It's Wednesday and I have comments on a few items today. I haven't been able…
CNBC’s Head of News, one Patrick Allen produced this article (May 10, 2012) – European Central Bank Leveraged Like Lehman – which several readers E-mailed to me suggesting that there was a problem that had to be addressed and would prevent the ECB funding member state deficit increases in pursuit of growth. The only problem I am afraid to say is the “author” doesn’t know much about the subject that he is writing about. This, sadly, in a general problem out there in commentary land. The article was in fact reporting the views of one Satyajit Das who gets a lot of airtime on national radio in Australia and elsewhere but perpetuates many of the mainstream myths about the way the monetary system operates and its limits and propensities. Das mixes factual statements (which I agree with) with causalities and reasoning (which I do not agree with). The journalists then build their stories based on an uncritical precising of so-called experts like Das and the myths then spread. Let us be absolutely clear. There is no meaningful comparison between the ECB and Lehman or any central bank and any private bank. Further, the ECB cannot go broke.
The CNBC article quotes extensively from Das article from April 20, 2012 – Europe’s debt crisis is back – in fact, it never left> – where Das informed the Australian readership that:
Economist Walter Bagehot advised that in a crisis, central banks should lend freely but at a penalty rate and secured by good collateral.
The ECB does not appear to have quite understood Bagehot’s commandment. The rate is below market rates, amounting to a subsidy to banks. The ECB and eurozone central banks have loosened standards, agreeing to lend against all matter of collateral.
In effect, the ECB is now functioning as a financial institution, assuming significant credit and interest rate risks on its loans.
If the European Financial Stability Fund (EFSF) was a Collateralised Debt Obligation, the ECB increasingly resembles a highly leveraged bank.
Of-course, Walter Bagehot was an early editor of The Economist Magazine which had been started by this father-in-law. He wrote the now-famous book – Lombard Street in 1873, which explored banking and finance in an international setting.
Serious students of monetary economics would not cite Bagehot in the context of the lender of last resort role of the central bank as Das has done. Bagehot derived the advice from an earlier writing of Henry Thornton (The Paper Credit of Great Britain), which is the essential starting point for these types of discussions.
In Lombard Street, Bagehot essentially argued for increasing the “reserve” held at the Bank of England. He was a conservative and was writing during the period when the central bank was constrained by the 1844 Peel Act (the so-called Bank Act), whih held that the Bank could only issue new bank notes by holding physical stocks of gold against the issue.
At the time, the the so-called Bank of England note was the dominant instrument of credit in private transactions. The Bank Act acted like a straitjacket on commerce because there was limits on the amount of credit that could be extended at any point in time.
The Peel act did not limit “cheques” though and progressively, the “joint stock banks” grew and the modern credit-creation role of banks (on receipt of security) developed.
Further, in Lombard Street, Bagehot was, in fact, analysing the collapse of one bank in Lombard Street, London (which caused a panic in 1866). What Bagehot advised was that the central bank in reducing panic should not make advances by which the “the Bank will ultimately lose” but he also noted (quoting from Chapter 7):
The amount of bad business in commercial countries is an infinitesimally small fraction of the whole business …
The same could not be said in the banking sector of the Eurozone at present. The crisis is not an isolated case of one or two bad banks, but a whole sector poisoned by deregulation and greed.
The CNBC article building on Das’s arguments wrote that:
The European Central Bank is indebted to the hilt and is beginning to look like one of the banks it has done so much to save … Having subsidized the European banking industry with its 1 trillion euro ($1.29 trillion) long-term refinancing operation (LTRO), funds that were distributed at well below market prices, the central bank is leveraged to levels Bear Stearns and Lehman Brothers might have felt comfortable with in early 2007.
This is like comparing a household to a treasury (given that the central bank is part of the consolidated government sector). Please read my blog – The consolidated government – treasury and central bank – for more discussion on this point.
Quoting an array of leverage ratios and other ratios which are applicable to non-government institutions and households (the users of the currency) is a waste of time when considering the central bank which issues the currency.
