What’s at stake: As the European debt crisis continues to worsen there are growing calls for the European Central Bank to take a more active role in the crisis resolution through purchase ever-greater quantities of troubled sovereign debt. The absence of a lender of last resort has been highlighted as one of essential weaknesses of the euro area. German and French officials are now openly fighting about turning the ECB into a lender of last resort to governments in an effort to end the crisis and salvage the common currency.
Fighting self-fulfilling crises
Guillermo Ortiz – former Governor of Banco de Mexico – argues that the unfortunate reality leaves the European Central Bank as the sole institution able to make a difference. The central bank has acted resolutely as a lender of last resort to the banking system. The nature of the crisis requires the ECB to act as a lender of last resort to solvent sovereign credits as well, despite Germany’s opposition.
Paul De Grauwe argues that the single most important argument for appointing the ECB as a lender of last resort in the government bond markets is to prevent countries from being pushed into this sort of bad equilibrium—a self-fulfilling debt crisis(for more on the self-fulfilling aspect of the crisis see this post by Paul Krugman). When solvency problems arise in one country (say, Greece), bondholders may sell other nations’ bonds as they fear the worst. This loss of confidence can trigger a liquidity crisis in these other markets because there is no buyer of last resort. Without such a backstop, fears can grow until the liquidity problem degenerates into a solvency problem. In the case of bonds, the cycle starts as the loss of confidence increases the interest rates governments must pay to rollover bonds. But the higher interest harms governments’ solvency. Since there is always an interest rate high enough to make any country insolvent, the cycle of fear and rising interest rates may lead to a self-fulfilling default. The central bank can solve this coordination failure by providing lending of last resort.
Martin Wolf argues that eurozone sovereigns are what Charles Goodhart calls “subsidiary sovereigns”.Their debt bears a risk of outright default rather than mere monetization. Fearing default, investors create illiquidity, which turns into insolvency. The greater the proportion of foreign creditors, the more plausible default becomes: investors know that politicians are more unwilling to default to their own citizens than foreigners.
Bernard Delbecque discuss different variants of the LoLR approach that could be considered, such as an announcement that the ECB would buy unlimited amounts of sovereign bonds if a solvent country came under attack (De Grauwe), or an arrangement whereby the ECB would offer a limited guarantee on existing public debt and full guarantee on future public debt (Wyplosz). His proposal is to set up a framework that builds on the following principles: the EFSF would fully commit to purchasing new debt issued by solvent EZ members as soon as market interest rates reach a predefined level. The idea here is that the yield on already-issued bonds does not affect a government’s solvency. The issue only arises when it comes time to issue new bonds to either roll over the stock of debt or cover new government borrowing. Focusing only on the new debt issues thus turns the EFSF’s job into a more manageable size.
The difference between a LoLR for banks and a LoLR for sovereigns
Mervyn King argued during the Bank of England’s Inflation Report presentation last week that being a LoLR is a million miles away from the ECB buying sovereign debt of national countries. 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. It is very clear, from the origin, that lender of last resort by a central bank is intended to be lending to individual banking institutions, and to institutions which are clearly regarded as solvent. And it's done against good collateral and at a penalty rate. That's what lender of last resort means.
In his 1873 essay “Lombard Street”, Walter Bagehot writes that the first thing that the ‘ultimate bank reserve’ has to do in a crisis is ‘to lend to all that bring good securities, freely, and readily’. This is what the Bank of England did in the 1825-26 crisis. As Jeremiah Harman, the governor of the Bank of England, explained it “lent […] by every possible means and in modes [it] had never adopted before”. The restrictive provisions – known as the Bagehot Rule – that the Bank should only lend freely against good collateral and at penalty rates are supposed to limit aid to otherwise solvent firms panic had rendered illiquid and limit moral hazard.
Brad DeLong argues that the most astonishing thing about the ECB’s monochromatic price-stability mission and utter disregard for financial stability is its radical departure from the central-banking tradition. Modern central banking got its start in the collapse of the British canal boom of the early 1820’s. During the financial crisis and recession of 1825-1826, a central bank – the Bank of England – intervened in the interest of financial stability as the irrational exuberance of the boom turned into the remorseful pessimism of the bust. The Bank of England’s charter did not give it the legal authority to undertake such lender-of-last-resort financial-stability operations. But the Bank undertook them anyway.
Gavyn Davies writes that the custom and practice of central banking, and of the relationships between central banks and fiscal policy, is being rewritten under the glare of a global spotlight, and in the harshest of circumstances. First, when the BoE or the Fed conducts QE, they typically acquire bonds issued by their own treasuries, which by assumption have no credit risk attached, or they buy other assets where the treasuries underwrite possible future losses. That is not true when the ECB buys Italian or Spanish bonds.
Moral hazard, income-transfer mechanism and independence of the ECB
Jacob Funk Kirkegaard argues that had 10-year interest rates in Italy been capped at 5 percent by the ECB, Prime Minister former Silvio Berlusconi would still be in office. Undertaking a major "bridging monetary stimulus" that some have called for would in similar fashion undermine chances of a permanent political resolution to the euro area’s underlying under-institutionalization problem. Despite the best attempts of markets and financial commentators to get the ECB to take action driven by its estimate of the next couple of quarters’ nominal GDP growth, the ECB is thinking not about the next two quarters but about the design of the political institutions that will govern the euro area for decades.
Gavyn Davies argues the one essential problem is that it would generate an indirect subsidy of troubled Euro governments by prudent ones, with inflation or eventual ECB capital losses serving as the income-transfer mechanism. Davies argues that if the ECB board chooses to use its notional capital today by buying Italian bonds at subsidized rates, it is in effect triggering a transfer of resources to Italy, away from other members, most notably Germany. This could emerge in the form of ECB losses, which might need to be to be recapitalized by member states after an Italian default. Or it might emerge as a reduced flow of future profits from the ECB to nations like Germany. In any event, there would be an implied transfer of resources from Germany to Italy, which is precisely what the German government has opposed implacably.
Claire Jones writes on the FT’s Money Supply blog that regardless of the rights and wrongs of Paris’s stance, if the French want more action from the ECB, then they might want to consider thinking a little more carefully about what they say. It is not just Germany and European treaties that are barriers; no central bank in its right mind is going to agree to being a lender of last resort for governments. The louder France call for the ECB becoming a lender of last resort for governments, the more the compromised the central bank will feel. And the more compromised it feels, the more resistant to action – whatever its rationale – it is likely to become. For them, it is not just their actions, but the rationale for those actions, that matter. The Bank of England, the Federal Reserve and the Bank of Japan are loath to think of themselves as monetising government deficits, even though they have bought government debt in significant amounts.
Marc Chandler writes in Credit Writedowns that the lender of last resort to sovereigns is the IMF. On Wednesday, it announced new precautionary and liquidity facilities, providing funds for between six and 24 months. The likely candidates in the euro zone are Italy and Spain, while countries in eastern and central Europe would be other potential candidates. These are still relatively small steps for the IMF and for the scale of the crisis. More will be needed. The IMF does not have the funds if both Italy and Spain wanted to borrow 10x their IMF quotas. This means that the IMF will be going back to the drawing board sooner or later.
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