Let the ECB capital key float

Bankers clear and settle with each other at a clearing house

Perry Mehrling had in interesting comment about how to settle the Eurosystem's Target2 imbalance problem.

If there were Eurobills, balances could be settled periodically by transfer of assets, just as is done in the Federal Reserve System. More precisely, if there were a System Open Market Account at the ECB, in which all of the national central banks held shares, settlement could be made by transfer of shares.

Perry is talking about adapting the structure of the Fed's Interdistrict Settlement Account to Europe. To understand the ISA, check out my Idiot's Guide to the Federal Reserve Interdistrict Settlement Account. In short, the 12 regional Reserve banks run up debts and credits to each other over the course of the year due to changes in payments flows. These debts and credits are settled each year by transferring securities that have been bought in open market operations from debtor Reserves banks to creditor Reserve banks.

The Eurosystem, on the other hand, doesn't require that the clearing debts wracked up by the various National Central Banks (NCBs) be settled. Which is odd. Not even Keynes's ICU would have allowed infinite debts, and Keynes was a forgiving sort of guy.

Perry's idea is that with the Eurosystem embarking on a program of Outright Monetary Transactions (OMTs), maybe the securities amassed will allow for a mechanism to settle intra-Eurosystem imbalances. Debtor NCBs like the Bank of Greece will have to transfer OMT securities to creditor banks like the Bundesbank. Perry specifically discusses the idea of having each NCB own shares in the OMT portfolio and have these shares transferable so as to facilitate settlement.

I like this idea and think it can be twinned with the already existing ECB capital key. What is the capital key?

All NCBs have an ownership stake in the overlying ECB. The relative amounts held by each are determined by the capital key. The key's weights are based on relative population and GDP. Germany for instance, has been given an 18.9% weighting in the capital key. Greece has been given a 1.96% weighting.

The ECB holds a unique set of assets on its balance sheet (see year-end 2011 statements). These have been transferred to it from the NCBs. First, it holds 16 million ounces of gold, worth around €21b. It also holds around €41 in forex reserves denominated in yen, dollars, and more. Lastly, it holds a few assets purchased during previous open market campaigns. Also worth considering is that the Eurosystem's total profits are paid out according to the capital key. This means that the profits yielded by assets held by the Bank of Greece don't necessarily get paid out to the BoG... they get amalgamated with all NCB profits and then allocated to each individual NCB according to the capital key. So having a big weighting in the capital key is definitely worth something.

Say that going forward all OMT purchases are conducted through the ECB and not the NCBs. That means that in addition to its gold and forex position, the ECB gets even bigger, and shares in the capital key are rendered more meaningful.

You can then institute a Fed-style settlement program by letting each NCB's weighting in the capital key float. Each year debtors get their share in the capital key lowered. Creditors get their's increased. That adds some quid pro quo to intra-Eurosystem balances. What happens if a central bank's representation in the capital key were to fall below zero because of persistent capital flight? Then the national government would have to recapitalize their respective NCB's contribution to the ECB so that it's portion of the key rises back to 0%. Or you could soft-pedal the whole thing and institute some sort of broad system of reforms a country has to initiate once it falls below 0%. Either way, the system is redesigned to have a tendency to equilibrate.

Is such a tendency necessary? I leave you with some words from Keynes's Proposals for an International Currency (or clearing) Union, February 11, 1942:

Measures would be necessary to prevent the piling up of credit and debit balances without limit, and the system would have failed in the long run if it did not possess sufficient capacity for self-equilibrium to prevent this.

QE-zero

Bob Murphy asks if central bank actions taken during the early 1930s might be considered "unprecedented". In the comments I pointed out that during that era an early form of QE was tried. I'm not referring here to the famous 1933 Roosevelt purchases of gold that market monetarists often point to. For instance, see David Glasner here, David Beckworth here, and Scott Sumner here. Scott also has a very interesting paper on the 1933 gold purchasing program (pdf). No, I was referring to the 1932 treasury purchasing program.

