The Eurozone’s escape-valve
The ECB has understandably refused to lend directly to governments (a practice which would, after all, be against the letter and the spirit of the 1992 Maastricht Treaty) and reluctant to purchase on a large scale any one government’s bonds in the secondary market (which is against the spirit of the Maastricht Treaty, although not the letter). Sure enough, it has since May 2010 made substantial purchases of Greek, Irish and Portuguese government bonds, and in autumn 2011 it also dabbled in Italian and Spanish government bonds. But those purchases have gone ahead only because of intense (and arguably very misguided) pressure on the ECB from politicians. Most members of the ECB Governing Council realize that they must prevent rapid, unlimited and indiscriminate expansion of the ECB’s balance sheet (i.e., with the liabilities that make up the Eurozone monetary base). Rapid expansion of the monetary base risks being associated with rapid expansion of the quantity of money (i.e., the deposit liabilities of the commercial banks) and, hence, with inflation. The ban on direct ECB lending to government is specifically intended to ensure that the ECB’s management of its own balance sheet is always conducted in a non-inflationary way.
However, the ECB is meant to be banker to the banking system. Assuming that commercial banks have maintained their solvency and have complied with regulations, one of the ECB’s principal responsibilities is to help them, so that at all times they have enough cash to fund their assets. This is a standard central bank role. In saying this, I am only repeating the message of hundreds of textbooks. I don’t care if Mervyn King has another opinion. But here we come to a difficult subject, where much depends on judgement and specifics. At present the Eurozone’s banks are experiencing severe funding stress, which is forcing them (among other things) to sell off government bonds. Those sales are then pushing up bond yields and so government’s refinancing costs, with disastrous implications for fiscal solvency. If the ECB lends to the banks on a sufficient scale and on reasonable enough terms, the banks will not be forced sellers of peripheral Eurozone sovereign bonds. Indeed, if the ECB lends to the banks on a generous scale and on easy-going terms, the banks may become quite eager buyers of peripheral Eurozone sovereign bonds. More generally, the greater the ECB’s willingness to fund commercial banks, the greater is commercial banks’ preparedness to acquire Eurozone government bonds and the weaker are the upward pressures on Eurozone government bond yields.
ECB lending to Eurozone banks is perfectly acceptable according to the letter of the Maastricht Treaty and, in some circumstances (and we are undoubtedly in these circumstances now), it does not breach the treaty’s spirit either. But we can see that there is an artful dodge at work here. If the ECB lends to commercial banks which then buy short-dated government bonds, the result may be much the same as if the ECB purchases short-dated government bonds in the secondary markets. In other words, ECB lending to commercial banks can act as the Eurozone’s safety-valve in current conditions. As it happens, the ECB has in recent weeks renewed the generous liquidity facilities (i.e., the facilities whereby banks can borrow from it for over six months, at rates not much above market rates) that were first made available in late 2007, and were so useful in 2008 and 2009 in protecting the Eurozone banking system from the worst of the challenges then facing the American and British banking systems.
These facilities were withdrawn in 2010, on the grounds that they were “non-standard” measures that had unduly expanded the monetary base and hence risked inflation over the medium term. (I criticized the decision to withdraw the facilities – which was driven by analysis from Jurgen Stark, then the ECB’s chief economist – as “inflation nuttiness” of a high order. I accept that the beneath-market cost of the ECB facilities raised valid competition concerns. Last-resort loans from the central bank to commercial banks should always have an element of penalty in them.) It was the withdrawal of the facilities that in the three months to April 2010 undermined the demand for peripheral Eurozone government debt (because the banks had to shrink their assets and dumped Greek etc. government bonds) and so led to the first phase of the Eurozone sovereign debt crisis. In May 2010 the ECB responded to the yield surge by purchases of Greek government bonds, inaugurating a new phase of the crisis.
In short, the withdrawal of the non-standard measures was an important causal influence on the surge in peripheral Eurozone government bonds yields in early 2010, and – critically for the future – the virtual re-introduction of the non-standard measures (i.e., the credit lines made available to the Eurozone’s banks) in recent weeks could prove an important causal influence on a recovery in the peripheral Eurozone government bond markets in early 2012.
The escape-valve has limited capacity
For the diminishing band of the single currency’s supporters, the discussion in the last few paragraphs may sound very encouraging. In the extreme the ECB can expand its balance sheet without limit. If the Eurozone needs a “bazooka” to resolve its troubles, here is one which appears to have tremendous range and impact. The ECB’s armoury seems to contain a Very Big Bazooka.
