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They better keep the vacuum on or else!

While the Eurozone leaders appear to be obsessed with a relentless series of meetings which discuss largely irrelevant problems that they identify, there is a growing chorus that is highlighting the reality facing the region. It is patently obvious that the only short-term solution to the Euro crisis is for the ECB to keep its vacuum cleaner on and keep “hoovering” up the debt of governments who are unable to gain access to funds in private bond markets at reasonable yields. While the long-term solution is an orderly dismantling of the monetary union, the ECB is the only show in town at present that can in the spiralling crisis and ensure that the Eurozone countries return to growth as quickly as possible. This is even more paramount now Germany has recorded a negative quarter of growth with worse expected in the coming months. It beggars belief that the Euro elites have engineered a crisis of such a proportion that that their worst fears become the only solution.

There was an interesting article, originally in the UK Daily Telegraph, but syndicated in the Sydney Morning Herald (January 11, 2012) – No sign of euro getting off its knees – which also argued that the ECB was the only hope for the Eurozone at the moment.

This article argued the Euro leaders will once again engaged in distraction by concentrating on some irrelevant commitment to financial transactions tax.

It says that:

On the evidence of Monday’s Merkozy press conference, they still prefer imposing a Tobin tax to confronting the crisis. The dishonesty is breathtaking – if we tax the speculators in the City of London, they seem to be saying to their voters, all our problems will be over. No, there’s little help coming from this quarter.

The article noted the noted the recent German bond auction where 6 month bonds were issued with negative yields.

What this literally means is that investors are happy to lose out to inflation is they can park their funds in what they deem to be safe assets.

In terms of Euro assets, German bunds are probably as safe as anything at present.

They also noted that Eurozone governments have about “€1.6 trillion of debt to issue in the coming year” and that figure is based upon “the heroic assumption that deficit-reduction targets are met”.

With even the German economy now reporting negative growth, there is no way that the deficit-reduction targets will be met.

That is what the Euro elites don’t seem to get – budget deficits and public debt ratios are endogenous – that is, they respond in a counter-cyclical fashion and with fiscal austerity during growth these financial aggregates can only rise.

The other “funding cliff” in 2012, will be encountered by the Eurozone banking sector that requires some “€500 billion of new market funding”.

The solution? The article says:

If this is to be another year of muddling through, much of the remedial action must therefore come from the ECB. The politicians have shown themselves consistently too slow and constrained to cope with the crisis.

At that point the article seems to fall off its own cliff by suggesting that the ECB “finds itself on thin ice, too”.

Why so?

Already, it has a larger balance sheet as a proportion of GDP than either the US Federal Reserve or the Bank of England. What’s more, the composition of this balance sheet, stuffed to the gunnels with dodgy sovereign debt and, increasingly, even dodgier banking assets, is plainly much higher risk. With its gilt-buying program, the Bank of England can be virtually certain of getting its money back. The same is not true of the ECB, which already has to reconcile itself to write-downs on its holding of Greek sovereign bonds.

Even if the ECB its so-called “dodgy sovereign debt” the sun would still rise next morning. there is virtually no limits to the capacity of the ECB to expand its balance sheet in line with the need to continue supporting Eurozone governments that can no longer access private bond markets at reasonable yields.

While the private banks are clearly capital constrained, the ECB is the issuer of the euro currency and thus has no financial constraints on its operations, other than those they voluntarily imposes upon itself via regulations. Clearly it’s Securities Market Program (SMP) is allowing it to keep Eurozone governments solvent in the absence of any other alternative.

The Daily Telegraph article though, says;

All the same, it’s hard to see alternatives to yet further ECB balance sheet expansion. The bank’s president, Mario Draghi, has already promised the banking system unlimited liquidity. Might he go further and promise it to governments too?

The answer to that question is a resounding – he definitely should!

The article hypothesises that Germany will be forced to accept “wider-ranging quantitative easing”. It notes that:

Central banks like to pretend that such support is all about demand management, and really has very little to do with printing money to fund governments. Most observers, reasonably, find it hard to see the distinction.

Half the value of debt issued by the UK Debt Management Office since the start of 2009 has been hoovered up in secondary markets by the Bank of England. Even the bank admits that the effect has been to depress gilt yields by a full percentage point. It is little wonder that the euro-zone periphery looks at what is happening in Britain and the US, and asks in exasperation why the ECB cannot do the same for Europe.