I'm going to replicate the simple graphical analysis that market monetarists use in order to look at the 1932 episode. See this post by Lars Christensen, for example, who overlays important monetary events (QE1, QE2, LTRO) over the S&P500.

Here is the context. Prior to 1932, the Federal Reserve system was significantly limited in its ability to embark on large purchases of government securities. This was because of strict backing laws in the Federal Reserve Act that limited eligible backing assets to gold and assets accepted as collateral for Fed discount loans, primarily commercial paper. In effect, the Reserve banks could only purchase government debt to the extent that there was already excess gold and discounted assets on the Reserve bank balance sheets.

This limitation was removed with the passage of the Glass Steagall Act of February 1932, which allowed the Fed to include government debt as backing for notes and deposits. Almost immediately the Federal Reserve began a large scale asset purchasing program that increased the system's government debt portfolio from $743 million at the end of February 1932 to $1413m by May. The program, which I'll call QE0, continued at a slower rate after May, eventually hitting a peak just above $1800m by the end of July 1932. I overlay this on the Dow Jones Industrial Average.

The second chart extends the time frame to include 1933, putting QE0 on a scale with the Roosevelt devaluation.

Gavyn Davies, who has treaded this path before, notes that Milton Friedman and Anna Schwartz declared QE0 to be a success. In their Monetary History of the United States, the two drew attention to the conjunction of QE0 with a lull in bank failures and a "tapering off of the in the decline in the stock of money". They point to the bottoming of industrial production in August, five months after QE0 started, as a sign of its success. In his History of the Federal Reserve, Allan Meltzer also strikes a note of optimism when he discusses QE0, noting many of the same improvements in data that Friedman and Schwartz point to. Meltzer writes that "it seems likely that had purchases continued, the collapse of the monetary system during the winter of 1933 might have been avoided" and notes the rise in stock prices beginning in July as evidence.

But no market monetarist would agree with Friedman and Schwartz's analysis, since the new breed of monetarists take asset prices as the best indication of monetary stance. Scott Sumner points out here, for instance, that US equity markets had one of their fastest two day rallies in history as President Hoover met with Congressional leaders to begin work on Glass Steagall. All good, then, for the market monetarist stance, who like to see rising market prices coincide with easy monetary policy at the zero lower bound. Unfortunately for them that was the end of the rally. Markets continued falling to new lows even as QE0 accelerated. Scott Sumner indeed notes that "In many respects, the period from April to July 1932 was the worst three months of the entire Depression. Commodity prices continued to fall, and both stock prices and industrial production reached their Depression lows in July." Oddly enough, only with the end of the QE0 did stock prices begin to rise again, as the first chart shows, which runs contra to market monetarist thinking.

No wonder then that market monetarists prefer to look at the second chart. In 1933, the conjunction of increases in stock prices with various monetary events, including the departure of the dollar from gold convertibility and Roosevelt's gold purchase plan, is quite striking. This cozy relationship is no doubt the main reason that market monetarists prefer to point to 1933 rather than QE0 for evidence of monetary policy effectiveness at the zero lower bound.

QE0's seeming failure might seem to confirm Murray Rothbard's view that the huge increase in the money supply engendered by QE0 "endangered public confidence in the government's ability to maintain the dollar on the gold standard," leading to a loss of confidence on the part of foreigners who drew out gold, and on the part of Americans who converted deposits into notes. This turned an intended inflation into an unintended deflation. The aboves is also Peter Temin's view, who points out that the purchases reduced confidence, the resulting gold outflow nullifying QE0's potential for expansion.

My reading of Scott Sumner is that the 1932 purchasing program was rendered ineffective because of growing expectations that the dollar would float, leading to gold ouflows and an ensuing general panic in equity markets. In meting out blame for this panic, Sumner emphasizes the role of Congress in engendering uncertainty rather than the Fed's QE0 program. Once the dollar panic was alleviated and the hoarding instinct of foreign central banks and the private sector satiated, markets began their rise in the latter half of 1932.

