of the US central bank Ben Bernanke was aired on CBS last night. I notice  that he said fears of inflation are “overstated” although to be fair the interview was recorded before the recent oil price surge. However he also said something on unemployment too. According to Bloomberg.

We’re not very far from the level where the economy is not self-sustaining………..It’s very close to the border. It takes about 2.5 percent growth just to keep unemployment stable and that’s about what we’re getting……At the rate we’re going, it could be four, five years before we are back to a more normal unemployment rate.

So if you read between the lines you get the feeling that with inflation fears overstated according to Ben Bernanke and unemployment a problem then more easing and either an expansion to QE2 or perhaps a QE3 might be on the horizon. Adding the comment that an expansion in monetary stimulus is “entirely possible” will only feed speculation. But we have a situation where the somewhat surprising strength in US equities on Friday may not be so surprising. Also we have moral hazard piled on moral hazard.

Let me make this clear I am already worried by the level of central bank intervention in world markets. Mr. Bernanke’s policies are extremely interventionist which is a danger but recording a programme several days before it is aired has the danger that whilst after the programme is aired everybody is equal, in the time gap before it is shown there is the danger that some are more equal than others ( with apologies to George Orwell)! The programme was recorded on the 30th of November and since then as I recorded above the US equity market has been rather strong to say the least. Central bankers should avoid even the suspicion of this sort of thing.

The continuing Euro zone crisis

In the Financial Times today Jean-Claude Juncker Luxembourg’s prime minister who also chairs meetings of euro zone finance ministers, and Giulio Tremonti, Italy’s finance minister have written an article suggesting that the creation of a European Debt Agency with the ability to issue so-called E or Euro zone bonds would improve matters. So rather than individual countries issuing their own national bonds there would be a pan-Euro zone bond. This idea has been floated around for a while,mostly in my view by people whose knowledge of financial markets veers towards fantasy. Mr Juncker gives us the advantages of such a plan but the disadvantages appear to have slipped his mind. Some of his fantasies are expressed in these two sentences and the emphasis is mine.

An E-bond market would also assist member states in difficulty, without leading to moral hazard. Governments would be granted access to sufficient resources, at the EDA’s interest rate, to consolidate public finances without being exposed to short-term speculative attacks.

Of course Mr.Juncker feels that there has been no moral hazard in what has happened so far in the Euro zone crisis! However let me explain why this is a fantasy. He is plainly hoping that a pan-European EDA would issue bonds at an interest-rate that say the German treasury can issue at. He will be relying on the fact that markets will not spot that as well as German taxpayers and economic efficiency such an arrangement will also depend on Ireland,Greece, Portugal, Spain, Italy and Belgium all countries with how can one put it either current or potential fiscal concerns. So interest rates on this debt will be higher than those at which the German treasury can issue which immediately begs the question of why the Germans should join this programme as it guarantees a higher cost to their debt. I have written in previous articles that the recent extension in effect of Germany’s creditworthiness to some of the peripheral Euro zone countries has coincided with her longer-term interest rates rising by around 0.5 to 0.6%. So Mr.Juncker is relying on the Germans not spotting this ruse. Without Germany the plan falls down somewhat.

The German Finance Minister Wolfgang Schäuble has already pointed out many of the flaws in the plan so Mr.Juncker’s ability to pull the wool over German eyes did not last even one day. The ability of the Euro zone to shoot itself in the foot continues to be a feature of its crisis.

Comment

We hit again on the fundamental flaw in the construction of the Euro zone which is that it is a monetary union constructed without fiscal union. I suspect that Mr. Juncker is using his E-Bond plan as a way of moving the Euro zone towards more fiscal union without having to actually ask voters. It can be presented as an improvement  and then when trouble hits emergency measures can be imposed. In a way though he is raising the fundamental problem that the Euro zone has to sort out. Does it want fiscal union and all that implies, or not?

As we stand Europe’s leaders appear divided which is not a good start. They often blame each other for Europe’s problems and when they tire of this they usually blame the financial markets. When they do occasionally agree we see an enormous amount of hype and hyperbole which is never matched by the actual deeds and this in itself leads to further problems and disappointment. One of the ironies of the current situation is that in many ways with their continual squabbling the leaders of the Euro zone are in fact one of the worst examples of the sort of unity their words call for.

Last week with its bond purchases under its Securities Markets Programme the European Central Bank bought the leaders of the Euro zone some time. The aggression and timing of the move was a success in terms of buying time but we should not forget that it takes a genuine solution to the current problems further away. As the SMP buys ever more bonds that one day will need some form of restructuring or even default then the balance sheet of Europe’s central bank looks ever riskier to me and it is quite conceivable that we could be in an era where central banks as well as private-sector banks need bailing out. In a strategic sense the ECB is in a hole and it is digging rather than trying to get out of it. It will make getting out of the hole ever harder if it is forced to carry on with such a plan.