So the ECB should get out its vacuum cleaner and turn up the speed while at the same time urging member states to expand net public spending in the cause of stimulating economic growth in their economies.

The Daily Telegraph article is in no doubt that it will be “inevitable that the ECB will eventually give in”.

While Modern Monetary Theory (MMT) economists have been urging the ECB to use its currency monopoly to provide support to ailing Euro zone economies, it seems that the message is now being delivered by even the most unlikely candidates.

Even the corrupt ratings agencies are now willing the ECB to:

… ramp up its buying of troubled euro zone debt to support Italy and prevent a “cataclysmic” collapse of the euro

Apparently, Fitch ratings have been on a European road show suggesting that “a collapse of the Euro would be disastrous the global economy”.


… urged the European Central Bank to abandon its current reluctance to scaling up its purchases of troubled euro zone debt … and drop its resistance to the bloc’s bailout fund, the EFSF, borrowing directly from it.

They could have been more emphatic when they said the euro could not be saved ” without more active engagement from the ECB”.

Interestingly, they also said that the ECB “had plenty of scope to expand its balance sheet without unleashing a wave of inflation across the Eurozone.”

Their advice for the ECB?:

Why not have the ECB come out and say ‘We are going to cap interest rates’, say ‘We are not going to allow interest rates to exceed 7 per cent’ or whatever level they see is the limit?.. Why not turn the EFSF into a bank so it can borrow from the ECB so it doesn’t have to go to the market?

The Economist Magazine (January 9, 2012) ran an article – Merkozy rides again – which is humorously in the series “Saving the euro, part 473”.

It is similarly saving of the leadership vacuum in the Eurozone at present. It said:

ANGELA MERKEL and Nicolas Sarkozy kicked off the 2012 season of the euro soap opera with a summit meeting in Berlin today. Neither said anything startling; certainly nothing that would betoken a swift and happy conclusion to the long-running saga.

The German chancellor promised some growth measures that we shouldn’t hold every waiting for them. The Economist article said the German leader:

… spoke of spreading best practice in labour-market regulation across the euro zone (which is German practice, Mr Sarkozy admits) …

I discussed some of these issues in yesterday’s blog – Labour market deregulation will not reduce unemployment.

In an earlier blog – Doomed from the start – I discussed the aggressive implementation in Germany of their so-called “Hartz package of welfare reforms”.

A few years ago we did a detailed study of the so-called Hartz reforms in the German labour market. One publicly available Working Paper is available describing some of that research.

The Hartz reforms were the exemplar of the neo-liberal approach to labour market deregulation. They were an integral part of the German government’s “Agenda 2010?. They are a set of recommendations into the German labour market resulting from a 2002 commission, presided by and named after Peter Hartz, a key executive from German car manufacturer Volkswagen.

The recommendations were fully endorsed by the Schroeder government and introduced in four tranches: Hartz I to IV. The reforms of Hartz I to Hartz III, took place in January 2003-2004, while Hartz IV began in January 2005. The reforms represent extremely far reaching in terms of the labour market policy that had been stable for several decades.

The Hartz process was broadly inline with reforms that have been pursued in other industrialised countries, following the OECD’s Job Study in 1994, which I wrote about again yesterday.

The focus was on supply side measures and privatisation of public employment agencies to reduce unemployment. The underlying claim was that unemployment was a supply-side problem rather than a systemic failure of the economy to produce enough jobs. It was a false claim.

The reforms accelerated the casualisation of the labour market (so-called mini/midi jobs) and there was a sharp fall in regular employment after the introduction of the Hartz reforms and the suppression of real wages growth in Germany. It was a way to ensure more real income was transferred to profits (via the growing gap between static real wages growth and rising productivity growth).

Anyway, I was reading all this ECB-urging while also considering some documents today published by the Bank of Japan. There is a detailed account of the Functions and Operations of the Bank of Japan – which was published in December 2000 and with a Supplement – updated later to reflect “subsequent major changes in the Bank’s operations until the end of January 2004”.

It really is a nitty-gritty account of how the bank works and its responsibilities. It provides some great insights into how a central bank works. I should add, institutional variations notwithstanding, the description applies more generally to other central banks around the world.

In Chapter 4 – The Payment and Settlement System in Japan and the Bank of Japan’s Payment and Settlement Services – you learn about the way the central bank interacts with the commercial banks to ensure financial stability is maintained.

