The Perils of Sterilization: Calvo (1991) Was Right
|Sep 16th, 2012 | Filed under: Emerging markets, Today's Post | By: cfaille||
The word sterilization is much in the news from Europe. Leaving aside the clean hands required of a surgeon and other analogs: what does this word mean in finance?
Sterilization in the classic sense comes about when a policy change creates capital inflows, and the accumulation of reserves worries the authorities of that country (or zone) or of its central bank. They fret in particular that this accumulation will be taken by markets as a signal of weakness on inflation by the private sector. In this situation, they sell securities, thus “sterilizing” that dangerous capital inflow.
As Guillermo Calvo noted in a classic 1991 paper for the IMF, aptly titled “The Perils of Sterilization,” one of the problems with this approach is simply that the larger amount of government debt itself induces higher inflationary expectations “because sticking to a stable price level … would make servicing the public debt excessively costly from a social and political point of view.” It is rather as if the hot water and soap the surgeons use to ensure the sterility of their hands were itself a potential cause of infection.
Calvo cited the failure of the July 1989 stabilization program in the Republic of Argentina as an example of these dynamics, and he refers to Roque B. Fernandez,“What Have Populists Learned from Hyperinflation?,” another IMF paper on the Argentine experience.
Fernandez’ Table 1, from the Carta Economica, shows the extent of the hyperinflation, and how it undercut the wages of working Argentineans in the period 1987-89 especially.
What about Europe?
The situation in Europe is somewhat different from the one that Fernandez and Calvo discussed. Here it isn’t so much an inflow of cash that has to be countered as a straightforward creation thereof! Early this month the European Central Bank under Mario Draghi announced a plan it called Outright Monetary Transactions (OMT) whereby the ECB will purchase unlimited amounts of the debt of the distressed Eurozone countries. That certainly suggested the creation “outright” of unlimited supplies of euros, almost by definition an inflationary policy.
A country must ask to use the bail-out fund and agree to conditions, that is, to austerity. “The involvement of the IMF shall … be sought for the design of the country-specific conditionality and the monitoring of such a program.” If it does, the ECB will start buying its bonds on the secondary markets — bonds with one to three years of remaining maturity, as short-term interest rates are thought to be the key — until the interest rate has fallen to a reasonable level or until the country fails in terms of the conditions.
Draghi also announced though that the purchases will be “fully sterilized” — the ECB will sell notes, or take deposits, as quickly as it creates this new money.
The results of the program, then, if it works entirely as advertised, will be the use of the money taken in deposit or via the sale of the notes by the ECB to subsidize those sovereign bonds. But why would the markets not make the calculation that Calvo attributed to them more than 20 years ago? Why should the markets not calculate that the issuance of these new notes by the ECB, or the creation of new obligations on that institution in any form, will itself create inflationary pressures down the line, because otherwise the servicing that that debt, those obligations, will require will prove “excessively costly from a social and political point of view”?
Sterilization Under SMP
A related point: the history of sterilization under the precursor to OMT, the SMP, isn’t very reassuring. Last November, the ECB proved unable to sterilize the new cash it was creating under SMP.
Source: International Financing Review
The weekly deposit auction last year made increasing demands on the private banking system of Europe in its continuing effort to mop up liquidity. But it seemed to hit a ceiling around €250bn as the year came to an end. Thus: even assuming that the hot water in question will clean the surgeon’s hands properly, there may not be enough of it on tap.
What is the bottom line? Armageddon has been pushed off until, at the least, after the U.S. decides on its next president and does something about its fiscal cliff.
Still, the fix is not more long-term than that, and the possibility of an event in Europe that will work like a re-run of the September 2008 bankruptcy filing of Lehman Brothers continues to hang over world markets.
I should say, though, that Dr. Calvo, now at Columbia, has kindly replied to my emailed question about the applicability of his 1991 paper to the present circumstances. He believes “the situation is different” in Europe from what it was in the emerging markets he was discussing there, where “the central bank was part of the problem.” Calvo’s own view of our present discontents is itself a fascinating subject and deserves separate treatment.
I’m afraid, in the meantime, that Calvo’s present views don’t speak so persuasively to me of the present difficulties as does that 1991 essay.
Christopher Faille is a Jamesian pragmatist. William James has taught him, for example, that "you can say of a line that it runs east, or you can say that it runs west, and the line per se accepts both descriptions without rebelling at the inconsistency."