It looks like the ECB is about to step forward and cap sovereign bond interest rates, if reports from the German media are to be believed. I am sceptical that the ECB will follow through on this given political pressure in the euro zone against greater central bank activism. But I want to outline the salient background details for you.
Federal Reserve Example from US Crisis
The European sovereign debt crisis has many parallels to the US mortgage crisis with sovereign debt taking on the role in creating fragility in the banking system that mortgage debt did in the US. Just as the Fed expanded its balance sheet during QE1 with an alphabet soup of emergency liquidity facilities during the height of the US mortgage and banking crisis in 2008 and 2009, the ECB has found that it must do the same.
The expansion of the Fed’s balance sheet has been widely misunderstood within the economics profession, because it has been viewed through the lens of a pre-existing debate about the monetary transmission mechanism. Those who emphasized the importance of the money supply (on nominal spending) saw the expansion as quantitative easing, and warned about eventual inflationary consequences. Those who emphasized the credit channel (as Bernanke did) saw the expansion as providing credit that was temporarily unavailable in the private market. The fact that the balance sheet expanded on both sides, and in both cases with the private sector as counterparty, tells us that something else was going on.
I would argue that the Fed’s actions after Lehman should be understood as moving the wholesale money market onto its own balance sheet. Banks with surplus funds lent them to the Fed by holding excess reserve balances, and banks that needed funds borrowed them from the Fed through the discount window. Foreign banks that needed dollar funding got it through their own central bank, which got it from the Fed through the liquidity swap facility. Banks that were short of collateral eligible for discount borrowed directly through the new commercial paper facility. Shadow banks that could not deposit in the Fed instead bought Treasury bills, and the Treasury deposited the proceeds at the Fed.
Once we think about the Fed’s balance sheet expansion in this way, the doubling seems in fact rather small. After all, the wholesale money market is much larger than the mere trillion or so that Fed took on. Deleveraging provides one answer why the expansion was not even larger. But the deeper answer, I think, comes from an appreciation that the Fed was acting as lender of last resort, and in doing so supporting continued lending in the private money market that would otherwise have frozen. In effect the Fed was offering a standing facility at prices away from market prices, so only those who most needed it took advantage. Simply knowing it was there made others willing to deal privately at more reasonable prices.
Thus, the commercial paper lending facility expanded and then contracted as private lending recovered. The central bank liquidity facility has followed a similar course. The important thing to realize is that, as these temporary liquidity facilities have wound down, the Fed has ramped up additional facilities, now aimed at restarting the securitized lending system more generally.
In sum, QE1 was a legitimate bank lender of last resort operation. The Fed did not use a Bagehot rule in applying its liquidity programs i.e. lending only to solvent but illiquid financial institutions at a penalty rate of interest. The Fed lent freely, but at a low rate, on dodgy collateral. So while the Fed’s actions were absolutely necessary in its capacity as bank lender of last resort. Its implementation was exceedingly poor.
Now, before the Fed embarked on its third easing campaign last year, I wrote a synopsis of the differences between QE1, QE2 and QE3 which I think draws a good distinction between the different kind of liquidity operations that central banks use during financial panics. There I write that:
The second round of quantitative easing was distinct from the first – and more akin to what the Japanese had done. The aim was to support economic activity in the US domestic economy.
The same is true of the third easing round, which I dubbed rate easing and predicted would occur in the post. This was an operation in support of the Fed’s dual mandate, one that the ECB does not have. Therefore QE2 and QE3 style operations are unlikely to occur in the euro zone.
Quantitative Easing in Europe
But QE1 will have to happen in Europe to avoid euro zone breakup and economic collapse because the ECB has been boxed into a corner.
