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.

The non-independent ECB

Imagine that the Scottish National Party (SNP) had won the independence referendum. The SNP starts negotiating with the remaining UK (rUK) government over issues like how to split up national debt. On some issue the negotiations get bogged down. Rumours start circulating that this might mean that rUK will not form a monetary union with Scotland, and that Scotland might have to create its own currency. People in Scotland start withdrawing money from Scottish banks.

Now it is almost the definition of a private bank that if everyone who has an account at the bank wants to withdraw their money, the bank will run out of cash and go bust. That is why bank runs are so dangerous. It is also why one of the key roles of a central bank is to supply an otherwise solvent private bank with all the cash they need, so they will never deny depositors their money. (To be a lender of last resort.) If they did not do this, anyone could start a rumour that a bank was insolvent, and as people withdrew their cash just in case the rumour was true, the bank would run out of money and go bust anyway.

So in my hypothetical story, as people started withdrawing cash from Scottish banks, the Bank of England should supply these banks with all the cash they need. Except suppose it did not. Suppose it put a limit to the amount of cash it would supply. The Scottish banks would protest - you agreed we were solvent before independence, they would say, so why are you rationing our liquidity? The Bank of England replies that although they might have been solvent before independence, if there is no agreement solvency is less clear. The Bank of England says that the limit on cash will remain until the Scottish and rUK government come to an agreement.

This announcement of course leads everyone in Scotland to try and get their money out, and the Scottish Banks have to close. The Scottish economy begins to grind to a halt. The English media report that Scotland is running out of money because the Bank of England will not ‘lend’ any more to the Scottish banks. The Scottish government is forced to agree to the rUK’s terms. The English media say look what happens when you elect a radical government. In Scotland they call it blackmail. What would you call it?

If it sounds to you like the Bank of England is taking sides and putting impossible pressure on Scotland, then you will know what it feels like in Greece right now. When, on 28th June, the ECB stopped providing emergency funding to Greek banks, it took sides. Part of the ECB’s logic is that Greek banks may be insolvent if there is no agreement between the Troika and Greece (even though it is the Central Bank of Greece, and therefore the Greek people, which stands to suffer losses from defaults by commercial banks).

Why should the failure to reach an agreement influence the solvency of the Greek banks? Is it because without an agreement there would be a Greek exit? But Greece does not want to abandon the Euro, and the other Eurozone countries have no formal grounds to expel Greece. Greece will only leave the Eurozone if the ECB stops supplying Euros. We reach exactly the same self-fulfilling logic of a bank run. Is it because without an agreement the Greek government would default on some of its debts, and that might adversely influence the solvency of Greek banks? But the fact that the Greek government will not get money from the Troika to pay back the Troika seems to have no implications for the underlying solvency or either the Greek state or its banks. (Paul De Grauwe discusses this further.) If the Troika can make Greece insolvent by itself withholding money we have another self-fulfilling justification.   

The real explanation for the ECB’s actions is much simpler. Limiting funding on 28th June was the Greek government’s punishment for failing to agree to the Troika's terms and calling a referendum the day before. The ECB was not, and never has been, a neutral actor just following the rules of a good central bank. It has always been part of the Troika, and right now it is the Troika’s enforcer.

As Charles Wyplosz recounts, this is not the first time the ECB has chosen to bow to political pressure. There will be some on the left who will say of course - what else do you expect of a central bank? In response, let me go back to my hypothetical example involving Scotland and the Bank of England. I may be wrong, but I think in that case the Bank of England would have supplied unlimited cash to the Scottish banks. I may be naive, but I believe it would have realised that to do anything else was an overtly partisan political act, and recoiled from doing that. Just as I do not think it was inevitable that the Eurozone committed itself to austerity, I also think it was possible that the ECB could have been a more independent central bank. The really interesting question is why it has turned out not to be such a bank.  