Hsieh and Romer (pdf), on the other hand, use data on dollar forward rates to show that traders were not particularly worried about a dollar devaluation. If H&R are right, then one can only conclude that there was no dollar crisis, leaving market monetarists with no corresponding event to blame for counterbalancing the inflationary effects of QE0. So QE0, it would seem, was irrelevant -- a non-event. Scott talks about Hsieh and Romer's paper here. It all seems rather tortured to me, and leads me to (somewhat dismally) conclude that one can probably get a set of historical events to say almost anything one wants it to say. This is not a criticism of Scott, but one of economics in general.

All of this leads to current discussion of QE3. The New Keynesians point to the ineffectiveness of QE itself at the zero lower bound. For instance, see Simon Wren Lewis. This view is inherited from John Maynard Keynes who, it would seem, got it from his observations of the failure of QE0 in 1932. Here is Keynes in Chapter 15 of the General Theory:

There is the possibility, for the reasons discussed above, that, after the rate of interest has fallen to a certain level, liquidity-preference may become virtually absolute in the sense that almost everyone prefers cash to holding a debt which yields so low a rate of interest. In this event the monetary authority would have lost effective control over the rate of interest. But whilst this limiting case might become practically important in future, I know of no example of it hitherto. Indeed, owing to the unwillingness of most monetary authorities to deal boldly in debts of long term, there has not been much opportunity for a test. Moreover, if such a situation were to arise, it would mean that the public authority itself could borrow through the banking system on an unlimited scale at a nominal rate of interest.

The most striking examples of a complete breakdown of stability in the rate of interest, due to the liquidity function flattening out in one direction or the other, have occurred in very abnormal circumstances. In Russia and Central Europe after the war a currency crisis or flight from the currency was experienced, when no one could be induced to retain holdings either of money or of debts on any terms whatever, and even a high and rising rate of interest was unable to keep pace with the marginal efficiency of capital (especially of stocks of liquid goods) under the influence of the expectation of an ever greater fall in the value of money; whilst in the United States at certain dates in 1932 there was a crisis of the opposite kind — a financial crisis or crisis of liquidation, when scarcely anyone could be induced to part with holdings of money on any reasonable terms.

The market monetarists, of course, believe in the effectiveness of QE, although announcing a nominal target would greatly improve a purchase program's effectiveness.

This is what Nick Rowe means when he says that there are two types of economists (HT Bob Murphy). There are those who think monetary policy is useless at the zero lower bound, and those who don't. I wonder how much of the divergence between these two traditions has its origins in the data generated by the separate 1932 and 1933 monetary events. If you focused on the latter, you became a monetary policy believer, if you focused on the former you stopped believing.

Other posts on the efficacy of QE or lack thereof:

Stephen Williamson (here and here), Bruegel blog, Richard Serlin, Miles Kimball (here and here), Paul Krugman (here and here), James Hamilton, John Taylor, John Cochrane, Michael Woodford (pdf), and Simon Wren Lewis.

ECB, IMF, ICU and other exciting monetary acronyms

Gavyn Davies drew some interesting parallels between the ECB and the IMF last week. This follows on his post the "ultimate taboo", in which he analyzed the idea of "convertibility risk", a term first used by ECB head Mario Draghi in a speech in late July.

Gavyn points out that in explicitly drawing attention to its job of controlling convertibility risk - ie. ensuring that all euros are the same - the modern ECB is becoming more like the IMF. Specifically, during Bretton Woods the IMF sometimes financed the balance of payments deficits of member nations in order to ensure the system of fixed exchange rates stayed, well, fixed. When it did so, the IMF was engaging in a mind game of sorts with the market, for the market knew that the IMF knew that the market knew that rates could be modified if attacked with enough force. In admitting to the world the existence of convertibility risk, the ECB is now displaying an IMF-degree of hyper self-awareness... for the first time.

