In defense of the ECB
This phrase ‘lender of last resort’ has been bandied around by people who, it seems to me, have no idea what lender of last resort actually means, to be perfectly honest. It is very clear from its origin that lender of last resort by a central bank is intended to be lending to individual banking institutions and to institutions that are clearly regarded as solvent. And it is done against good collateral, and at a penalty rate. That’s what lender of last resort means.
That is a million miles away from the ECB buying sovereign debt of national countries, which is used and seen as a mechanism for financing the current-account deficit of those countries, which inevitably, if things go wrong, will create liabilities for the surplus countries. In other words, it would be a mechanism of transfers from the surplus to the deficit countries. That’s why the European Central Bank feels, and with total justification, that it is not the job of a central bank to do something which a government could perfectly well do itself but doesn’t particularly want to admit to doing.
I think it’s very important to recognise that there are circumstances where governments will try and put pressure on central banks to do things that they would like central banks to do in order to avoid their having to own up to the actions that they actually would like someone else to carry out. So I have every sympathy with the European Central Bank in this predicament …
The only circumstance in which looking at the data for the euro area as a whole has merit is in realising that actually the euro area does have the resources, if you were to regard it as a single country, to make appropriate transfers within itself. It doesn’t actually need transfers from the rest of the world. But the whole issue is, do they wish to make transfers within the euro area or not? That is not something that a central bank can decide for itself. It is something that only the governments of the euro area can come to a conclusion on. And that is the big challenge that they face. [emphasis added]
–Mervyn King, Governor of the Bank of England
In this post, I am going to defend Mervyn King, and by association the ECB, because what King has said here is not at all in disagreement with what I think. While this post will be long, it cannot be long enough to cover the full range of issues involved, and so I have provided links in this post to other posts that cover the key issues highlighted in the linked text that I can’t cover here.
Let’s be clear now. The ECB is the monetary agent. It is not the fiscal agent, and as such, it wants to say clear of policies that create winners and losers.
The monetary agent conducts policy principally through interest rates, but it can also credit and debit bank reserves via monetary operations, affecting the composition of bank assets and private sector portfolio preferences. It cannot add net financial assets to the private sector. That is the domain of fiscal policy conducted by elected officials through a democratic process.
The central bank is never permitted to add net financial assets to the system. It can only conduct asset swaps, changing private portfolio preferences for the types of liabilities it buys and sells. For example, the central bank can buy Italian bonds and pay for them with reserves. These are asset swaps. There is no net addition to the number of net financial assets in the system, ever.
Unlike with the central bank, a national government can always add or subtract net financial assets in the system if it so chooses. This is the essence of fiscal policy. If you pay taxes, that creates a net loss of private sector financial assets. Deficit spending, on the other hand is a net gain of financial assets in the private sector. Whenever the government taxes you, on net, it is draining net financial assets from the system. Whenever the government spends, it is adding net financial assets to the private sector, instantly creating a zero-day net financial asset.
Conclusion: central bankers always prefer to force elected officials to make the tough political choices that are the essence of fiscal policy. The fiscal agent adds and subtracts net financial assets in the private sector by deficit spending, or cutting spending and raising taxes. Central bankers want the fiscal agent to use these tools as the driver of macroeconomic policy while the monetary agent is tasked with more narrow aims.
In the US, the monetary agent, the Federal Reserve, has a dual mandate for price stability and full employment, and therefore has some political legitimacy as a quasi-fiscal agent. Even in the US, you hear Fed Chair Ben Bernanke stating very clearly that he does not want to do more and that he wants the fiscal agent to take on the principal policy burdens for maintaining full employment. The European Central bank has one mandate, price stability. And that means it is much more reluctant to step into a quasi-fiscal role.
So when Mervyn King talks about the ECB “buying sovereign debt of national countries, which is used and seen as a mechanism for financing the current-account deficit of those countries”, he is talking about a policy choice that helps the national governments achieve their fiscal aims, a quasi-fiscal role.
The ECB has balked at doing this – rightly so, I might add (in a brief role as policy advocate). Their position is that the fiscal agent is elected by a democratic process and must solely take on the responsibility of achieving macroeconomic objectives outside of price stability.