The BOJ note that:

Various forms of economic transactions in a monetary economy may all be understood as agreements to exchange goods or services for money. The transfer of money that completes such transactions is called settlement. Where the goods in such transactions are securities, the delivery of securities is also called settlement. Settlement is an integral part of financial institutions’ business operations, and it is also closely related to various services the Bank of Japan provides.

The BOJ accepts responsibility for the “smooth settlement of funds among financial institutions to maintain the stability of the payment and settlement system”.

There are various ways that settlement occurs but ultimately it is “BOJ account deposits, which are current account deposits financial institutions hold with the Bank of Japan” that come into play on a daily basis.

These accounts form a major part of what we call bank reserves.

The following example is given by the BOJ to help us understand what goes on every day:

When school tuition, for example, is paid by funds transfer between bank accounts, payment is made by debiting the tuition from the payer’s deposit account and crediting the school’s account. If the two parties hold accounts with different financial institutions, funds need to be transferred between the two institutions. Likewise, when a firm uses a check or a bill drawn against its deposit to purchase materials from another firm, and the two firms do not have accounts at the same financial institution, an interbank funds transfer between the two institutions is needed. For most of these interbank funds transfers, the net settlement position of each financial institution is calculated by a clearing system … by netting payments made and received by the institution, and is then settled by debiting and crediting the institutions’ current accounts at the Bank (BOJ accounts).

In Section 3 of the Document which covers stability, the BOJ outlines various monitoring tasks (in real-time and otherwise) that they engage in to “minimise systemic risk”, which would occur if a commercial bank failed to meets its payments obligations. Sub-section C then talks about “Acting as the lender of last resort”.

There we read:

At times when there is an imminent danger that systemic risk will materialize despite the efforts described above, the Bank acts as the lender of last resort,
providing funds to financial institutions in the form of lending or other means … In emergency cases where systemic risk is likely to materialize, public confidence may be lost in the deposit money issued by financial institutions; in the worst cases, the deposit money may no longer be accepted as a payment instrument. At such times, the Bank’s provision of cash and BOJ account deposits, both of which are payment instruments by which the highest settlement finality can be achieved, is an essential and effective way to ensure smooth settlement. The Bank should act as the lender of last resort only to ensure the smooth operation of the payment and settlement system and the functioning of the financial system as a whole, and not to bail out failing institutions.

So for solvent banks, the central bank will always step in and provide bank reserves when a deposit-taking institution, acting within its capital constraints cannot find funds to cover its loan book on any particular day.

The ECB also operates in this way although many financial market commentators don’t seem to represent this role very clearly.

For example, this Bloomberg article (January , 2012) – Europe Banks Hoarding Cash Resist Draghi Bid to Avoid Crunch – suggested that the ECB loans to banks recently (489 billion-euro worth) are being “hoarded” and this is:

… thwarting attempts by policy makers to avert a credit crunch in the region.

The facts are obvious, the deposit-taking institutions are using the ECB Standing Facilities (deposit facilities) to park the money they borrowed so that they can guarantee themselves low cost funding of their existing loan books which are rolling over in 2012.

Did the commentators think that these banks were constrained in their lending by a lack of reserves? Clearly, they did.

The fact is that the banks, which “account for about 80 percent of lending to the euro area” are restricting “the supply of credit” to the private sector which is – so the story goes – starving economic growth and making the Euro crisis worse.

First, the lack of growth in the Eurozone is the major problem. That should be tackled as a matter of urgency by the Euro leaders and not through vapid schemes like further labour market deregulation. Wages and conditions have to be maintained and real wages have to grow to allow workers to fund their consumption out of work rather than credit.

Second, the lack of credit growth in the Euro is not because banks have reserve constraints. There are simply not enough credit-worthy firms queuing up to borrow. The banks would lend if they thought it was safe to do so and there customers around who credit worthy. Banks lend first and worry about reserves second.

Firms are not borrowing much at present because consumers are saving and are generally pessimistic given the fact that the recession is into its fourth year now, and the outlook is for things to worsen. This is being exacerbated by the fiscal austerity that is being imposed upon the region by the troika.

It is no surprise that the Euro banks are storing the cheap funds that the ECB is making available to them in the deposit facility provided by the ECB given the uncertainty in the Eurozone, the lack of demand for credit from the private sector, and the vast loan books that have to be refinanced in the coming year.

If times were more robust, and banks were faced with an increased demand for credit from the private sector, then I would always be able to “fund”
books to ensure the payments system maintained its integrity. The ECB would never let a solvent bank runs short of funds and default on its payments obligations.

