Paul De Grauwe is a member of the INET Council on the Euro Zone Crisis and a professor at the London School of Economics. In this article prepared for INET, he discusses thoughts that he presented to the Council members on the role of a central bank as lender of last resort and how the ECB and European institutions must respond to stabilize and ward off a self-fulfilling default crisis in the sovereign debt markets of key euro zone countries.
Prof, De Grauwe raises very important questions on the institutional structure of Europe and how it must be modified to fortify the euro zone. He focuses on the business model and social role of the ECB. In addition he raises provocative and deeper questions about the role of central banks in society.
Embedded in his analysis are a series of profound social questions that are rarely examined: Why are central banks reluctant to buy sovereign debt in troubled countries but willing to lend to insolvent financial institutions? Why do central banks worry can about moral hazard vis-à-vis fiscal authorities and at the same extend credit freely to banks to alleviate their stress? Do central banks pick winners and losers? If so, is whom they are picking helpful to society?
We say that central banks are independent – meaning insulated from politics – but if politics is about getting people with power to give you what you want, is it right to assume that this process both begins and ends with the ballot box? While it may be helpful to allow central banks to operate outside of the pressure politics of election cycles, does this really move their decisions outside of the realm of politics? In what sense are central banks really independent? From whom are they independent? For whom in society do they deliver?
Prof. De Grauwe’s concerns on these issues would appear to be prescient. ECB President Mario Draghi, feeling the pressure of the euro zone’s downward spiral, recently said the ECB would do “whatever it takes” to preserve the euro. We will see how Draghi lives up to this promise, but in order to do so the ECB would do well to take Prof. De Grauwe’s advice on reexamining its mandate and its business model. These questions about a central bank’s role in society are very much in play in the euro zone crisis.
And while Prof. De Grauwe raises these concerns in the context of Europe, they are also important to debate in the United States and around the world. Questions surrounding the cutoff of municipal services in the U.S. - including police, firefighters, and teachers - stand alongside the Federal Reserve’s policies of supporting banks and at times making loans to family and friends of financial executives.
In China, there are frequent and controversial questions surrounding the allocation of credit and its relation to political power and crony capitalism. The role of the central bank and regulators in this process is often questioned, as it has been in Japan for many years.
At the core of this issue is how our institutions are constructed to serve society and to maintain the trust in them that is required to allow expertise to be of value. In times of crisis like we have experienced in recent years, all of these institutions are put to the test and their every action is scrutinized by an anxious society seeking a restoration of soundness, fairness, and order. Addressing and resolving these and other related questions is an important and necessary part of getting our society back on track.
Paul De Grauwe’s comments below are very helpful in facilitating this discussion in the context of the mandate of the ECB. It is a discussion well worth having.
INET Executive Director
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The ECB can save the euro – but it has to change its business model
At the latest European Summit meeting, the European Stability Mechanism (ESM), the European bailout fund, was given new responsibilities. In addition to its conditional financial assistance to member countries, the ESM was given two new tasks. The first is that it will be able to directly recapitalize troubled banks. The second is that it will be allowed to buy government bonds in secondary markets to prevent further destabilizing surges in bond rates. These are eminently important objectives.
Surely something must be done about the inexorable rise in the sovereign bond rates of a number of Southern European countries. These surges in interest rates are only partly the result of bad fundamentals. For countries like Spain and Italy a significant part of the increases in the spreads is the result of fear and panic in markets that have the potential to drive countries into bankruptcy in a self-fulfilling way (De Grauwe and Ji(2012)).
The question then is whether the ESM will be able to stabilize the government bond markets. My answer is no.
The ESM has financial resources amounting to 500 billion euros. Compare this with the total government bonds outstanding of close to 2000 billion euros in Italy and of about 800 billion euros in Spain and it is immediately evident that the ESM will be unable to stem a crisis involving even one of these two countries, let alone the two together.
In fact the reality is worse. As soon as the ESM starts intervening it will quickly destabilize the government bond markets in these two countries. Here’s why. Suppose a new movement of fear and panic, triggered for example by the deepening recession in Spain, pushes up the Spanish government bond rate again. To stem the tide the ESM starts buying Spanish bonds.
Suppose it buys 200 billion euros worth of Spanish bonds. At the end of the operation it will be clear for everybody that the ESM has seen its resources decline from 500 to 300 billion euros. Less will be left over to face new crises. Investors will start forecasting the moment when the ESM will run out of cash. They will then do what one expects from clever people: they will sell bonds now rather than later. The reason is not difficult to see. Anticipating the moment the ESM runs out of cash forcing it to stop its intervention, they expect bond prices to crash. To prevent making large losses they will have an incentive to make their bond sales now rather than wait until the losses are incurred. Thus the interventions by the ESM will trigger crises rather than avoid them.
This feature is well known from the literature on foreign-exchange crises. The classic Krugman model, for example, has the same features (Krugman(1969), see also Obstfeld(1994)). A central bank that pegs the exchange rate and has a finite stock of international reserves to defend its currency against speculative attacks faces the same problem. At some point the stock of reserves is depleted and the central bank has to stop defending the currency. Speculators do not wait for that moment to happen. They set in motion their speculative sales of the currency much before the moment of depletion, triggering a self-fulfilling crisis.
The only way to stabilize government bond markets is to involve the ECB, either indirectly by giving a banking license to the ESM so that it can draw on the resources of the ECB (see Gros and Mayer(2010)), or by direct ECB interventions. But the European leaders have been unable (unwilling) to take that necessary step to stabilize the euro zone.
