This week I am doing the weekly newsletter in two parts, both outside the paywall. This is part two.
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 banking – sovereign nexus
A major difficulty in the eurozone crisis is the connection between distress in national banking systems and national governments within the eurozone. We have witnessed repeatedly that market distress at the bank level has spilled over into distress at the national level and vice versa. For example, in Spain now, the undercapitalisation of the banking system has led Spanish sovereign debt to sell off and now the worry has moved from bank insolvency to Spanish national insolvency. Indeed, because European governments are not self-funding issuers of currency, this connection between banks and national governments can lead to an unnecessary national insolvency very quickly. The ECB, as issuer of currency, plays a fundamental role as a bank lender of last resort, making it the only entity which can break the banking-sovereign nexus. This column is an attempt to present a rules-based framework that the ECB could use to provide liquidity to banks in a way that decouples banking system distress from problems at the fiscal level.
Limitations of the ECB
In November, I listed a verbatim copy of a number of the articles of the Lisbon Treaty guiding the political economy of the euro zone. I believe these are the most relevant parts of the Lisbon Treaty governing how the EU is supposed to operate legally pertaining to ECB intervention in the sovereign bond market. The overarching question is under what circumstances and in what capacity is the ECB supposed to intervene.
As laid out in Article 127 of the Lisbon Treaty, "[t]he primary objective of the European System of Central Banks… shall be to maintain price stability". This article also states that:
The basic tasks to be carried out through the ESCB shall be:
– to define and implement the monetary policy of the Union,
– to conduct foreign-exchange operations consistent with the provisions of Article 219,
– to hold and manage the official foreign reserves of the Member States,
– to promote the smooth operation of payment systems.
Further, Article 127 does give the European System of Central Banks wide discretion when it states:
The ESCB shall contribute to the smooth conduct of policies pursued by the competent authorities relating to the prudential supervision of credit institutions and the stability of the financial system.
The Council, acting by means of regulations in accordance with a special legislative procedure, may unanimously, and after consulting the European Parliament and the European Central Bank, confer specific tasks upon the European Central Bank concerning policies relating to the prudential supervision of credit institutions and other financial institutions with the exception of insurance undertakings.
The question, therefore is how much discretion should the ESCB be allowed "to promote the smooth operation of payment systems" without compromising ECB or ESCB independence as defined in Article 130 that reads as follows:
When exercising the powers and carrying out the tasks and duties conferred upon them by the Treaties and the Statute of the ESCB and of the ECB, neither the European Central Bank, nor a national central bank, nor any member of their decision-making bodies shall seek or take instructions from Union institutions, bodies, offices or agencies, from any government of a Member State or from any other body. The Union institutions, bodies, offices or agencies and the governments of the Member States undertake to respect this principle and not to seek to influence the members of the decision-making bodies of the European Central Bank or of the national central banks in the performance of their tasks.
Goals of ECB Liquidity Operations
I would submit that the goals of the ECBs crisis liquidity operations are designed "to promote the smooth operation of payment systems" by operating as the euro area’s banking system lender of last resort.
Let me caution in defense of the ECB that:
central bankers always prefer to force elected officials to make the tough political choices that are the essence of fiscal policy. The fiscal agent adds and subtracts net financial assets in the private sector by deficit spending, or cutting spending and raising taxes. Central bankers want the fiscal agent to use these tools as the driver of macroeconomic policy while the monetary agent is tasked with more narrow aims.
In the US, the monetary agent, the Federal Reserve, has a dual mandate for price stability and full employment, and therefore has some political legitimacy as a quasi-fiscal agent. Even in the US, you hear Fed Chair Ben Bernanke stating very clearly that he does not want to do more and that he wants the fiscal agent to take on the principal policy burdens for maintaining full employment. The European Central bank has one mandate, price stability. And that means it is much more reluctant to step into a quasi-fiscal role.
So when Mervyn King talks about the ECB “buying sovereign debt of national countries, which is used and seen as a mechanism for financing the current-account deficit of those countries”, he is talking about a policy choice that helps the national governments achieve their fiscal aims, a quasi-fiscal role.
The ECB has balked at doing this – rightly so, I might add (in a brief role as policy advocate). Their position is that the fiscal agent is elected by a democratic process and must solely take on the responsibility of achieving macroeconomic objectives outside of price stability.
The ECB is a banking system lender of last resort. It is specifically prohibited from taking instructions from national governments in furtherance of the fiscal aims of those governments. And so, the ECB is not a government lender of last resort.
Nevertheless, euro area sovereign bonds are indeed a major source of collateral for euro area banks. And as such, the ECB is mandated in its role promoting the smooth operation of payment systems to intervene in these bond markets in order to fulfil its role as banking system lender of last resort. It has done so. However, the ECB’s interventions have been politically-charged with some arguing that the manner in which the ECB has conducted its liquidity operations violates the ECB’s mandate as set out in the Lisbon Treaty. This is troubling. And I therefore suggest the ECB should move away from an ad-hoc approach to providing banking system liquidity and move to a rules-based approach.
The Bagehot Principle
"Before we had much specific experience, it was not easy to prescribe for this compound disease; but now we know how to deal with it. We must look first to the foreign drain, and raise the rate of interest as high as may be necessary. Unless you can stop the foreign export, you cannot allay the domestic alarm. The Bank will get poorer and poorer, and its poverty will protract or renew the apprehension. And at the rate of interest so raised, the holders—one or more—of the final Bank reserve must lend freely. Very large loans at very high rates are the best remedy for the worst malady of the money market when a foreign drain is added to a domestic drain. Any notion that money is not to be had, or that it may not be had at any price, only raises alarm to panic and enhances panic to madness. But though the rule is clear, the greatest delicacy, the finest and best skilled judgment, are needed to deal at once with such great and contrary evils."