The Bloomberg article quotes an official of a major French bank as saying:

There is ‘no credit crunch’ … The reality is that credit is available.


The ECB boss appears to understand what is going on when he said, in relation to the US economy, that “Lending really picked up when the economy got better”.

Again, exactly!

Chapter 5 of the Bank of Japan document referred to above is about – – is an interesting section on lender of last resort.

Essentially, after other methods of oversaw including on-site examination and off-site monitoring are exhausted, the Bank of Japan will ensure financial stability in the commercial banking system by acting as a lender of last resort.

We read that:

As the lender of last resort, the central bank is called upon to provide liquidity when needed to prevent materialization of systemic risk … The Bank provides liquidity as the lender of last resort, (1) when the allocation of funds among financial institutions becomes unbalanced due to a disruption in the financial markets, and (2) when sound financial institutions face a temporary liquidity shortage.

In practice, the Bank acts as the lender of last resort by (1) extending loans against collateral such as bills and JGSs at the official discount rate as part of its regular business … and (2) extending uncollateralized loans, with interest rates and procedures specially set by the Policy Board, to cover an unexpected temporary shortage of funds in financial institutions due to accidental causes … or to conduct business, at the request of the FRC and the Minister of Finance … to maintain an orderly financial system …

Chapter 10 of the document – The Bank of Japan’s Japanese Government Securities Services – also is provides some interesting insights into the operations of the central bank and the way it interacts with the treasury, which extend generally, in principle to central banks everywhere (although institutional arrangements vary across countries).

There is a detailed account of the issuance of government securities, the auction process and the settlement procedures.

Of interest was the following discussion:

Article 5 of the Public Finance Law and Article 34 of the Bank of Japan Law both prohibit the Bank of Japan from underwriting JGBs and TBs or extending loans to the government, in principle. The Bank is not allowed to underwrite JGBs and TBs, based on the principle that JGBs and TBs should be issued in the market. The principle that the central bank should not provide credit to the government is drawn from valuable lessons learned from the history of Japan and other major countries. If the central bank were to provide credit to the government by, for example, underwriting JGBs and TBs, the government might lose the fiscal discipline. There would be no brakes to stop the government from making the central bank issue more currency, leading in all likelihood to spiraling inflation. This would cause a loss of confidence, both domestically and internationally, in the country’s currency and its economic policy.

Central banks of Japan and other major countries are forbidden to provide credit to their governments in an effort to avert such a chain of events. In the United States, for example, the Federal Reserve Act allows the Federal Reserve Banks to buy U.S. Treasury securities from the market, but prohibits them from underwriting them. Moreover, in the 1951 accord between the Federal Reserve Board and the Treasury, it was agreed that the Federal Reserve Banks will not purchase U.S. Treasury securities through open market operations aimed at supporting Treasury security prices. In Europe, both the Maastricht Treaty, which came into effect in 1993, and the European Central Bank Law based on the Treaty, call upon participating countries to establish similar prohibitions against credit provision to the government as one of the requirements for taking part in the European Monetary Union and the European System of Central Banks.

A proviso to Article 5 of the Public Finance Law allows the Bank of Japan to extend credit to the government, up to an amount authorized by the Diet, in exceptional cases. In practice, such cases are limited to the Bank’s underwriting of JGBs and TBs from the government to refund JGBs and TBs that the Bank purchased through market operations that have reached maturity.

So paragraphs 1 and 2 of this extended quote, are factual in one sense, but in another sense are also just a statement of the dominant ideology that imposes these artificial constraints on intra-government relations for fear of inflation.

The final paragraph really gives the game away. It is obvious that the Japanese government, that is the parliament, can gain credit directly from the Bank of Japan whenever it might want.

The last sentence is a categorical statement that outstanding Japanese government debt is risk-free because the central bank will always meet any liabilities that exist in relation to Japanese government debt.

This should never be any question raised in the financial press or otherwise about the solvency of the Japanese Government. The same applies to all sovereign governments who issue their own currency. There will always be clauses embedded in the rules and regulations that allow the Treasury to access “funding” from the central bank.


What we learn from the Bank of Japan document is that embedded in the most detailed rules and regulations that govern daily practice of the central banks is a coherent statement of currency sovereignty for the government in question.

Ultimately, the Diet (that is, the elected Japanese Parliament) can access funds from the central bank should desire to do so. The same goes for all governments, one way or another.

