What’s at stake: The European Central Bank will most likely reveal on Thursday its plans for a program of sovereign bond buying, as it steps up its efforts to stave the eurozone off deflation. In a previous review, we addressed the question of whether the expansion of the money base should be temporary or permanent to have a meaningful impact on inflation. In this review, we provide background on the exacerbated concern of what would happen to the Eurosystem’s capital resources if a country defaults and, in particular, whether this would generate a fiscal transfer between members.
Paul De Grauwe and Yuemei Ji write that the most important argument used by opponents of a government bond buying programme by the ECB is that such a program mixes monetary and fiscal policy. The argument goes as follows. When in the context of QE the ECB buys government bonds from fiscally weak countries it takes a credit risk. Some of these countries may default on their debt. This then will lead to losses for the ECB, which, in turn, means that the taxpayers of the fiscally sound member countries of the Eurozone will be forced to foot the bill. Thus, when the ECB buys government bonds, it creates a risk that future taxpayers will be liable to bear losses. Put differently, the ECB is, in fact, conducting fiscal policies in that it organizes fiscal transfers between member states. The ECB has no mandate to do so.
Hans Werner Sinn writes that buying low quality paper would increase the burden on taxpayers should default occur, since taxpayers will have to make up for the drop in the distribution of ECB profits to the respective treasury departments.
The basics of central bank accounting
Karl Whelan writes that commentaries along the lines of “the ECB is taking huge risks with its balance sheet”, “the ECB risks becoming insolvent, endangering the future of the euro” or that “Eurozone states may have to recapitalize the ECB at huge cost to taxpayers” are based on a widespread failure to understand that central banks are fundamentally different from commercial banks. Central banks do not need to have assets greater than liabilities and cannot “go bust” due to losses on asset purchases. That said, most of the international policy community seems happy to perpetuate this myth.
Paul de Grauwe and Yuemei Ji write that contrary to private companies, the liabilities of the central bank do not constitute a claim on the assets of the central bank. The latter was the case during gold standard when the central bank promised to convert its liabilities into gold at a fixed price. Similarly in a fixed exchange-rate system, the central banks promise to convert their liabilities into foreign exchange at a fixed price. The ECB and other modern central banks that are on a floating exchange-rate system make no such promise. As a result, the value of the central bank’s assets has no bearing for its solvency. The only promise made by the central bank in a floating exchange-rate regime is that the money will be convertible into a basket of goods and services at a (more or less) fixed price. In other words the central bank makes a promise of price stability.
Karl Whelan writes that if a central bank purchases assets that then decline in value, it could end up having negative capital. When a commercial bank has negative capital, it is termed insolvent and either re-capitalized or shut down. The “insolvent” terminology is sometimes applied to a central bank in this situation but central banks are unique organizations and this phrase isn’t particularly appropriate. Wolfgang Munchau writes that a NCB facing default could just go with negative capital. It might also claim some of the ECB’s future profits as part of its own capital. It is, after all, a shareholder in the ECB. It might also use some of its gold reserves to prop up its capital. What will happen will therefore depend on the size of the default, the size of the shareholding in the ECB and the size of any reserves.
QE and fiscal transfers
Paul de Grauwe and Yuemei Ji write that in a monetary union with no fiscal union a bond-buying programme leads to fiscal transfers among countries – but not the one common in the public perception. One often hears in the creditor countries that these would be the losers if one of the governments whose bonds are on the balance sheet of the ECB were to default. This is an erroneous conclusion.
Paul de Grauwe and Yuemei Ji write that an ECB bond-buying programme leads to a yearly transfer from the country whose bonds are bought to the countries whose bond are not bought. Take that the example of the ECB buying €1 billion of Spanish bonds with a 4% coupon. The fiscal implications are now as follows. The ECB receives €40 million interest annually from the Spanish Treasury. The ECB returns this €40 million every year to the EZ national central banks. The distribution is pro rata with national equity shares in the ECB. The national central banks transfer this to their national treasuries. For example, the ECB will transfer back 11.9% of the €40 million to the Banco de España. The rest goes to the other member central banks. The largest receiver is the German Bundesbank; with its equity share of 27.1%, it would get €10.8 million.
Paul de Grauwe and Yuemei Ji write that the ECB could implement a bond-buying programme that avoids fiscal transfers by buying national government bonds in the same proportions to the equity shares of the participating NCBs if interest rates were uniform across countries. But this would not eliminate all transfers because the interest rates on the outstanding government bonds are not the same. In fact the countries with the highest interest rates would in this weighted bond-buying programme be net payers of interest to the countries with the lowest interest rates. Thus even a bond-buying programme weighted by the equity shares would involve fiscal transfers from the weaker (debtor) countries to the stronger (creditor) countries.
Paul de Grauwe and Yuemei Ji write that in the case of default on the €1 billion of Spanish government bonds, the Spanish government would stop paying €40 million to the ECB. The ECB would stop transferring this interest revenue back to the member central banks pro rata. The German taxpayer, for example, would no longer receive the yearly windfall of €10.8 million. In no way can one conclude that German taxpayers, or any EZ taxpayer, would pay the bill of the Spanish default – except in the narrow sense that they would no longer be able to count on the yearly interest revenues.
Paul De Grauwe and Yuemei Ji write that eliminating this type of transfers can be achieved by following a somewhat different interest distribution rule. Instead of pooling the interest payments the ECB receives and then distributing them according to the equity shares, one could also use a rule of ‘juste retour’. This would mean that the ECB redistributes the exact amounts of interest payments it has received from each member government back to the same government. If this rule is applied, there would be no net interest transfer before or after the default. Complete neutrality is restored and taxpayers are shielded from movements of the value of the bonds on the ECB’s balance sheet.
Paul de Grauwe writes that suppose that for reasons of reputation the member states decide to recapitalize the ECB. Will that not inevitably involve taxpayers in Germany, France, etc? The answer is no. This will just be a bookkeeping operation without involving taxpayers. When national governments decide to recapitalize the ECB to make up for the loss of €1 billion, they transfer bonds to the ECB worth 1 billion, allowing the ECB to increase its equity by €1billion. These transfers occur using the same capital shares. Thus the ECB holds government bonds worth €1 billion. As a result, each government pays interest to the ECB in the same proportion to its capital share. But at the end of the year the ECB transfers these interest revenues back to the same governments using the same capital shares.