Extreme times sometimes lead to extremely unusual sights. At the moment, nominal interest rates in Denmark are negative. The zero lower bound on interest rates has been smashed: the return to holding cash is higher than the return to depositing it in a bank or investing it in government debt (with anything less than a five year maturity). Wow. Before asking how we can even get negative rates, how did the economy get here?
Fearing some combination of the breakup of the Euro area, a European banking crisis, and a Europe-wide fiscal crisis, European investors are getting out of risky Euro-denominated assets, such as deposits in European banks or short-term European government debt, and into safer claims denominated in safer currencies, like claims on banks and governments that are denominated in Swiss Francs or Danish Krone. Thus, capital is flowing into Switzerland and Denmark and pushing interest rates down in these countries.
Following the increase in demand for these currencies, the Swiss Franc has appreciated significantly against the Euro, but the Danish Krone is pegged to the Euro. For Switzerland, the appreciation hurts exports and increases imports. For Denmark, there is little immediate effect on exports and imports, but the pressure for the currency to appreciate is the same. To stop the appreciation, the Danish central bank – Nationalbank — has to buy Euros and sell Krone. This is what the peg means and how the value of the Krone is maintained against the Euro. As it turns out, the central bank doesn’t actually sell Krone. Instead, the central bank buys Euros from banks and pays for them by crediting their Krone accounts with the central bank, account balances which are called “reserves.” Reserves are a lot like commercial bank’s bank accounts with the central bank. These reserves can be withdrawn from the central bank as Krone, and some are as the bank’s customers make withdraws to buy safe assets like Danish government debt and the bank withdraws from the central bank to meet the withdrawals. One upshot of all this is that the Danish central bank has roughly doubled its foreign reserve account balances and is becoming a long-short currency fund: long Euros and short Krone deposits (and Krone themselves – cash in circulation is a central bank liability). But that is almost an aside, the interesting point is that the demand for Krone-denominated Danish assets has driven interest rates on short term government debt negative. And Nationalbank has now reduced the interest rate it pays on reserves to negative 0.2 percent! Yes, it is more expensive to hold reserves with the central bank than to hold cash in the vault.
And this is how we actually get negative nominal rates: the convenience and safety of deposits or short-term government debt relative to cash. Holding a large amount of cash is inconvenient and risky. As an individual, it is much easier to buy a house with a check than with cash (imagine how you would feel walking with the suitcase of money from the bank to the closing agent). As a business, it is much easier to meet payroll with deposits than cash. And even as a bank, vaults are only so big and so safe. So short term nominal rates in Denmark are solidly in the negative range. The Zero Lower Bound is broken. Expect an increase in vault construction and possibly an increase in bank robberies. And a reconsideration of the Zero Lower Bound as an economic law.
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Here and here are links to two very interesting readings about bank runs occurring in Greece and Spain. Why is the bank “jog” happening? In a couple of sentences, concerns about the safety of deposits. If you have deposits in a Greek/Spanish bank and the bank goes under, will you get your money back? What about if the country leaves the Euro — will you be paid in Euros or in the new, less valuable currency? Given the fears that either might happen, depositors are taking their Euros out of these countries to the banks of other countries.
What I think this bank jog is forcing, is a quiet but massive increase in the financial commitments of the ECB (Germany) to Spain and Greece. The ECB is being forced to either lend to these banks or let them collapse; if they collapse, then Germany must decide to either lend to these countries or let them collapse/leave the Euro. The loans are supposedly collateralized. But the sheer size of the bank jog and the problems in these counties suggests that the collateral probably contains lots of bad collateral, like debt of sovereigns of questionable solvency and packaged highly-rated debt that should never have been highly rates. That is, while we can call the current support loans, I suspect that many of them will be transfers (big transfers) in the case that these countries/banks do not grow and solve their fiscal imbalances. How does it end? It has to end when the banks run out of collateral that even the ECB in its most desperate hour cannot in good conscience lend against, and the banks start to collapse. But it may end sooner, when some politicians have the good sense to finally pull the plug and default and devalue.
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The details of the write-down of Greek debt are set, or at least set conditionally, it will be very interesting to watch how the markets respond. On the details, this figure sets out the timeline and how market/debt-holder participation influences the process.
After all this time and European money, a flat out default is still quite possible. And it is also interesting to note that the structure has not solved the free-rider problem or the CDS problem. Some debt holders may not accept the terms of the restructuring in the hope that others will be restructured and they will be paid in full. This problem may bring the whole structure crashing down. Some investors may have debt which is written down by more than appropriate for its term (e.g. long-term debt holders taking very severe write-downs or short term debt holders taking even modest write-downs). The CDS problem is that insurance creates moral hazard. The decision-maker for any given debt instrument may not have an interest in maximizing the payoff of the debt and may instead prefer full default or a differently structured write-down (or even be over-insured and benefit from a complete default).
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Posted in Euro Debt Crisis on January 12, 2012|
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Here is a nice short piece by Martin Feldstein explaining the error in the argument made by some French politicians – including the head of the French central bank — that UK sovereign debt should be downgraded before French sovereign debt. In short, it seems they do not understand what it means to be in a monetary union. The piece could emphasize more that while France is at a greater danger of default, inflation is also a pernicious destroyer of investor returns on debt, just not one covered by bond ratings.
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Tom Sargent’s Nobel lecture is one of the most interesting and topical ever. As he says “between 1780 and 1884 . . . the United States faced institutional choices and policy choices that remind me today of present day Europe.” In it he considers the question: should a government default on its debt? Should a central government bail out subordinate states? Should a monetary union precede a fiscal union or vice versa? In short, the U.S. began without centralized fiscal power, much as Europe today. The U.S. Federal Government faced a fiscal crisis in the 1780’s which lead to increased fiscal authority for the Federal government (the Articles of the Confederation were replaced by the Constitution), which in turn was followed by Federal bailouts of state government debts in the 1790’s. Fascinating stuff. The lecture is here, starting at about the 17 minute mark (very nice introduction by my former colleague (and very smart and nice person) Per Krusell starting at about the 10 minute mark). Not sure why the Nobel folks can’t figure out how to edit out the first ten minutes of people filling the lecture hall.
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Fiscal crisis and financial crises are intimately linked. Fiscal crises damage financial sectors by destroying the wealth of financial institutions which are holding government debt. This in turn means that the financial sector cannot perform the central role of allocating capital to its most efficient uses, leading to large declines in productivity, output, employment and all other good economic indicators great and small. In the other direction, financial crises usually end up as fiscal crisis because governments back up their economies through explicit guarantees like despoitor insurance or implicit guarantees that stem from the unwillingness to let the economy suffer as it would from a complete collapse of the financial sector (the Great Depression was a collapse of roughly half the US financial sector). As Reinhart and Rogoff show, the typical financial crisis is associated with a whopping 86 percent increase in government debt. This dual causality — fiscal to financial and financial to fiscal — can lead to a deadly spiral.
Thus, the big fear in Europe — that is causing so much hot air (talk of leadership, determination, coordination, etc.) — is that the fiscal crisis of the few becomes the financial crises and then fiscal crises of the many. And Germany is struggling with the question of whether it is better to co-sign Italy’s borrowing and take the hit to its national debt now, or to let the fiscal crisis become a European banking crisis and take the hit to its national debt when it bails out its financial sector. That is the choice. And it looks like the financial crisis is coming, according to this FT article.
Not to be rude, but if you don’t like my description of the central issues in the Euro crisis, you may enjoy the amusing “Absolute Moron’s Guide to the Euro Debt Crisis” instead.
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