Winner of the New Statesman SPERI Prize in Political Economy 2016

Monday 2 November 2015

The ECB as sovereign lender of last resort

Understandably the element of my talk at the Royal Irish Academy which generated most discussion was the role of the ECB. (Here is a media report, but ignore the last two paragraphs which are confused/wrong. Abstract for the talk is here. Paper will follow.) The proposition I put forward was that the ECB’s OMT programme should have been put in place in 2010, and if it had been countries outside Greece could have implemented a more efficient austerity programme (one that produced less unemployment) and might have retained market access (interest rates on government debt would have remained reasonable). [1]

There are two serious and related arguments against this view. The first is that it is unrealistic for the ECB to act as a sovereign lender of last resort because of the transfers between countries that this might lead to. (A sovereign lender of last resort is a central bank that is always willing to buy its government’s debt.) [2] The second is that in practice OMT is bound to be coupled with a requirement for austerity programmes that might have simply duplicated what was actually put into place by national governments. Both arguments speak to a real problem that remains unresolved within the Eurozone, but do not nullify the argument that things should have been done much better.

Government debt in advanced economies is regarded as a safe asset for two reasons. The first is that most governments that borrow in their own currency rarely default. The second is that an individual investor does not need to worry about market beliefs, because if the market panics and refuses to buy the government’s debt the central bank will step in (hence sovereign lender of last resort). If the central bank did not do this, the government might be forced to default because it cannot roll over its existing debt.

It makes sense for the central bank to act as a sovereign lender of last resort, because it avoids self-fulfilling market panics. Doubly so because such panics will be more likely to occur after a large recession when the social value of government borrowing is particularly high. The complication in the case of the ECB is the following. If the market panic is so great that the ECB was forced to actually buy a ‘distressed’ government’s debt (normally the threat to do so is enough), it is possible that this government might choose to default even with ECB support. If it did that, the ECB would make losses which would be born by the Eurozone as a whole (the transfer risk).

Partly for this reason, the ECB has to have the ability not to act as a sovereign lender of last resort, or withdraw support if circumstances change. If that ability exists (a point I will come back to), then the transfer risk associated with the ECB acting as a sovereign lender of last resort are tiny. It represents the kind of minimal risk that should always be offset by the trust and solidarity that comes with the territory of being in a monetary union. I suspect those that suggest otherwise are often trying to hide other motives.

A government that is receiving ECB support of this kind will naturally want to know what it has to do to maintain it, because the threat of its withdrawal is so great. It would be unreasonable to withhold that information. Does that in practice amount to nothing more than the kind of conditions that have in practice been imposed on Ireland and Portugal anyway? Absolutely not. Just as the market does not worry about the build up of debt in a recession in countries like the UK or Japan, a rational ECB would have no reason to impose fiscal consolidation at the time it would do most damage. The time a rational ECB might withdraw its support is once a recovery is complete and the government refuses to embark on fiscal consolidation.

So a sovereign lender of last resort in a monetary union must have the ability not to provide that support. In other words it has to sort Greece from Ireland. That decision is a huge one, because in effect it is a decision about whether the country will be forced to default. It is natural that the ECB wants to share that responsibility with member governments, but as we have seen with Greece member governments are hopeless at making that decision (particularly when their own banks may be compromised by any default). We have also seen that European central bankers are far from rational on issues involving government debt (compared with at least one of their anglo-saxon counterparts), so giving the decision to someone else other than the current ECB would seem like a good idea. However at present there is no institution that seems capable of doing this job.

In this post I suggested contracting out this task to the IMF, although that presumed a reduction in the political influence of European governments on that institution. I have also wondered about whether a body like the newly created network of European fiscal councils could play this role. Another possibility is to reform the ECB so that it is not subject to deficit phobia, and is more accountable. It seems to me that this is where current research and analysis should be going, rather than into schemes involving greater political union.

The existence of various alternatives here means that we should not take what has actually happened in the Eurozone as some kind of immutable political constraint beyond which economics cannot go. There is no intrinsic reason why the OMT that was introduced in September 2012 could not have been introduced in 2010. There is no intrinsic reason why any conditionality that went with that could not have been much more efficient in terms of unemployment costs. Beyond Greece, the Eurozone crisis happened because the ECB thought it could avoid undertaking one of the essential functions of a central bank. This was perhaps the most important of the many errors it has made.

[1] For a country within a monetary union which needs to reduce debt more rapidly than does the union as a whole, a gain in competitiveness relative to the rest of the union is required to offset the deflationary impact of fiscal consolidation. That ‘internal devaluation’ probably requires some increase in unemployment, but it is much more efficient to obtain that increase in competitiveness gradually.