The ECB is the only institution that can prevent panic in sovereign bond markets from pushing countries into a bad equilibrium, because as a money-creating institution it has an infinite capacity to buy government bonds. Its infinite resources are key to being able to stabilize bond rates. This is the only way to gain credibility in the market.
The ECB did buy government bond markets last year in the framework of its Securities Markets Programme (SMP). However it structured this program in the worst possible way. By announcing the program would be limited in size and time, the ECB mimicked the fatal problem of an institution that has limited resources. No wonder that this strategy did not work.
The only strategy that can work is one that uses the ECB’s unlimited resources as its core. Thus, the ECB should announce a cap on the spreads of the Spanish and Italian government bonds, say of 300 basis points. Such an announcement is fully credible if the ECB is committed to using all its firepower, which is infinite, to achieve this target.
If the ECB achieves this credibility it creates an interesting investment opportunity for investors. They obtain a premium on their Spanish and Italian government bond holdings while the ECB guarantees that there is a floor below which the bond prices will not fall. (The floor price is the counterpart of the interest rate cap). In addition, the 300 basis points acts as a penalty rate for the Spanish and Italian governments giving them incentives to reduce their debt levels.
But the ECB is unwilling to stabilize financial markets this way. Many arguments have been given for why the ECB should not be a lender of last resort in government bond markets. Many of them are phony (see De Grauwe(2011), Wyplosz(2011)). Some are serious like the moral hazard risk. That issue, however, should be taken care of by separate institutions aimed at controlling excessive government debts and deficits. These are in the process of being set up (European Semester, Fiscal Pact, automatic sanctions, etc.). This disciplining and sanctioning mechanism then should relieve the ECB from its fears of moral hazard (a fear it did not have when it provided 1,000 billion to banks at a low interest rate).
The deeper reason for the ECB’s reluctance to be a lender of last resort in government bond markets has to do with its business model. This is a model that says the ECB’s main concern is the defense of the quality of its balance sheet, i.e., it should avoid losses and to show positive equity, even if that leads to financial instability.
When the ECB was instituted it was deemed necessary for it to issue equity to be held by the EU-governments. Thus the idea was created that in order to sustain its activities the ECB needed to obtain capital from the member countries. This idea was reinforced in 2010 when a decision was taken by the Governing Council to raise the amount of capital by 5 billion euros. It is useful to read the justification for this decision: “Taking into account the increase of the ECB’s balance sheet total over the last years, it is considered necessary to increase the ECB’s capital by EUR 5 000 million in order to sustain the adequacy of the capital base needed to support the operations of the ECB” (ECB (2010)).
It is surprising that the ECB attaches so much importance to having sufficient equity. In fact, this insistence is based on a fundamental misunderstanding of the nature of central banking. The central bank creates its own IOUs. As a result it does not need equity at all to support its activities. Central banks can live without equity because they cannot default.
The only support a central bank needs is the political support of the sovereign that guarantees the legal tender nature of the money issued by the central bank. This political support does not need any equity stake of the sovereign. In fact it is quite ludicrous to believe that governments that can, and sometimes do, default are needed to provide capital to an institution that cannot default. Yet, this is what the ECB seems to have convinced the outside world.
All this would not be a problem were it not for the ECB’s insistence on having positive equity being in conflict with its responsibility to maintain financial stability. Worse, this insistence has become a source of financial instability. For example, in order to protect its equity, the ECB has insisted on obtaining seniority on its government bond holdings. In doing so, it has made these bonds more risky for the private holders, who have reacted by selling the bonds. This also implies that if the ECB were to take up its responsibility of lender of last resort, it will have to abandon its seniority claim on the government bonds it buys in the market.
The business model the ECB should have is one that it pursues financial stability as its primary objective (together with price stability), even if that leads to losses. There is no limit to the losses a central bank can bear, except as imposed by its commitment to maintain price stability. In the present situation the ECB is far from this limit (Buiter(2008)).
It follows that if the ECB takes up its responsibility as lender of last resort in government bond markets – and it should do this – it will also have to change its business model. It should move away from an excessive fear of making losses on its asset holdings. A central bank should be willing to take such losses if in doing so it stabilizes financial markets. In fact when it successfully stabilizes financial markets losses may not even appear.
Today, the fear of making losses paralyzes the ECB. It should set aside these fears. As Franklin Roosevelt said: “The only thing we have to fear is fear itself”.
Paul De Grauwe
London School of Economics
Buiter, W., (2008), Can Central Banks Go Broke, CEPR Policy Insight, No. 24, Centre for Economic Policy Research, London, May.
De Grauwe, P., and Ji, (2012), Self-fulfilling Crises in the Eurozone. An Empirical Test, CEPS,http://www.ceps.eu/book/self-fulfilling-crises-eurozone-empirical-test
De Grauwe, P, (2011), The ECB as a Lender of Last Resort in the Government Bond Market, CESIfo,http://www.cesifo-group.de/portal/pls/portal/docs/1/1211348.PDF
ECB, Decision of the European Central Banks of 13 December 2010 on the Increase of the European Central Bank’s Capital ,(ECB/2010/26), Official Journal of the European Union.
Gros, D., and Mayer, T., (2010), Towards a European Monetary Fund, CEPS Policy Brief,http://www.ceps.eu/book/towards-european-monetary-fund
Krugman, P., (1979), A Model of Balance-of-Payments Crises. Journal of Money, Credit and Banking, Vol. 11, No. 3. (Aug.), pp. 311-325.
Obstfeld, M. (1994), The Logic of Currency Crises,http://elsa.berkeley.edu/~obstfeld/ftp/currency_crises/cc.pdf
Wyplosz, C., (2011), They still don’t get it,