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14 thoughts on “Political leaders in the Euro zone make its central bank buy more government bonds adding to the dangers going forwards

  1. Hi Shaun, “In a strategic sense the ECB is in a hole and it is digging rather than trying to get out of it. It will make getting out of the hole ever harder if it is forced to carry on with such a plan.” Isn’t this another example of the entwined cross-over between politics and economics? I suspect that if Trichet were truly independent and if the ECB were truly independent (as for example the Bundesbank used to be, or as the BoE was supposed to be, but which it is clearly not) then he would have stood firm, and not got the ECB into this mess. He has however been over-ruled by EU politicians and has thus been forced to do things which he knows are not acceptable to longer-term EU economic stability, because the ECB is not longer independent, if indeed it ever was?

    • Hi Drf
      Each of the world’s major central banks have faced severe stresses and crises over the past 2/3 years. If we ignore China as there isnt even a claim of central bank independence there then all of the others have suffered from the implications of endulging in “extraordinary monetary measures”. Once you take this route you can never then claim to be completely independent of politics as usually central banks need political permission to start such policies and/or thery need a guarantee against any losses from the national treasury. So the spiders-web has them at that point.

      In many ways the ECB has struggled quite hard against the web as it was planning an exit strategy whereas I believe both the Fed. and the Bank of England have no explicit exit strategy at all. However each time the ECB tries to break free something gives in one or more of the peripheral Euro zone nations and it has to retrace at least some of its steps. Unfortunately for it short-term successes like the bond buying it did last week only tie it further into the web as one day these bonds will have to take a haircut. And here is my problem for the day. Exactly which treasury will the ECB go to when its losses need underwriting? Here is why it undertakes the form of accounting that shireblogger was asking about……

      • Shaun,
        Presumably the ECB would look to the national treasuries in proportion to the key for capital subscription in its Statute (Article 29) If they couldn’t or wouldn’t pay, I suppose it would just have to create the money.

  2. What I don’t understand about the European Debt Agency is the relationship between the bonds that it would issue and the national governments.

    Say France needs to borrow some money. Presumably EDA would issue bonds, and pass that money on to France, who would then spend it. Would the bond buyers know that the bonds they have just bought were for the benefit of France, or would they look just like all other EDA bonds?

    Now, is it France who is responsible for paying off these bonds? In the event that she in unable to, is the idea that these bonds would become a general obligation of the EU as a whole?

    • Hi Dan
      The questions you ask highlight a flaw in the programme. The EDA could raise money in a particular country’s name using its own credit rating. But as I pointed out this is good for those with a weaker credit rating but bad for those with a stronger one. Once we get past the problem of why the stronger countries would even agree to making themselves worse off we then get a litany of problems.
      If we stick with your question of who is liable for paying off the bonds you hit one of the problems right on the head……..For all the talk what would stop a country who just keeps borrowing? Or one who dissembles about her figures? We get a lot of talk about Euro zone institutions stopping this but of course it is now sixteen years since an auditor was willing to sign off the European Union’s accounts…
      Usually they try to get around this problem by saying that the amount of bond issuing would only be a proportion of economic output. It used to be 60% but these days it seems now to have dropped to 40%. But as ever this solves very little. We always return to the fundamental problem that there is a name for this sort of thing and it is economic union.

  3. Hi Shaun and others – L’quantitativeeasing de L’Europe :
    It’s worth pointing out that the ECB operate within a differing legal framework than does the Fed and the BoE – Lorenzo Bini Smaghi said in a 2009 speech

    ” In the first place, we need to be mindful of the Treaty requirements relating to the prohibition of monetary financing and the granting of privileged access, as well as of the consistency with the Treaty principle of open market economy and the preservation of the disciplining function of markets for borrowers and lenders. Although purchases of government bonds are possible in the secondary market, there is a risk to eventually become a market maker for public debt, which could be construed to be against the Treaty prohibition of monetary financing. Moreover, we have more than just one fiscal authority in the euro area. The Eurosystem would have to decide how to spread purchases of government bonds across euro area countries. If, for example, the Eurosystem only concentrated on public bonds with the best credit rating, it would risk providing privileged access to some countries, contravening Article 102 of the Treaty. If it spread purchases according to a specific key and ended up affecting cross-country differences in yields, it would be seen as granting privileged access, as financing conditions for some governments would be supported to a greater extent than for others. It may also be the case that the risk-free component of corporate bonds would not move exactly in tandem with the risk-free component of government bond yields. This would be tantamount to giving preferential treatment to government debt. These issues would need to be addressed before implementing a government bond purchasing programme in the euro area. ”

    Mr Trichet’s webcast last week gave me the impression that he and his colleagues were taking some careful legal advice. Its a bit similar to the German constitutional challenge to the EFSF bailouts – the legal presumption for these being that peripheral member states have been hit by circumstances beyond their control…have they?

