The ECB as a Lender of Last Resort to Governments

John McHale rightly points out that in my earlier post on the European Commission’s justification for austerity, I said little about the Lender of Last Resort to governments (LOLR) issue. What I did say is that OMT should have been established much earlier, and that this might have allowed Ireland and Portugal to continue to sell government debt to the markets at tolerable interest rates, which in turn might have allowed them to implement budget consolidation at a less damaging pace. (Whether they would have taken that opportunity is another matter.)

However this begs an obvious question, which is how OMT conditionality should operate. One possibility is that the ECB imposes as least as harsh conditions as the current Troika. Alternatively the ECB passes responsibility for imposing conditions to the Troika, and the Troika continues to do what it has already done. It would be wrong to say nothing would be gained as a result. If OMT works and the governments continue to borrow from the market, then we avoid some of the toxic intergovernmental lending that is in danger of tearing the Eurozone apart. However we will still have excessive fiscal deflation.

Do we need any conditionality at all? Unfortunately we do. To offer OMT unconditionally would take us back to the pre-2007 situation, where default was not thought possible. It revitalises the arguments that gave rise to the disastrous Stability and Growth Pact and the more recent Fiscal Compact. As Charles Wyplosz and others have emphasised, it is very difficult to run any kind of system where component parts have autonomy to borrow without having the discipline of default, unless you resort to a degree of central control that is not feasible for the Eurozone.

Conditionality should not come naturally to any independent central bank. There is no significant example of a country delegating fiscal decision making to an unelected body, and even if it did so there are reasons not to use a central bank for that task. But before addressing this dilemma, we should establish what the nature of conditionality should be.

The remit of the central bank should be short run macroeconomic stabilisation and long run price stability. OMT can be justified under this remit, as I argued here, because if a country finds itself in a bad market equilibrium, this will have a negative impact on the monetary transmission mechanism and short run macroeconomic stability. Conditionality can also be justified under this remit, because a complete failure of fiscal control in one country in a union when default is not allowed will compromise monetary policy for the union as a whole. (One of my own papers with Campbell Leith looks at this in a two country case. [1]) By complete lack of fiscal control, I essentially mean that a government is insolvent at a level of interest rates consistent with normal monetary policy. [2]

In other words, all the ECB needs to worry about is whether fiscal policy is sustainable in the long run. It should have no concern about which of the many possible sustainable fiscal paths a government chooses - that is up to the national government. There is a analogy with the well established rules for central bank support of private banks. If the bank is solvent but suffering from liquidity problems, support should be unequivocal and unlimited. If the bank is insolvent, no support should be forthcoming. [3]

The problem with this analogy is that solvency for a government involves a political as well as a technical judgement. Suppose a government submits fiscal projections that are sustainable. This could involve government debt initially rising but stabilising at some high level. If it then starts falling again so much the better. There could be two things wrong with this projection. The first is technical: for example growth assumptions may be too optimistic or tax receipts given growth are too optimistic. The second is political: the plan may involve cuts in spending, or increases in taxes, that are unlikely to be realised because the political costs are too high.

No central bank should like to be in a position where it has to make these political judgements. It would like to offload the problem on someone else. The obvious someone else is the market, but that will not work because all the market tells you is that there exists a bad equilibrium, and not whether a good equilibrium exists. To use Keynes’s famous analogy, the market is judging who the market thinks is beautiful, and not who is actually beautiful. The ratings agencies seem ‘market like’, but are in effect just a bunch of people with a (perhaps informed) opinion, and a not very good track record.

Who else could the ECB delegate conditionality to? Delegating to EU heads of state would be a bad idea, for reasons that I hope are obvious. [4] Delegating to the Commission seems too close to that. A better possibility would be the IMF. The IMF certainly knows all about this issue: see this research for example. However all of these agencies have a recent track record that does not inspire confidence. An acid test is how any arrangement would have worked in the case of Greece. What should have happened, as soon as the true extent of Greece’s fiscal problems had become clear, is that whatever body the ECB had delegated its conditionality assessment to should have concluded that default was more likely than not, and therefore OMT should not have been provided.[5]  

I have an alternative suggestion, which regular readers will not find surprising. A number of Eurozone countries now have fiscal councils, whose very job is to assess the sustainability of fiscal policy. They are the obvious people to ask. Putting such an important question to the relevant national fiscal council may be politically unwise - could that council survive a decision that led to default? It would be better, for this and other reasons, for fiscal councils to act as a group in advising the ECB on the sustainability of national fiscal plans. That way expertise could be pooled, and experience shared.

Let me be quite clear what I am suggesting here. As soon as a country specific default premium began to emerge on a Eurozone member’s government debt, the ECB would ask the collective of Eurozone fiscal councils whether they thought current fiscal plans would result in a sustainable level of debt. If they did, the ECB would announce that OMT would apply to that country i.e. it would buy whatever quantity of that debt that could not be sold to the market. That decision could be reviewed annually until the default premium faded away. If the fiscal councils collective did not think current fiscal plans were realistic and sustainable, OMT would not be forthcoming. In these circumstances, there would be no bailing out by the Eurozone or IMF, and default would almost certainly follow.

The Commission plays no part in this. However, I think the Commission still has a very important role to play. The ECB, as part of the role it should have in preventing deficient aggregate demand in the Eurozone as a whole, should publicly state that because of the zero lower bound they cannot use monetary policy to fulfill this function. They should ask the Commission to coordinate fiscal actions to provide additional support to demand. In doing this, the Commission would clearly not ask that much of countries on OMT, so most of the ‘burden’ would fall on others, like Germany or the Netherlands.

Which brings me back to my previous post, and why I think what I said there was quite compatible with LOLR issues. Now some commented on that earlier post that it was not politically feasible, by which they mean Germany would not countenance it. I am sure that is right, although what has disappointed me (and others - see Kevin O’Rourke) is that the election of Hollande did not emboldened countries like France and Italy to provide any kind of counterweight to German views.

One of the advantages of being an academic is that your advice does not have to be bound by what is politically feasible. It is important that someone sets out what is best as they see it, and others can then modify it to satisfy political constraints. However the problem in this case is not so much that fiscal stimulus rather than austerity, and the ECB acting as a LOLR, are not in the German national interest. I think you could make a case that they are in fact in Germany’s long term national interest, because a well functioning Eurozone is in their interests. The problem seems more that policy makers throughout Europe have two economic blindspots. [6] Those blindspots are the fallacy of austerity at the Zero Lower Bound, and the necessity of a LOLR. What I will not do is give advice which accepts that those blindspots cannot be removed.

 

[1] See also Canzoneri, M. B., R. E. Cumby and B. T. Diba (2001), “Fiscal Discipline and Exchange Rate Systems”, Economic Journal, No. 474, pp 667-690.

[2] Using Eric Leeper’s terminology, it means the fiscal authority is active: for a discussion of the active/passive idea and its application to the ECB and OMT see here.

[3] One problem with the Bagehot dictum is contagion: if an insolvent bank is allowed to fail, this may create a liquidity (or even solvency) crisis for others. These contagion arguments have much less weight when it comes to countries in the Eurozone, once OMT has been established and the conditionality involved is clear and non-political.

[4] See, for example, Cyprus. Colm McCarthy describes it well here (HT Kevin O’Rourke)

[5] This may be a little unfair on the IMF, who almost certainly came under intense political pressure from the Eurozone to provide funds before the inevitability of default was conceded. I do not know whether this assistance, which allowed default to be delayed, was provided against the better judgement of some of those in the Fund.

[6] See a shrill Kevin O’Rourke here.