Mario Draghi, December 8, 2011. Image by Getty.
Will the European Central Bank save the eurozone? This is an extremely controversial question. What is clear, however, is that the central bank is the only entity with the capacity and the calling to do so. Without the euro, the ECB ceases to exist. That is true of no other eurozone institution. It gives it the incentive to act. It is also acting on a large scale.
The resistance to funding governments by purchasing bonds on a large scale, even in secondary markets, remains strong, as Mario Draghi, the new president of the ECB made plain in his interview with the FT on December 18.
Nevertheless, he argued, the ECB took important action the week before:
“We cut the main interest rate by 25 basis points. We announced two long-term refinancing operations, which for the first time will last three years. We halved the minimum reserve ratio from 2 per cent to 1 per cent. We broadened collateral eligibility rules. Finally, the ECB governing council agreed that the ECB would act as an agent for the European Financial Stability Facility (EFSF).”
Thus the ECB is determined to fund banks freely, at low rates of interest, thereby subsidising them directly and the governments they lend to, indirectly.
Why lending to banks that use the money they borrow to lend to governments is good, while lending to governments directly is bad, is hard to understand. The only obvious difference is that in the case of lending via banks, the intermediaries may themselves go broke. That makes them unavoidably unreliable conduits. Yet if this complex procedure gets round theological objections to direct financing of governments, those who believe some financing of governments is now needed should be content.
In short, the recent decisions of the ECB look like a clever way of relieving the funding constraints suffered by banks and vulnerable sovereigns. This does not redress solvency concerns directly, though the subsidy may be large enough to make a difference even here, particularly for the banks. But it should mitigate – if not eliminate –liquidity constraints, which have proved of rising importance over the last year and half.
Yet the role being played by the ECB is controversial, particularly in Germany, the principal financier. The newly expanded role put in motion by Mr Draghi will surely make it more controversial still.
The best critical discussion of what is going on continues to be by Hans-Werner Sinn of the Ifo Institute in Munich. He has provided an up-to-date analysis, jointly with Timo Wollmershäuser in a recent paper for the National Bureau of Economic Research.*
In essence, his analysis does two things.
First, the analysis correctly describes what is happening in the eurozone as a set of balance of payments, not fiscal, crises. The problem in the vulnerable countries is not that the governments can no longer finance themselves on reasonable terms from voluntary private lenders: it is that few of the would-be borrowers in these economies, be they private or public, can readily finance themselves. This then is a crisis of public and private borrowers who are, as is always the case, tied closely together.
Second, the analysis explains that what we are seeing, in response, is a remarkable example of monetary financing of the balance of payments via the so-called TARGET (Trans-European Automated Real-Time Gross Settlement Express Transfer) system of the European system of central Banks. This has allowed the central banks in vulnerable countries to create money with which to pay both current and capital account claims. Over time, the central banks of creditor countries are accumulating vast claims on the central banks of debtor countries (see chart). These covert forms of finance are, notes Professor Sinn and his co-author, far more important than the finance provided by governments, including the International Monetary Fund. They seem sure to become more important still.
What are these TARGET balances and how do they arise? The simplest way of thinking about this is as follows. Consider a country that is running a large current account deficit financed by voluntary bank lending from the counterpart surplus countries. Then residents of the deficit country send more money to the bank accounts of residents of the surplus country than they receive in return, in settlement of their net spending on goods and services. This current account deficit is then financed, in turn, by lending by the residents of the creditor country to residents of the deficit country. The monetary accounts balance. That was, more or less, the position before the crisis.
After the crisis, the flow of voluntary lending largely dried up. The buyers could no longer finance their purchases of goods and services. Without external assistance, they would have had to slash their spending on goods and services from abroad. That would have caused a depression in their economies. Moreover, as the foreign funds were cut off, the lending that had fuelled asset price bubbles disappeared. Asset prices collapsed and banks became insolvent. So, in addition to the need to finance the ongoing current account deficits, there was also, in some cases, capital flight or, put more neutrally, a huge net private capital outflow.
How then are these huge current account and net private capital outflows financed? The answer is via the monetary “printing press”.
National central banks provide their banks with the funds needed to offset the money their residents send abroad, as they pay more for imports than they earn from exports and, instead of being financed voluntarily from abroad, as before, now start to send a large part of their money out of the domestic financial system. This money then ends up in the commercial banks of the surplus countries, which deposit it at their own central banks. In essence, base money is being created in deficit countries and used to pay for goods and services from – and flight capital to – surplus countries.
These net flows of money then end up as liabilities of the central banks of the surplus countries to their own banks. The offsetting shift in the books consists of rising claims of the central banks of the surplus countries (above all, of the Bundesbank) on the central banks of the deficit countries.
Suppose the monetary system was based on sea shells. Then we could imagine that the residents of, say, Greece, collected shells that they used to pay for Mercedes cars bought from Germany. Since the producers of Mercedes cars do not spend all the shells they receive, they leave them in their banks, which hold them as monetary reserves. Over time the shell reserves in Germany become bigger and bigger.
As the paper notes, this is rather similar to what ended the Bretton Woods monetary system in 1971. Then the Federal Reserve created money that ended up in Europe. What broke the system was the decision of the French government to demand gold – the accepted means of settlement – in return for its dollars. But the US did not have enough gold and had no intention of deflating its economy sufficiently to remedy this lack. It went off gold, instead.
In sum, as the paper notes, “the ECB forced a public capital export from the core countries that partly compensated for the now reluctant private capital to, and the capital flight from, the periphery countries”. According to the paper, the TARGET system financed the current account deficits of Greece and Portugal, over-financed Ireland, because of capital flight, and under-financed Spain, which was still able to attract private inflows of capital.
What are the implications of this way of funding the balance of payments deficits in vulnerable countries? Here are some possible concerns:
First, the creditor countries are exposed to risk of loss. There is a big debate on whether the potential loss to the Bundesbank depends on its total claims or on its share in the ECB. The answer is that it is formally limited to the latter, but, in the event of a collapse of the eurozone, that might not be relevant, since other member countries might not pay for their shares.
Second, monetary conditions in core countries are no longer determined by central bank policy but by the import of base money. Whether this matters from a eurozone point of view depends on whether the ECB successfully manages monetary conditions for the eurozone as a whole. This should not be much of a problem when the vulnerable countries are relatively small. But as this process of monetary creation by national central banks starts to affect big economies, including even France, monetary control might become harder to achieve. Of course, in the short run, a more expansionary monetary policy would probably be desirable.
Third, while this process has taken care of a large part of the financing of vulnerable countries after the crisis, it blocks needed adjustment. At the same time, if the import of base money creates easy monetary conditions in the core countries, as is likely, this could also facilitate adjustment by ultimately raising inflation above rates in the stricken periphery.
An obvious question is whether such a system of monetary financing is inherent in a monetary union. The answer is: no. The paper argues that such imbalances do not accumulate in the US, because regional members of the Federal Reserve System are forced to settle their accounts in assets they cannot create at will. Of course, doing so in the eurozone today would force governments in the vulnerable countries into bankruptcy, since they do not possess such assets in the requisite scale. Alternatively, they would have to be financed openly via transfers.
The bottom line, then, is that a transfer union already exists. It is run by the ECB and is about to get a great deal bigger. The questions are whether it should be allowed to endure and, if not, what should replace it. Hans-Werner Sinn, has a clear answer: no.
I hope to turn to these hugely important questions in my next post.