Well, yes and no. I criticized the withdrawal of the non-standard facilities in early 2010, because – in my view – the virtual stagnation of broad money at that time meant that Stark’s warnings of rising inflation over the medium term were wrong. Now almost everyone agrees that inflation will fall in 2012. Moreover, with many commentators fearing that the current minor Eurozone recession could evolve into a big slump, Stark’s early 2010 warnings about medium-term inflation risks have clearly been unjustified. Further, it seems to me plausible that the ECB could extend between 250b. and 500b. of extra loan facilities to the Eurozone’s banks over, say, the next six to 12 months, and that this amount of support would go a long way to defeat the sellers in the sovereign bond markets for the time being. Given the likely high profitability of bank purchases of peripheral sovereigns if the Eurozone stays in one piece, many players might join a bond market party from their own resources (i.e., without borrowing from the ECB). Note also that this gives the Eurozone’s government enough time to translate treaty changes into national legislation.
At 2nd December the ECB’s “lending to euro area credit institutions related to monetary policy” was 656b. euros. The all-time peak was in late June 2009 at 896.8b. euros. (See the chart on p. 15.) So the suggestion that the ECB might grow its loans to Eurozone banks by 250b. euros would not take us into uncharted territory. In the last four weeks the ECB has lent almost 70b. to the Eurozone’s banks, with an implied annual rate of lending of about 900b. euros. (That is, if the 70b.-for-each-four-weeks rate continued for a year, the ECB’s loans to banks would grow by 900b. euros.) It is not to be ruled out that this lending total grows to between 1,000b. and 1,200b. euros in 2012.
So why did I say “yes and no” above rather than merely “yes”? At least three arguments against continued growth of the ECB’s balance sheet at the current fantastic rate can be developed. First, Jurgen Stark’s fears of inflation in late 2009/early 2010 were pretty silly. Everything in this subject depends on magnitudes. At that time, as now, the behaviour of the quantity of money, broadly-defined, did not suggest medium-risks of rising inflation.
But Stark (and the Bundesbank orthodoxy that he represents) would be correct if the broadly-defined quantity of money were to start expanding too rapidly. I don’t deny that relentless, 50%-a-year, year-after-year expansions of the monetary base would cause inflation, to the extent that increases in the monetary base spilled over into a broad money aggregate. (And, sooner or later, such spill-overs would be inevitable.)
Secondly, the dependence of commercial banks on the central bank for a very high proportion of their funding is inherently unsatisfactory, because of the artificiality and highly political nature of the relationships at work. The pricing of such facilities has to be to a degree administrative, not subject to market disciplines, and all sorts of objections are to be raised, particularly in the EU context with the various treaties’ opposition to non-market government guarantees and such like.
Finally, even if the pricing of central bank loans to commercial banks could be arranged in a satisfactory way, the distribution of the facilities between the 17 banking systems of the Eurozone’s member states would be highly contentious. At present the Irish banking system is totally dependent on ECB support, whereas the German and Dutch banks are relatively (only relatively) capable of funding their assets from market sources. Sharp contrasts between different nations in their banking system’s reliance on central bank money are hardly sustainable in the long run.
Night falls
Inescapably the conclusion must be that a large increase in ECB lending to Eurozone banks – of a kind that already seems to be under way – is an important safety-valve for the single currency project. Over the next six to 12 months the full take-up of the safety-valve’s capacity could give the Eurozone valuable breathing space for more fundamental reforms. However, the capacity of the safety valve is finite. The ECB has already retracted the non-standard measures once and it would be desirable if it does so again, perhaps in 2013 or 2014. The best timing may be even later. These are matters of judgement that have to be decided at the time.
A relief rally in some peripheral Eurozone bond markets in the remaining days of 2011 and early 2012 cannot be ruled out. Indeed, if a scheme were hatched to boost Eurozone M3 (by means, for example, of coordinated buybacks by governments of their own long-dated paper financed by borrowing from commercial banks, not the ECB, as proposed above), macroeconomic conditions could improve quite dramatically. Also, as explained in the middle section of this note, the ECB has an accountancy trick available to hide the true losses on its government bond purchases since May 2010. It has to be said that – given the incoherence of their public statements and the frequency of their meetings – Eurozone officialdom does not have an organized plan at all. Nevertheless, government borrowing from commercial banks will almost certainly be rather high in early 2012, simply because the deficits are large and have to be financed somehow.
In the short run much depends on whether Greece can somehow stay inside the Eurozone, despite the chaotic state of its public finances and the apparent breakdown of public order in some parts of the country. But, frankly, if Greece is still a Eurozone member in spring 2012, it would then voluntarily have decided to be in a macroeconomic prison. The Eurozone remains riddled with inconsistent patterns and unsustainable trends, and is deeply dysfunctional, just as it was when it began. Over the medium and long runs, in its present form and with its present membership, the Eurozone is not viable.
Tim Congdon is the founder of International Monetary Research Ltd.