In order to ensure that this financing was not permanent, the IMF would impose limits on the borrowing nation's finances. This is what the ECB is now doing, too, as Gavyn points out. For instance, in order to be able to participate in the ECB's new outright monetary transactions (OMT) program, nations will be expected to conform to basic ECB requirements or risk being dropped. This is the idea of "conditionality".

In the comments I brought up a comparison to the institution that the IMF could have been if Keynes had won his debate against Harry Dexter White: the International Clearing Union (ICU). I only point this out because having as many comparisons as possible might help shed clarity on the Target2 imbalance problem. It also just so happens that I am reading Barry Eichengreen's book Exorbitant Privilege which touches on this bit of monetary history.

The ICU was first put forward by Keynes in 1941. Much like the ECB clears all intra-European payments on its own books via Target2, the ICU was to have cleared all international payments on its own books. Where the ECB uses the euro, the ICU would have used the bancor. Keynes's purpose for establishing the clearing union was to ensure that each country would be "allowed a certain margin of resources and a certain interval of time within which to effect a balance in its economic relations with the rest of the world" (Proposals for an International Currency (or clearing) Union, February 11, 1942). This would allow the war-ravaged world to return to an era of unfettered free trade rather than isolationism, especially the sort that prevailed in the inter-war years in which narrow bilateral clearing agreements were the norm.

What is interesting is that unlike Target2's open ended granting of credit, Keynes envisioned that the ICU would set explicit limits on any country's deficits. Here is (presumably) Keynes:

Measures would be necessary to prevent the piling up of credit and debit balances without limit, and the system would have failed in the long run if it did not possess sufficient capacity for self-equilibrium to prevent this. (Proposals   for an International Currency (or clearing) Union, February 11, 1942)

It really is too bad that the architects of the Euro never bothered to read that gem. Here, for instance, are the specific fine-print defining the maximum ICU debit:

The amount of the maximum debit balance allowed to any member-State shall be determined by reference to the amount of its foreign trade, and shall be designated its quota... The initial quotas might be fixed by reference to the sum of each country's exports and imports on the average of (say) the three pre-war years, being either equal or in a determined lesser proportion to this amount, a special assessment being substituted in cases where this formula would be, for any reason, inappropriate. Subsequently, after the elapse of the transitional period, the quotas might be revised annually in accordance with the actual volume of trade in the three preceding years.

 A charge of 1 per cent. per annum will be payable to the Reserve Fund of the Clearing Union on the average balance of a member-State, whether credit or debit, in excess of a quarter of its quota; and a further charge of 1 per cent. on the average balance, whether credit or debit, in excess of half its quota. (ibid)

The keen reader will notice that in the above quote Keynes advocated levying penalties and limits not only on debtors to the system but also on creditors. These penalties were sure to be "valuable inducements towards keeping a level balance", as Keynes put it. Eichengreen draws attention to a more self-serving motive for Keynes's plan. Envisioning large US surpluses after the war (and large UK deficits), Keynes wanted to devise a way that would soften the effects of these imbalances on the UK by giving the nation time to rebalance, while at the same time penalizing the US for its large credit position. It was not to be, of course, as the ICU never came into being, displaced by the IMF and (to a degree) the Marshall Plan.

In addition to imposing a 1% charge per annum on surpluses above one-half of their quota, listed below are Keynes's specific proposals on credit limits:

A member-State whose credit balance has exceeded a half of its quota on the average of at least a year shall discuss with the Governing Board (but shall retain the ultimate decision in its own hands) what measures would be appropriate to restore the equilibrium of its international balances, including—

(a) measures for the expansion of domestic credit and domestic demand;

(b) the appreciation of its local currency in terms of bancor, or, alternatively, an increase in money-wages;

(c) the reduction of excessive tariffs and other discouragements against imports;

(d) international loans for the development of backward countries. 