When the Italian crisis hit late last year, I believed the ECB would be forced to intercede because of the size and importance of the Italian economy. The logic is clear. Running through Italian default scenarios makes clear that questioning Italy’s solvency leads inevitably to monetisation. We have seen this monetisation via the ECB’s own alphabet soup of liquidity programs – the SMP and the LTRO. But this was never going to be enough because credible lenders of last resort use price, not quantity signals. As I wrote during the Italian crisis:
For the ECB, it’s not about buying up Italian debt or Greek debt. It’s about credibly defending specific financial assets as the monopoly supplier of reserves with a specific target price. Central banks are price-targetting monopolists. They can only be effective if they realise this affects everything they do. The role of the lender of last resort is about price, not quantity.
The ECB becomes more explicit about its backstops: As I write this, Italian interest rates are now edging over 7%. The question, especially when the Italians have to roll over so much debt, is how do they continue on in that environment? The answer is they can’t. If Italian yields stay at 7% for too long, everyone not just some bond investors will start to believe they are essentially bankrupt. That gets you into Greece territory. Bottom line: the ECB will then face a stark choice. Make their Italian backstop more explicit or go through a debt deflationary and depressionary crisis and cease to exist as an institution as the euro unwinds. I think they will choose inflation.
Here’s how I said the ECB should go about it last month. I call it the ECB’s Bagehot Rule Policy:
Previously, this column argued that it was folly for the euro zone to take the bailout and austerity approach because it risked breaking the entire euro zone apart. Here, this column continues with a prescriptive outline of how the ECB can best meet its institutional mandate to help the euro survive by implementing a rules based-approach to providing emergency liquidity.
The ECB will make a standing offer while sovereign bond markets are disrupted to buy any euro area financial institution’s euro area sovereign debt at the prevailing lowest benchmark euro area rate for a security of the same maturity duration plus a penalty based on the debts and deficits of the sovereign debtor backing the bond to be purchased. The penalty could be 40 basis points for each ten percent over the 60% Maastricht Treaty debt hurdle, for example. For Italy that would mean 240 basis points over Bunds for the debt ratio alone. Deficits would also incur a cost of 40 basis points for each percent over the 3% Maastricht Treaty debt hurdle. A federal budget deficit of 10% of GDP would mean a 280 bp penalty.
As with the policy rate guarantee that central banks set, the ECB would not have to necessarily buy any government debt to police this rate. The ECB would guarantee a rate and let the markets move interest rates to that level or below. Of course, the ECB would promise to defend the rate(s) if and when necessary. The ECB could be tested initially, but it has an unlimited supply of liquidity, so I would expect the balance sheet effects for the ECB to be muted. The ceiling rate is not supposed to be a proxy for the ‘correct’ interest rate. It is a ceiling, a penalty rate above where functioning market with ample liquidity would set rates. We want the market to set the rate, not the ECB. So, in practice, the ECB would always buy bonds at a spread level below the ceiling rate.
Under these guidelines, Greece would have had an extremely high hurdle and would have still needed a debt restructuring. Spain and Italy too would have hurdles of 300-350 basis points based on their combined debt and deficit numbers.
The ECB doesn’t have to use 40 bps for the Bagehot rule.; it could use 50 or 75 bps. The point is to have a rule and to apply it in a way that satisfies the aims of the Maastricht Treaty.Remember, investors will buy Italian bonds after ECB monetisation because the only reason not to buy them at a huge premium over Bunds is because they do not have an explicit ECB backstop. Once the backstop is in place, investors will pile in without the ECB having to buy lots of paper.
My suspicion is that the ECB may not follow a rules-based approach like this but rather an ad-hoc approach like the Fed, which provides insolvent financial institutions with liquidity and which doesn’t discriminate between good and dodgy collateral. Moreover, any ECB activism is destined to be fought tooth and nail by those that want to punish so-called fiscal profligates without any support. But my sense is that we are at a momentous moment in the history of the euro zone. The ECB is about to go all-in. Other players are going to call its bluff. It has the cards to beat back bond investors; after all it has unlimited liquidity since it can print money. But it may not have the cards to beat back the political uproar its actions would cause. If it does have the cards, the euro zone will continue. If not, it will break apart entirely.