-Walter Bagehot, Lombard Street
The dictum distilled from Walter Bagehot’s analysis is called the Bagehot Rule: lend freely only to illiquid but fundamentally solvent institutions, at penalty rates and against good collateral. This is what the ECB must do. As I see it, they have a number of goals to promote the smooth operation of payment systems in so doing.
Goals
- To provide liquidity only to illiquid but fundamentally solvent euro area financial institutions when markets are disrupted;
- To break the link between the sovereign debt crisis and poor banking liquidity that now exists within the euro zone;
- To maintain a rules-based system for differentiating between the credit profiles of euro are sovereign bonds that does not rely on ratings agencies;
- To enforce these rules via a mechanism that penalises the use of lower quality collateral;
- To reduce the need for ECB to undertake programs like the SMP, which force the ECB to buy sovereign debt;
- To eliminate the political charge associated with programs like the SMP that some construe as facilitating borrowing by indebted euro area member state governments;
- To punish unwanted speculation in government bonds and associated derivative markets
The ECB Ceiling Spread
The best way to meet the seven goals described above while still following the Bagehot rule is to provide "penalty ceiling spreads" for sovereign bond collateral. I believe I am the first to have broached this mechanism as a possibility. When I wrote in July 2011 that:
The ECB could do rate easing. Frankly, I am uncomfortable with any kind of easing but I certainly see some legitimacy in the ECB acting as a lender of last resort here. The ECB would ‘guarantee’ a rate for Italian bonds that is high enough to be a Bagehot penalty spread to Bunds but low enough that it effectively acts as a lower bound for a positive nominal GDP target. This would be liquidity at a penalty rate, say 200 bps to German Bunds, which would be 4.7% right now.
In practice the ECB would want to step in at unpredictable times and buy up sovereign issues below the guarantee rate to ‘punish’ speculators and police the guarantee this way.
As I explained four months later during the Italian crisis:
If a central bank guarantees investors credibly that they can invest in certain debt instruments and not suffer principal or interest repayment risk, but only currency and inflation risk, some investors are almost definitely going to buy the debt instruments with the greatest yield pick up. Put another way, the only reason not to buy Italian debt at 2 or 300 basis points over Bunds, or Greek debt at 3 or 400 basis points over Bunds is because those governments are not credibly backstopped by the ECB.
Credible lenders of last resort use price, not quantity signals. They set price targets for liquidity operations, not quantity targets. As Bagehot first outlined, they decide what penalty price they are willing to offer for a specific piece of collateral in exchange for a loan. They do not simply offer cheap loans to one and all, irrespective of solvency and collateral quality.
Proposal
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.
How does this meet the ECB’s mandate?
Instituting the Bagehot Principle for euro area sovereign bond markets promotes the smooth operation of payment systems while simultaneously fulfilling the seven goals I outlined above. Specifically, the benefits are:
- The ECB provides liquidity only to illiquid but fundamentally solvent euro area financial institutions when markets are disrupted. The EC and national governments will still be forced to recapitalise insolvent institutions that cannot use this liquidity facility. The debate now for insolvent banking systems like Spain’s is who will foot that bill and provide regulatory oversight. According to Lisbon’ Treaty’s Article 127, "[t]he Council… may… confer specific tasks upon the European Central Bank concerning policies relating to the prudential supervision of credit institutions and other financial institutions…"
- The ECB breaks the link between the sovereign debt crisis and poor banking liquidity. If Spain were able to achieve a debt to GDP of 90% and a deficit of 6% before its debt situation stabilised, that would mean a ceiling spread of 240 basis points, something that takes the country out of the danger zone. This would mean that the crisis in Spain would not necessitate a sovereign bailout nor would it have contagion effects to Italy or elsewhere. it would be specific to Spain.
- The ECB would break dependence on the ratings agencies. In setting up a rules-based system for differentiating between the credit profiles of euro area governments, the ECB would make the decisions of the ratings agencies less relevant and politically charged. These ratings would become the opinions that they are legally designed to be.
- The ECB would follow the Bagehot Rule by penalising the use of lower quality collateral. Although the ECB is promising to buy the sovereign bonds at a specific price, this mechanism could alternatively be seen as a collateral arrangement whereby the ECB accepts the bond as collateral in return for a loan. Doing this at penalty rates for governments not adhering to Maastricht guidelines is in spirit both with the Bagehot rule and the aims of the Lisbon Treaty.
- The ECB would not have to actually print money. The ECB would guarantee a rate. The markets would move interest rates to that level or below. The SMP would be obsolete, defusing much of the political debate around the ECB’s operations.
- The ECB would eliminate unwanted sovereign debt and sovereign CDS speculation. Many politicians in the euro zone have complained that this crisis has been driven by speculators, hedge funds and short-term oriented investors. Because the ECB lets the market set the interest rate by buying below the penalty ceiling, it discourages any speculators from trying to make a short-term profit at everyone else’s expense.
My thoughts
While I have put this proposal together based on some ideas I have had for a while about how the euro zone could overcome this crisis, I must admit I do not anticipate Europe will embrace anything like it. My view is increasingly that politicians in Europe’s core countries have embraced a faulty and moralistic view of this crisis in which the current account debtors are to blame and the current account creditors are not. This has led to remedies that see debtors ‘punished’ for their moral turpitude and attempts to change the debtors so that they can behave more like the creditors.
To my mind, this framing of the problems and solutions is destructive and has led to economic nationalism and an incipient debt deflation. If it is not stopped, it will lead to the euro zone’s breakup and economic destruction. It is my hope that Europe’s leaders see this and take a fresh approach. it is my belief that they will not.