No meaningful analogies can be drawn and it is surprising that these so-called experts do not understand that.
The CBNC article though persists, quoting Das (as above) in relation to the ECB:
It is supported by it own capital (scheduled to increase to 10 billion euros) and the capital of euro zone central banks (80 billion euros). This equates to a leverage of around 38 times …
To which someone who really understands all this says – “So what?”.
A private bank needs capital – clearly because there are prudential regulations requiring that – but because it can become insolvent. It has not currency-issuing capacity in its own right.
While the ECB has an elaborate formula for determining how capital is from the national member banks (for example, see Annual Report 2011) – at an intrinsic level, it has no need for capital. It could operate forever with a balance sheet that if held by a private bank would signal insolvency.
The point is that there are no comparable concepts for a currency issuer and a currency user in terms of solvency. The latter is always at risk of insolvency the former never.
I have previously considered the leaked (confidential report) from the Institute of International Finance – Implications of a Disorderly Greek Default and Euro Exit.
That Report claims that most profound issue relating to the Greek bailouts is the “increased involvement of the ECB in supporting the euro area financial system” which “would lead to significant losses and strains on the ECB itself” and the Greek government defaulted in a disorderly fashion:
When combined with the strong likelihood that a disorderly Greek default would lead to the hurried exhort of Greece from the Euro Area, this financial shock to the ECB could raise significant stability issues about the monetary union.
Given the political developments in Greece at present the instability relating to the “bailouts” is increasing. If the new elections give the Syriza the largest number of seats, which a Poll yesterday predicted, then the small little economy of Greece has renewed weight in Euro-politics, as long as the leaders of the party and the coalition it might be able to string together do not get seduced by the fine food and drink provided at the next EC Summit and strike a deal with the Germans etc.
But talk of a “financial shock to the ECB” is cheap, meaingless talk. It doesn’t mean a thing.
The ECB is the currency-issuer of the Euro. It can never run out of Euros.
Willem Buiter noted in his 2008 Discussion Paper – Can Central Banks Go Broke? – that in “the usual nation state setting” there is a unique “national fiscal authority” (treasury) which “stands behind a single national central bank”. He concludes in this situation that:
There can be no doubt … the fiscal authorities are, from a technical, administrative and economic management point of view, capable of extracting and transferring to the central bank the resources required to ensure capital adequacy of the central bank should the central bank suffer a severe depletion of capital in the performance of its lender of last resort and market maker of last resort functions.
So can a central bank go broke? Answer: Yes.
Willem Buiter provides the qualification that is essential:
… the central bank can always bail out any entity – including itself – through the issuance of base money – if the entity’s liabilities are denominated in domestic current and nominally denominated (that is, not index-linked). If the liabilities of the entity in question are foreign-currency-denominated or index-linked, a bail-out by the central bank may not be possible.
Which is the standard Modern Monetary Theory (MMT) definition of a risk-free sovereign government – one that only issues liabilities in its own currency. If the consolidated government sector – the central bank and the treasury – issue liabilities (for example, take on debt) – that is denominated in a foreign currency, then insolvency becomes a possibility.
What about the Eurozone, where there is no fiscal authority? In the Eurozone, the pecking order is that the member state treasuries are deemed to guarantee their own national central banks which “own” the ECB and which provide lender of last resort facilities to their own banking systems. There is no fiscal authority backing the ECB but despite all the legal niceties (complexities) involved in how the national central banks might carry out their lender of last resort duties, the reality is that the ECB is the ultimate lender of last resort in the EMU.
The other point to note (which is made by Buiter) is that it :
… is not necessarily the case that a central bank goes bankrupt even if its equity capital is completely depleted by its engagement in unorthodox monetary policies. The reason is that there are differences between central banks and commercial banks and a static visual inspection of the central bank balance sheet does not convey a complete picture.
Why is that?
Consider the US Federal Reserve which could easily buy all the outstanding US federal government if it wanted to and if the Federal Reserve lost capital it could simply issue new currency to replenish it.