The lesson for the Eurozone is that as a result of the flawed design of the monetary system, the ECB is the only institution that can currently save the day. All the other mechanisms that the Euro bosses have been flaunting with including the EFSF and other smokescreens default back onto the member states, which uniformly faced default risk because they operate with a foreign currency that is issued by the ECB.

That message appears to be becoming more acceptable to a wider group of interested parties and observers. Eventually the penny will drop for the Euro bosses and the ECB will defy the austerity-biased Germans and to use the words of the Fitch commentator “ramp up” their secondary bond market purchases.

That is enough for today!

This Post Has 15 Comments

  1. “If the central bank were to provide credit to the government by, for example, underwriting JGBs and TBs, the government might lose the fiscal discipline. There would be no brakes to stop the government from making the central bank issue more currency, leading in all likelihood to spiraling inflation”

    Isn’t that the same as saying dicatatorship is better than democracy.

    Let’s reword that.

    “If the unelected technocrats were to provide credit to the elected representatives, the elected representatives might spend it on the people who elected them. Because we don’t trust the proles, there is nothing to stop their elected representatives from forcing the unelected technocrats to issue more currency, leading to the technocrat class share of the pie shrinking”.

  2. Eventually ECB can avoid its constraints to lend to member states as they could lend to some international institutions (say European Investment Bank) wich in turn have no such limits and could buy member states bonds. That could be made at low yields and with no limits, and without changing a single rule (so it could be put to work instantly).
    Obviously that’s merely a short-term trick to provide growth while fixing the whole system (or dismantling it) and at the same time maintain the facade of “followiing the rules”.

  3. Neil, in a currency union with no spending limit, each member has the ability to “tax” every other member. That’s not democracy either, it’s anarchy.

  4. @ Neil Wilson

    Brilliant! The ideology of Edward Bernays et al combined with neo liberal economics.

    If I may, I might borrow your comment 🙂

  5. @Max
    Remember the comment is based on the operations of Central Bank belonging to a sovereign country, not a currency union. In that sense I guess is Neil’s translation. Representatives are elected and always have the ability to tax the rest of population. Maybe nobody here supports the creation of a currency union… thats because sovereignity really matters.

  6. Negative rates on German bonds – does this reflect fear of European banking sector stability? If you are willing to accept negative rates at term vs. demand deposits at zero. This is really weird.

  7. @Neil Wilson

    In fact, Keynes cites the same logic in his letters when he discloses that pro-cyclical repayment of stimlus spending need NOT be paid back. Asked why he did not include this in the General Theory, he stated quite plainly that he did not trust a democratic government would act properly without this restraint imposed upon them. Keynes is only called a liberal because conservatives didn’t like his conclusions. He in fact was quite conservative in many of his views.

  8. “Lending really picked up when the economy got better”

    I’d say it’s the other way round: the economy got better when lending picked up

  9. @ Bill,
    Quoting commentators (?) “to park the money they borrowed so they can guarantee themselves low cost funding of their loan books ……….”.
    Later — you say ” It is no surprise that the Euro banks are storing the cheap funds ………….. and the vast loan books that (will) have to be re-financed in the coming year”
    You seem to be agreeing with the ‘commentators’ and contradicting your own oft stated principle that lending is not reserve constrained .
    I am a beginner and and am unable to resolve this matter of excess reserves. Help would be greatly appreciated.

  10. Dear jb (at 2012/01/13 at 7:28)

    You might enjoy reading The role of bank deposits in Modern Monetary Theory –

    Banks are not reserve constrained in their lending decisions because ultimately they know they can get the funds necessary to ensure integrity of the payments system from the central bank. But ultimately they have to get the funds from somewhere – and the central bank is usually the least preferred option.

    best wishes

  11. GLH: With the German bond tied to the Euro, why is it any safer than the Greek bond?
    I agree, at least formally, and disagree with Bill. Practically, Bunds are safer because of where the ECB is, and because the Europirates, like the gentler kind in ships, don’t want to prey on their home base. And German finances are better. But formally, ultimately, Euro notes stuffed in mattresses are clearly safer Euro assets than Bunds. An enterprising brokerage should sell such mattresses as their latest high-tech derivative.

  12. @GLH & @Some Guy
    I think markets realise that besides being its bonds as bad as spanish or greekones (in terms of being in a foreign currency), the germans are in control of the ECB, so if they are close to default, they would be willing to change rules (or simply skip them as usual) and make the ECB support their debt. So they kind of have the monopoly of issue, but spanish or greeks don’t.

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