    • Hi Shireblogger

      Thanks for referencing this speech as it is intriguing. This section is fascinating as you only need to change one word to get what is happening now and yet it is a scenario with issues that would need to be addressed according to Mr. Smaghi. The word in brackets is me and you can replace the word before it with it to get the current position.
      “The Eurosystem would have to decide how to spread purchases of government bonds across euro area countries. If, for example, the Eurosystem only concentrated on public bonds with the best (worst) credit rating, it would risk providing privileged access to some countries, contravening Article 102 of the Treaty. If it spread purchases according to a specific key and ended up affecting cross-country differences in yields, it would be seen as granting privileged access, as financing conditions for some governments would be supported to a greater extent than for others.”

      I wonder how he voted on this? One the one hand it appears to be his view that it violates Euro zone treaties, on the other hand his own country is a potential recipient!

      I am by no means a legal expert so I will leave the Treaty to the lawyers but I do remember a claim that the SMP was responding to disequilibrium when it first began. If we put aside my theoretical objection that you have to establish an equilibrium first let us examine the evidence. Was Greece’s government bond market in disequilibrium? The answer I believe is not really as it was responding to bad news and yields were rising. In some ways it was the pricing mechanism working properly. However let us endulge supporters of the disequlibrium theory the problem is that Greek yields are at high levels again and are presumably in disequilibrium again! We are back to my point that the ECB could end up in extremis owning the whole Greek government bond market. It would probably end up owning it all just in time for the necessary restructuring.

      As to circumstances beyond their control? The answer here is a no too. Greece’s previous government willfully dissembled about her finances and the Irish government chose to give a blanket guarantee to its banks….

      • Hi Shaun
        I take your comments. It is these very legal issues which Germany are using to excuse themselves from going much further, either with eurobonds, increasing the EFSF limit or QE de L’Europe – note their consistent use of the phrase ‘anti competitive’. If you consider either of these propositions they all involve distorting competition in some regard – its like an enormous state-aid but in this case a eurozone-to-state-aid.

        If the German constitutional court agree with your last paragraph they might declare the bailouts anti-constitutional..

  4. I personally hope that Eurobonds do become a reality, and soon.

    The UK would then find joining the Euro unaffordable at any timescale – due to the hit to its borrowing costs, and with any luck would become increasingly marginalised and drop out of the EU altogether.

    Unfortunately, as you say, Eurobonds are merely fantasy.

  5. What is the purpose of EU if there is no solidarity? what is the purpose of Eurozone without common fiscal policy? what is there for the small countries, the weaker economies? to suffer from the German surplus? (it is impossible for all to have a surplus) how are they to compete with Germany if they have the same currency at an exchange rate that is good for Germany or the Netherlands? Either common fiscal policy or break up the EZ and the EU a bit later. As I have said in the past just a trade union is not in the benefit of the weaker economies of Europe. Either a real european union with both common currency and fiscal policy (such as Eurobonds) or no European union at all. The stakes are high. Not a lot have realised but I believe that EU gives a battle of survival. I only hope that another German government will explain to German people the importance of commitment of a united Europe also as Papandreou and others have explained to the weaker countries how important is to live within their means and make structural reforms from now on. However, you need two to tango, and in my opinion Germany does not tango at this moment.

  6. Basil,
    The problem with a lot of the comments I see here and elsewhere is that they are not quantified, even vaguely. That does not make them invalid but it would be very interesting to know, for example, how much of Germany’s current GDP would have to be transferred on an annual basis to the fringe EU nations to ensure that they could permanently remain within the Euro. I guess the figure is very large and, due to the obvious moral hazard, would probably increase with time. There are a lot of countries in the ‘fringe’. It may be that the Germans have scoped the numbers and decided that their living standard would drop further, remembering that a very large chunk of the European Development Fund already comes from there. Time will tell, but I guess A Merkel dropped a large hint the other day when she said that Germany could leave the Euro under some circumstances. Getting a handle on the dimensions of the problem could lead to some better understanding of the potential solutions, assuming any exist, which I am beginning to doubt.

    • This is fair enough but please go out and let the weaker economies default. Why not? because Germans want their empire also. If one wants an empire has to pay for the empire, otherwise collapses. Is there for example any doubt that the English pay the Scots for the UK?

  7. Obama has apparently reached an agreement with the Repubs: another 13 month extension of u/e benefits and all of the Bush tax cuts will remain in place for another two years. This is going to blow a gaping hole in the deficit; tomorrow will be fun in the Bond markets. Apparently borrow & spend ad finitum is the plan here on this side of the pond. Austerity is for other people.

  8. Looks to me like the EU is trying to implement a mechanism which will bail out the ECB! Trichet must be sick of kicking his can down the road, only for it to bounce back over his head, and instead has now kicked it over the garden wall.
    I just think the whole thing is mad with fiscal and political leaders wrapping themselves up so much in chaos theory economics they can’t tell sane economics from the insane variety!
    I got the same feeling listening to Darlings first budget response to the financial crisis, there goes the baby, the bathwater, the kitchen sink and probably any hope of a solvent future!

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