The same logic goes for the ECB – it alone creates the Euro currency. It can never go bankrupt.
While the mainstream economists would consider this to be dangerously inflationary if the central bank acted in this way the point is that at least that observation (erroneous or not) takes the debate beyond the inane level of insolvency.
I also think the evidence is pretty much in that there are no inflationary pressures emerging – some four years into the crisis and after a period of massive balance sheet building by the central banks.
So the argument that the the argument that the ECB is exposing itself to credit risk (buying up dodgy assets) and could go broke is erroneous.
Please read my blogs – The US Federal Reserve is on the brink of insolvency (not!) and Better off studying the mating habits of frogs – for more discussion on this point.
So why do these characters still rattle on about central bank insolvency?
I think that the claims are really being driven by those who their paranoia about so-called “central bank independence”. Please read my blog – Central bank independence – another faux agenda – for more discussion on this point.
The neo-liberals claim that the ECB has breached its charter of independence. They continually quote the June 15, 1998 comment from the then ECB President Wim Duisenberg, which was made during an interview published by Der Spiegel in the article – Der Euro wird Weltwährung:
Es gibt keine Zentralbank der Welt, die von der Politik so unabhängig ist wie die Europäische Zentralbank
That is – “There is no central bank in the world that is as independent from politics as the European Central Bank”. Not only was the construct of the ECB political – its austerity focus etc – but the appointments to the Board from inception were dominated by Euro politics.
But the critics of the ECB appeal to the Statute of the European System of Central Banks (ESCB) and of the European Central Bank (for example, Article 7 says that:
When exercising the powers and carrying out the tasks and duties conferred upon them by the Treaties and this Statute, neither the ECB, nor a national central bank, nor any member of their decision-making bodies shall seek or take instructions from Union institutions, bodies, offices or agencies, from any government of a member state or from any other body.
The critics then list the number of developments where the ECB has compromised its independence.
For example, they say that the ECB’s Securities Markets Program (SMP) – established on May 14, 2010 which involves the ECB buying bonds from governments which the bond markets will not lend to at reasonable rates – but the purchasing is via the secondary market from banks who took the primary issue, violates the no-bailout clause in the ECB Statutes.
They point to Article 21.1, Protocol (No 4) of the Statute of the European System of Central Banks and of the European Central Bank, which says:
… overdrafts or any other type of credit facility with the ECB or with the national central banks in favour of Union institutions, bodies, offices or agencies, central governments, regional, local or other public authorities, other bodies governed by public law, or public undertakings of Member States shall be prohibited, as shall the purchase directly from them by the ECB or national central banks of debt instruments.
The conclusion is that the SMP is a violation of the “intent” of the rules. I agree. But at least the ECB has had the sense to realise that without the SMP Greece and probably other member states would be totally insolvent by now (the appalling 70 per cent Greek haircut notwithstanding).
The SMP is ensuring that yields on precarious public debt issues are being kept down. The participants in the primary issuing market know that the ECB will operate rather vigorously in the secondary market when required.
Please read my blog – S&P ≠ ECB – the downgrades are largely irrelevant to the problem – for more discussion on this point.
The point is that the “rules” which established the EMU (and the role of the ECB) were ideological and based on the spin of the day that the business cycle was dead and that no recession could be bad enough to upset the financial system and cause governments to grossly violate the Stability and Growth Pact fiscal rules.
Please read my blog – The Great Moderation myth – for more discussion on this point.
I won’t go on to discuss the LTRO. But the same arguments are presented.
The problem is that elements in the ECB appear to buy into the myths and recently they have been making subscription calls to the national member states to add capital to prevent an inflationary outbreak which they claim would follow a “printed money” solution to their capital losses.
The dominance of inapplicable concepts, reasoning and understandings blocks any meaningful progress being made in the crisis at present.
These erroneous narratives lead to policy developments which have continued to make the crisis worse.
The Saturday Quiz will be back sometime tomorrow.
That is enough for today!