Why Sen is right about what is being done to Greece

At first sight the negotiations between Greece and the Troika seem to be simply a battle about resources: how much of the pie that is Greek national income their creditors should receive. There have been many similar types of battle over the years - what makes this one unusual is that the creditors have a unique weapon on their side. With primary surplus approximately achieved, Greece’s bargaining position would normally be extremely strong. The Eurozone creditors would be desperate to salvage what they could from their foolish decision to effectively buy some privately owned Greek government debt. The only reason the Troika is able to call the shots is that it can threaten to eject Greece from the Eurozone. [1]

Part of the deliberate mystification that goes on here is to present Eurozone exit as if it somehow automatically follows if there is a Greek default. But of course Greece has already defaulted, and it remains in the Eurozone. Greece wants to remain in the Eurozone. What will stop them if they do default will be a run on their banks, and a refusal of the lender of last resort for their banks - the ECB - to act in that capacity. Again this will be presented by the ECB as inevitable given the ECB’s own rules. But as Karl Whelan points out, the ECB in reality has considerable discretion, and it has been using that discretion in its role as part of the Troika.

Still, even if the sides are a little unequal in their power, is it still just a battle over resources? One side advocates left wing/populist/humanitarian policies and the other side policies that are more of the consensus/neoliberal/tough variety. [2] One side has suffered a massive fall in GDP partly as a result of previously agreements, while the other is negotiating over what is to them peanuts. So there is plenty of opportunity to pick sides based on preferences. Both sides would almost certainly be better off with an agreement, so it also makes sense for people to appeal for flexibility, which is why I signed this letter.

But to pick sides, or to call for flexibility from both, misses the main point. Yes, this is a battle over resources, but it is a battle where one side is using its power to pursue a policy that is very short-sighted, involving incredible hubris, and which is ultimately self defeating. The Troika are not acting in the long term interests of those they represent. This is I believe what Amartya Sen was saying when he compared these negotiations to the Versailles agreement. 

The most obvious example of this are the Troika’s continuing demands for positive primary surpluses and the austerity measures required to achieve them. This is just stupid. It continues to waste large amounts of valuable resources, as well as inflicting real suffering. It certainly is not in the interests of Greece, but it is almost certainly not in the interests of the creditors either. If you shrink the pie, you are less likely to get the amount of pie you have a claim to. (Martin Sandbu goes through the maths here.) It is disgraceful that key parts of the IMF plays along (or worse) with this. In the past I have described how heterogeneous the IMF is, but taking absolutely no notice of what your own research department says about austerity is crazy. Ambrose Evans-Pritchard talks about the Fund's own credibility and long-term survival being at stake. Keynes, who helped found the organisation, would be turning in his grave.

What about all the reforms that the Troika is insisting on? It is tempting to look at each in turn, and apply our economics expertise to come to an evaluation. If a reform demanded by the Troika might tend to increase the long run pie, then perhaps they are right to insist on it. This neglects one small issue: democracy. The Greek people have elected a government with a mandate. The Troika appear to be acting as if this is neither here nor there, and that is deeply worrying, at least to those of us who are very weary of yet further economic and political integration. (For those who have that integration as their ultimate goal, Greece can be seen as an annoying obstacle that should be thrown aside. [3])  

The hubris of the Troika is incredible. They have convinced themselves that they must override the democratic wishes of the Greek people because the Troika have the wisdom about what is good for the Greek economy. This is the same body that with its superior wisdom prevented full default, and imposed ridiculously strong austerity on Greece and crashed the economy as a direct result. To cover up these errors they play to stories in the media about the lazy and privileged Greek people, stories that largely disintegrate when confronted with evidence. Now they shrug their shoulders and say I have to keep on the same disastrous path because my electorate gives me no choice!

Amartya Sen is right. This is our Versailles treaty moment. It could be so very different. No doubt some of Syriza’s mandate may be unwise, but their own economists may recognise that and welcome the excuse to shelve them. The Troika and Syriza’s negotiating team could be cooperating in that endeavour, but I’m pretty sure that is not what is happening. On austerity the priority of the Troika should be to eliminate the Greek output gap, which means in the short term less rather than more austerity. This would not just be in the interest of the Greek people but also the interests of the rest of the Eurozone.

[1] This is why I think these negotiations are less like bargaining over a mutually beneficial exchange (rolling over lending in exchange for reforms), and more like a discussion with a mugger over which of your personal possessions you hand over.

[2] Or add any other description you prefer - my point is that they differ and people have strong views about them both in principle and practice, and therefore pick sides accordingly.

[3, postscript] Karl Whelan shows here that Giavazzi’s piece is as grounded in facts as some other FT op-eds. 

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.