[2] It could be argued that the Fed does not provide lender of last resort services to individual member states. But state debt is typically lower relative to GDP and income than for Eurozone governments. Before 2000, Eurozone governments were able to borrow more because they were backed by their central bank. That means that they are inevitably subject to a greater risk of suffering from a self-fulfilling market panic. The architects of the Eurozone might have initially believed that the SGP might avoid the need for a sovereign lender of last resort, but after the Great Recession they would have known otherwise.


  1. The performance of the ECB since the Euro introduction is a joke.

    I would hope that the failure of any Central Bank, not just the performance of the Bank of England, will be key discussion points of the a review of the Bank of England monetary policy remit for the future as requested by John McDonnell and the Labour party.

    The ECB is of course a key case study how central banking should not be done. First of all refusing to check excessive credit growth in the countries (prior to 2010), and then not helping quickly enough to rein in speculation against individual countries.

    That is by not adhering to its own EU institution rules of 3%/60% deficit/debt limits in the run up to the crisis of 2008/2010, the ECB undermined its own credibility. But after the crisis becomes apparent, the ECB takes the moral high ground of insisting that "structural adjustments" have to take place in the countries, whilst ignoring the ECB's own failure in the Eurocrisis debacle. The ECB's inability to rein in, for example, Credit Default Swaps growth, which allowed for the Eurocrisis to be made much worse, As from 2010 to 2012 everybody who had CDS seemed top scream for a default of Greek debt, just to bring the CDS bets against Greece to some payout point.

    The main point by SWP is right. The Eurocrisis could have been substantially ended in 2010 by a full underwriting of all European debt in 2010 or an introduction of OMT.

    But Greek debt would be higher (and CDS betting on Greek default all worthless) had the ECB fully underwritten all debt. There would not have been a partial restructuring of Greek debt in 2012.

    It is of course the austerity imposed, supported by the ECB, which prevents Greece (the main problem country in the European periphery) to meet any future repayment of financial assistance.

    Instead of AUSTERITY, the ECB/IMF/EU should insist on FULL EMPLOYMENT as the condition for its assistance.

    It seems a kind of revolutionary approach, to target unemployment in the Eurozone, but the Fed has a dual mandate, and the ECB should have, too.

    Targeting unemployment would of course lead to some more sensible fiscal policies in the end, than the ones imposed now by the IMF/ECB/EU, if the EU deficit/debt structure of 3%/60% is to be achieved.

    1. " but the Fed has a dual mandate, and the ECB should have, too. "

      As they say in the software business: 'this a feature not a bug'

      An economy that have employment as a priority implies redistribution. Unemployment is very convenient if you are the one hiring.

      I am little slow but it's obvious to me now what kind of project is the Euro: the dismantle of the welfare state and the creation of a 'competitive' and 'free' area.

  2. I entirely agree about the importance of politics, but I don't think the ECB thought it could avoid acting as lender of last resort. Rather, I think it viewed the threat of not doing so as a valuable form of political leverage, which it exploited to the maximum in service of a pro-austerity agenda. Thus, the reason OMT was introduced in 2012 rather than 2010 was that by 2012 Draghi thought that austerity agenda had been effectively locked in to European institutions by the fiscal compact.

    I wrote down a blow-by-blow account of the politics here: (pages 30-39).

    1. I agree that this is a perfectly viable explanation. It certainly fits with their obsessive tendency to advise on fiscal policy, which is (as I elaborated on in one of the linked posts) quite unlike the Bank of England or the Fed.

    2. I thought Draghi was one of the good guys? Trichet made the original mistakes. Given his background it seems unlikely that Draghi wanted to promote, let alone lock in, austerity, surely?

  3. The fact that the ECB was not allowed (by the Germans primarily, I think) to act as Lender of the Last Resort at the very beginning of the banking crisis has been the main cause of European financial problems ever since. It was so obvious that I wondered whether it was part of some long-run game plan by the Germans which, at the time, was not clear. I guess it was and apparently still is their game plan - as a means of dominating Europe. Or is this too simplistic?

    1. Not at all - see previous comment!

    2. So SWL believes that Germans have a game plan of dominating Europe? That's a clear case of a conspiracy theory - a fact that usually makes one doubt the sanity of the person propounding it. The fact is that the Euro treaty forbids the ECB to act as lender of last resort to gevernments (as opposed to banks).

      The further fact is that Germans were opposed to the Euro - and if they had had their way, the present problems would have been avoided. But as Martin Wolf has pointed out, the Euro was a price some other countries (mainly France and Italy) foolishly demanded of Germany for reunification. Later on, many other countries absolutely wanted to join the Euro in spite of the fact that many highly respected American and British economists had pointed out the difficulties the Euro would cause them.