Their policy response to date:
the ECB is buying just enough bonds to send a message to the Spanish and Italians that they need to live up to their austerity quid pro quo or else the ECB will stop buying.
At a minimum, the ECB wants to prevent ‘free riders’, if they are to move into a quasi-fiscal role. That means the quid pro quo is austerity for purchases. Moreover, institutionally, there is no appetite for capital losses at the ECB and that means buying Greek bonds is something the ECB sees as fraught with peril for the ECB itself.
Ireland is seen as the model here. Nicolas Sarkozy is reported to have said: "Ireland is today a country which is out of the crisis, or on the way out of the crisis". A leaked Troika document has admitted this policy has failed in Greece.
–Greece in debtor’s prison, Oct 2011
Now, I believe austerity during the greatest global economic calamity since the 1930s is a policy solution from a failed economic paradigm which says budget deficits are always bad. This produces procyclicality and increases business cycle volatility in the best of times, but leads to the debt deflation to which we are now witness in this once in a lifetime economic climate.
So I don’t support the framework for the austerity solution. But that’s a separate issue from what the ECB can/will/should do. The right thing for the euro zone as a whole to do would be to support growth through reducing unemployment and that means fiscal transfers. But, of course, the euro zone has a hopelessly broken and unworkable institutional arrangement. that doesn’t allow these transfers to take place. See my post “The Eurozone is unworkable in its present state” from early 2010 for more background and potential solutions.
The issue at hand, however, is liquidity. As Mervyn King opined:
“lender of last resort by a central bank is intended to be lending to individual banking institutions and to institutions that are clearly regarded as solvent”
Here’s how I put it last year predicting that the ECB will eventually step in:
This approach is the easiest and therefore a very likely outcome. Let me frame what I think the issues are and how to go about it. Note, this is not an advocacy piece so I am framing what could occur more than what I would recommend.
The monetisation scenario ostensibly involves an attempt to separate liquidity from solvency issues by using the currency creator’s power to stand behind debt obligations with a potentially unlimited supply of liquidity. This is the traditional lender of last resort role that a central bank is expected to play. For example, the Fed played this role in buying up financial assets during the crisis in 2008 and 2009. Of course, it did so recklessly by buying up dodgy assets at inflated prices instead of good assets at penalty prices so as to discriminate between the illiquid and the insolvent.
The point of course is to separate liquidity and solvency. The ECB’s providing liquidity to solvent entities is not a bank handout or ‘extend and pretend’. With Belgium, France, Austria, Finland and the Netherlands all being dragged down the path to higher yields, this is a classic liquidity crisis and you have to stop the panic as the first order of business. That means providing liquidity to solvent entities and letting insolvent ones fail — and the time to act is now.
The right way to provide liquidity is at a rate that is painfully high but low enough that the solvent are not bankrupted by this. You can best achieve this via an interest rate cap. In this scenario (that I advocate), Greece would default massively and Ireland’s banks would default massively. German and French banks and other holders of those bonds would be forced to eat the losses and be recapitalised. These investors must assume the risk of their investment decisions or you have moral hazard. Italy, Ireland, Spain and Portugal then have time to prove they are solvent and for the European fiscal agents to reform the institutional structure of the euro zone to allow sustainable longer-term solutions in aiding them in this endeavour.
To sum up, I am saying the ECB is right to resist acting as a lender of last resort but wrong in trying to impose a solution that is deflationary in a global crisis of Depressionary debt deflation proportions. If I were at the ECB, I would have moved to interest rate caps, what I call rate easing, already, instead of the sterilised quantitative easing they are conducting right now. It would be cheaper politically and in terms of the ECB’s balance sheet. I would not ‘monetise’ periphery debt by engaging in quantitative easing. Credible lenders of last resort use price, not quantity signals.
My concern is that the ECB will play chicken for too long. The buyers of French or Dutch sovereign bonds are pension funds and banks with no risk appetite. They bought these as safe investments with no credit risk. Any bond manager with fiduciary responsibility who benchmarks herself against her peers will be forced to sell these sovereign credits in a down market or risk being fired. This is the essence of liquidity-induced panics. It would behove the ECB to understand this. The longer the ECB waits to act as a lender of last resort, the worse it will get. And it may get ‘worse’ enough to tip us into bank runs and Depression with a capital ‘D’.