Financial Repression

I have been advocating that the ECB should be buying peripheral government bonds for quite some time (see Monetary easing in the wrong places or will the real ECB please stand up? dated 17 November 2010), however, that does not seem to be forthcoming. I have co-authored a research piece which proposes a different solution. It is based on the following:

1. There are no good solutions left

2. We are in the midst of a devastating debt-deflation spiral. While such a downward spiral starts with an insolvent borrower (in our case Greece) it also affects solvent borrowers and via the negative feedback loop (higher yields = higher deficit/lower growth = lower solvability = lower rating =higher yields) it ultimately destroys even the healthiest borrower (for every frequent borrower, there is a level of yield which it can not afford for a prolonged period of time).

3. What directly follows from the above is that we are in a state of multiple equilibria. One equilibria is the one where we are headed to now which will destroy all the sovereign borrowers of the Eurozone/the Euro. Another equilibria is if government bond yields can be lowered enough to restore fiscal solvability (via lower yields) and improve Eurozone bank balance sheets (via higher prices for government bonds).

4. Hence we need to find a very large buyer for Eurozone government bonds. If the ECB does not want to buy and the EFSF is not large enough (and remember as the EFSF has no banking licence, hence it needs to issue bonds itself to get cash before it can buy government bonds in the secondary market), then our solution is to use financial repression. More specifically, we would force banks to substantially increase their liquidity buffers over the next four years with only Eurozone public sector exposure allowed in this liquidity buffer. 

If complemented by a stability union, the prevention of further voluntary/forced haircuts on government bonds as well as the exclusion of Eurozone government bonds from further stress tests by the EBA then we are convinced that this will be able to break the debt-deflation spiral.

The publication can be found here:
English: Enhanced Liquidity Buffer Framework
Deutsch: Rahmenvereinbarung über erhöhte Liquiditätspuffer