    3. Prof. Wren-Lewis,

      Do I understand you to attempt dominating the Labour party through your advice about macroeconomic policy?


  4. "Government debt in advanced economies is regarded as a safe asset for two reasons. The first is that most governments that borrow in their own currency rarely default."

    In fact one could say can never be "forced" to default. Defaults by governments sovereign in their own currencies are, as you say, rare but where default has occurred the decision is entirely political e.g. Japan during the second world was and the UK as it left the Gold Standard.

    (btw great article, exposes the political "rock and a hard place" the ECB finds itself in (or rather the weakness of the system that created it)

  5. Prof. Wren-Lewis,

    I looked up the media report and ignored the last two paragraphs.

    But did you really say:

    "Mr Wren-Lewis was giving a lecture last night at the Royal Irish Academy in Dublin on “how to avoid austerity”, ahead of a full-day conference there today on the issue. He argued that austerity was not inevitable after a recession and could “easily have been avoided” in Europe."


    1. For the Eurozone as a whole that is accurate, and not madness at all. For Greece there was always going to be a crisis. For other periphery countries some austerity was necessary, but Eurozone policies almost certainly made it worse than it need have been.

    2. "Eurozone policies almost certainly made it (austerity) worse than it need have been.".

      What policies exactly? Which countries actually reduced government spending to a degree that brought about higher unemployment? Certainly not France, which has 10 % unemployment without reducing public expenditure.

    3. You need to read some of my past posts, or maybe just look at some data on cyclically adjusted primary surpluses.

    4. "You need to read some of my past posts,..."

      I did, and that is why I asked my question. You habitually avoid details, but I hoped to draw you out this time.

      "just look at some data on cyclically adjusted primary surpluses..."

      That's another way of avoiding the question. Surely, it cannot be so hard to tell us which countries, in your opinion, reduced public spending to a degree that brought about higher unemployment. If there are countries which did not reduce public spending and yet have higher unemployment, the reason for that would not appear to be austerity but something else.

  6. You say, "Government debt in advanced economies is regarded as a safe asset for two reasons. The first is that most governments that borrow in their own currency rarely default. The second is that an individual investor does not need to worry about market beliefs, because if the market panics and refuses to buy the government’s debt the central bank will step in (hence sovereign lender of last resort). If the central bank did not do this, the government might be forced to default because it cannot roll over its existing debt."

    Utter; total; complete bollocks. Sorry Simon, but this paragraph is just too ridiculous to warrant any effort on my part to correct it.

    1. The worrying thing is that I suspect this comment is not a joke.

    2. (1) So how does a currency issuing nation default in its own currency? If it is daft enough to have borrowed in some "other nation's" currency; and, defaults in that currency, then it is the "other nation" that has the problem.

      (2) A sovereign currency ISSUING government can always roll-over its own existing debt, it can not default in its own currency, nor can its central bank. The government (at least the tec's who actually understand how the system works), do not give a toss if the market refuses to buy the government's debt. Government bond markets are only ever secondary and parasitic to the "real" economy of a sovereign currency nation.

      The Treasury could stop issuing Gilts tomorrow and just leave its spending as "reserves", that will get cancelled by taxation down the road. This would leave excess reserves in the settlement system, which would drive down the overnight interest rate to zero. (MMT will tell you why zero is where it should be.)

      The central bank now pays interest on reserves trying to hold its policy rate. Hence, without any Gilts to buy, punters could put their money in NS&I Income Bonds, just as "risk free" as Gilts; and put them in their pension fund; and cheaper for Treasury to operate. There are simpler ways of controlling spending power in the economy to control sectoral inflation (bubbles), but they would put a lot of Casino banksters out of work in the spiv city of London.

      PS. Simon, did you bring any Potcheen back from the Emerald Isle ;-) ;-)

  7. I'd prefer to see a Eurozone federal government, or breakup. But face it things will likely muddle along with ridiculous unemployment levels.

    1. +1. Unfortunately orderly break-up is not in the cards, too much wasted political capital behind it.

      Thanks Simon, good post / effort.

  8. Your post and the reports don't say whether your paper mentioned the monetary tightening via the two rate rises in April and July 2011, plus all the tough anti-inflation talk. Euro Area RGDP was 2.4% YoY in 4q10 and NGDP growth was just 3.0%. Two of the periphery were already in a bailout (Ireland and Greece) out and a third was about to ask for one (Portugal). There was plenty of press and market comment at the time that these rate rises were huge mistakes.


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