I doubt modern Germany would accept a 1% penalty on its massive Target2 balance, or that it would let itself be shoehorned into increasing wages or expanding domestic credit so as to help its neighbors solve their Target2 imbalance problem.

As for debtor countries, Keynes envisioned that countries would not be able to increase their debit balances by more than one quarter of their quota without the permission of the ICU Governing Board. In the case of debit balances in excess of one-half of its quota, the Governing Board could force the country to reduce the value of its currency or impose controls on capital outflows. When debit balances exceeded three-quarters of the quota, the Board could put the debtor nation under a form of financial shunning in which

it may be asked by the Governing Board to take measures to improve its position and, in the event of its failing to reduce its debit balance below the figure in question within two years, the Governing Board may declare that it is in default and no longer entitled to draw against its account except with the permission of the Governing Board. Each member-State, on joining the system, shall agree to pay to the Clearing Union any payments due from it to a country in default towards the discharge of the latter's debit balance and to accept this arrangement in the event of falling into default itself. 

Anyhow, the point of all this is to show how the ECB is bereft of any form of control over its clearing members in comparison to what the ICU Governing Board would have exercised over its own members had it been established as per Keynes's plan. This may be one of the problems in forming a currency union. In order to motivate the political will necessary for the creation of any sort of international clearing union, prospective members can only be enticed to join by proposing systems with weak central control over member nation finances. But in order for a currency union to work, strong and systematic rules must be set in place prior to the system's debut. Thus the more robust ICUs of the world are destined to never get off the ground, whereas shaky propositions that should never get off the ground (like the ECB) do get off the ground.

The natural rate of interest and the own-rate argument

The Austrian vs Keynesian end of the blogosphere often battle over the existence of a natural rate of interest. The Keynesian side typically points to Piero Sraffa's argument that there are many natural rates of interest, or own-rates, and therefore an Austrian sort of monolithic natural rate of interest simply doesn't exist.

Over the last few weeks I've participated in the comments here at Jonathan Finegold Catalan's blog and here at Daniel Kuehn's blog. Here is an older comment in this vein on "Lord Keynes" blog. Bob Murphy also has a paper (pdf) on this subject and has commented on the above blogs on this subject.

Normal backwardation in crude oil markets

James Hamilton at Econbrowser had an interesting series of posts (here and here) on determining the effect of naive commodity index funds in crude oil and other commodity markets. His hypothesis was that:

the more futures contracts the funds want to hold, the more risk the counterparties who short the contract are exposed to. According to the model, the futures price must be bid high enough to compensate the short side for absorbing the risk. This compensation comes in the form of an expected profit to the short side of the futures contract. 

I pointed out in the comments that this sounded very familiar to me:

...isn't this an attempt to prove a version of Keynes's theory of normal backwardation? Here is Keynes: "If supply and demand are balanced, the spot price must exceed the forward price by the amount which the producer is ready to sacrifice in order to hedge himself, ie. to avoid the risk of price fluctuations during his productions period."

Keynes wrote that speculators would require a premium if they were to bear the risk of price movements. In a way, it seems you are substituting Keynes's hedgers with a more modern sort of naive indexer from whom speculators demand an extra return.

Unfortunately Hamilton did not find the data to back up his hypothesis. Too bad, it is a very elegant theory.

Sraffa, Hayek, natural interest rate, and own-rates of return

I commented on the blog Social Democracy for the 21st Century: A Post Keynesian Perspective in a post called Hayek’s Natural Rate on Capital Goods, Sraffa and ABCT.

Specifically, the issues in the above blog post are continued in one of my favorite David Glasner posts,  Sraffa v. Hayek.

I requote Glasner: "the rate of return from holding all assets net of their storage costs and their current service flows must be equal in equilibrium. If not, you’re not in equilibrium. So all you have to do is find an asset with no storage cost and no current service flow and calculate its expected rate of appreciation and you have the real natural rate of interest."