Rescheduling of promissory notes is monetary financing in all but name
Everybody seemed to be talking about monetary financing of debt last week – the ultimate taboo in monetary policy. And hidden behind a veil of unbelievable complexity, the eurozone may have done just that.
Various European central bankers rushed to proclaim that the agreed rescheduling of Ireland’s so-called promissory notes would not set a precedent for sovereign debt laundering. In legal terms, the agreement is probably watertight. It may be a borderline issue, but who cares? In economic terms, the situation is much clearer. This is monetary financing in all but name – and a jolly good thing it is too.
Let us start with an extremely abridged version of this complex saga – reduced to three stages.
First, when Anglo Irish Bank and Irish Nationwide Building Society got into financial difficulties a few years back, the Irish central bank provided their joint successor, Irish Bank Resolution Corporation, with emergency lending assistance (ELA). Think of ELA as a lender of last resort facility, but at national level. ELA comes in the form of a fortnightly revolving loan from the Irish central bank with a penalty interest rate. It constitutes money creation outside the eurozone system, which is why the European Central Bank watches this closely.
Second, when the Irish government started to restructure banking assets, it needed to provide the Anglo-Nationwide successor with assets that it could pledge as collateral for the ELA. This came in the form of a promissory note, a debt instrument with a complicated front-loaded repayment schedule.
For the third stage, let’s look at last week. The Irish parliament voted to liquidate the successor bank and with the acquiescence of the ECB, restructured the promissory note into a series of long-term bonds with maturities of between 25 and 40 years. The interest rates will be lower, but this is not the real issue, as the Irish economist Karl Whelan* explained in what must be the best paper ever written on ELA and promissory notes.
The real difference is that the debt repayment is now no longer front-loaded. Without rescheduling, the Irish economy would have fallen into a debt trap with an uncertain outcome. Ireland’s debt sustainability is secure – for now. And as Ireland’s finance minister Michael Noonan helpfully reminded us, with such a long-term bond, inflation will take care of most of the debt.
Mr Whelan calculated last year that a 40-year bond would bring a reduction in the net present value of the Ireland’s obligations by some 43 per cent. The result of the new deal is probably a bit less, since the average maturity is only 34 years. Ireland will have to be in a fairly healthy position before it can start repaying the money. A future Irish government may choose not to repay the loan, or only parts of it, or demand a further extension. My best guess is that one of these things will happen, which means that the reduction in net present value will approach 100 per cent.
This is monetary financing for all intents and purposes. The whole structure of this agreement is so convoluted that newspapers do not report all the relevant details. As always, convolution has a purpose. It renders legal what would otherwise not be, and it allows for obfuscation.
In this case, the purpose of obfuscation would be to hide what would otherwise be a contradictory message. You cannot admit publicly in the creditor countries that monetary financing is taking place – this is sacrilege. But then this is what it takes to save Ireland from a debt trap. It was then considered the best strategy to put back the debt repayment by a generation or two.
I am marginally encouraged by this, not so much because I believe that monetising is a good thing in principle, which I do not. What encourages me is that I can see this as one of several components of an ultimate solution of the eurozone crisis. Without some form of arbitrage between debtors and creditors, this would be hard to achieve.
In an ideal world, there would be a political deal on bank resolution and deposit insurance, a eurozone bond, and on economic adjustment. Back on earth, the ECB is all we have.
When Mario Draghi, president of the ECB, gave his now famous “whatever it takes” lender-of-last-resort pledge last year, I wrote that this would slow down the political process. Last week, the ECB went even further by acquiescing to a hidden form of monetary financing. The ECB will probably not compromise over inflation soon. But then again, I cannot really see the ECB resisting the ongoing changes that are currently taking place in global central banking either.
This is all better than nothing, but I have two concerns. Can central bank policies, however aggressive, be sufficient to resolve the debtor/credit arbitrage? And will the public in the creditor countries accept this in the long? For this work, to the answer would have to be yes to both questions. On this, I am not so sure.
*Briefing Paper on the IBRC, ELA and Promissory Notes, 2012, http://www.karlwhelan.com