Fiscal dimensions of central banking: the fiscal vacuum at the heart of the Eurosystem and the fiscal abuse by and of the Fed

Introduction: central banks need fiscal back-up

Even operationally independent central banks are agents of the state.  And like every natural or legal entity operating in a market economy, the central bank is subject to a(nintertemporal ) budget constraint.  Some central banks are owned by the ministry of finance.  The Bank of England, for instance, is owned 100 percent by the UK Treasury. The ECB is owned by the national central banks (NCBs) of the 27 EU member states. These 27 NCBs have a range of different ownership structures.

The Federal Reserve System is not owned by anyone (conspiracy freaks need not bother writing comments to deny this and to attribute ownership of the Fed to the Queen of England, the Vatican, the Rockefeller family or the Elders of Zion). Most of the operating profits of the Fed go to the US Treasury. The twelve regional Federal Reserve Banks issue shares of stock to member banks. However, owning Reserve Bank stock is quite different from owning stock in a private company.  Ownership of a certain amount of stock is, by law, a condition of membership in the System. The stock may not be sold, traded, or pledged as security for a loan; dividends are, by law, fixed at 6 percent per year (which is a lot better, actually, risk-adjusted, than you would get these days on stock in commercial banks).

Even though central banks can ‘print money’ or create money electronically by fiat, they are constrained in their financial operations by two factors. First, there is a limit to the amount of real resources that can be extracted through the issuance of nominal base money.  The demand for real base money is a decreasing function of its opportunity cost – the short nominal rate of interest.  Increasing the rate of monetary issuance will raise the actual and expected rates of inflation, putting upward pressure on the short nominal rate of interest.  Empirically, at sufficiently high rates of expected inflation, the demand for real base money declines more than proportionally with a further increase in the rate of inflation: there is a ‘seigniorage Laffer curve’.  Hyperinflations, where the inflation tax rate increases without bound but the inflation tax base goes to zero even faster, are the most dramatic example of that.

Unexpected inflation can raise inflation tax revenues.   It can erode even more dramatically the real value of long-maturity nominal fixed-interest debt, private and public.  But systematic surprises tend to be beyond the ken of the monetary authorities.

There is therefore a strict limit to the monetary authority’s capacity to service foreign currency debt or index-linked debt, if the only resources it has at its disposal are derived from seigniorage.

Second, a central bank with a price stability mandate is likely to be constrained in its ability to extract more resources through seigniorage by the fact that, even when it operates on the upward-sloping segment of the seigniorage Laffer curve, the real resources it needs for financial survival may only be extracted at an inflation rate well above its target or tolerance level.  In that case, the central bank needs additional resources from somewhere else to meet its price stability mandate.  Although in principle the source of additional capital for the central bank could be charitable donations, in practice, the central bank gets re-capitalised by the Treasury.  Behind every viable and credible central bank with a price stability mandate stands a fiscal authority – the only economic entity with non-inflationary long-term deep pockets.

Fundamental problems arise when there is uncertainty about the fiscal back-up of the central bank, as there is in the case of the ECB and the Eurosystem .  Other, but equally fundamental problems arise when the central bank, voluntarily or under political pressure, engages in risky financial transactions on behalf of the Treasury, but without a full guarantee from the Treasury for the losses it may incur as a result of these risky quasi-fiscal actions.  This is the case of the Fed today.

Why is the ECB so timid when it comes to taking direct credit risk?

The ECB are fiddling while the Eurozone burns.  Both the Bank of England and the Fed have started quantitative easing (QE, that is, purchases of longer-dated government securities financed by increasing the monetary base), albeit on a modest scale, especially in the US.  Japan, which pioneered QE, is at it again.  Switzerland has engaged in a special kind of quantitative easing, involving not the purchase of Swiss government securities but the purchase of foreign exchange reserves.  Such non-sterilised foreign exchange market intervention is a form of QE which is targeted specifically at the exchange rate.  Sweden is about to join the QE club.  Canada may not be far behind.

The Bank of England’s £150 bn Asset Purchase Facility (APF) gives it the option of buying up to £50 bn worth of private securities, and therefore also of buying at least £100 bn worth of government securities.  The Bank of England has announced that it aims, for the time being, at making £75 bn worth of asset purchases under the APF, most of them in the form of gilts purchases. The Fed has announced purchases of up to $300bn worth of US Treasury securities – a small number, but a start. Credit easing (CE) or qualitative easing – the outright purchase by the central bank of private securities – has been a part of the Fed arsenal since it started purchases of commercial paper in 2008.  The recent announcement that it will double its mortgage-debt purchases to $1.45 trillion indicates the scale of its ambitions on the CE front. The Bank of England is expected to start purchasing corporate securities soon.

No sign, however, of any QE or CE by the ECB.  When challenged on this, the ECB points to what it is doing.  In particular, it makes available unlimited credit at maturities from one week to six months – against eligible collateral – at the official policy rate, now 1.5 percent .  This is good, but not good enough.  The maturity for which such credit is extended should be extended to one year, 18 months and two years.

The ECB also has a very liberal definition of eligible collateral – effectively anything that does not move (and a few things that do) is eligible as collateral, as long as it originates from within the Eurozone, is euro-denominated and is rated at least BBB-. Indeed the Eurosystem has since the crisis started accepted increasing amounts of rubbish collateral, exposing it to serious private sector credit risk (default risk) on its collateralised lending and reverse operations.  For reverse transactions and collateralised lending, default risk is the risk that both the borrowing bank will default and that the collateral offered by the bank will go into default.

The Eurosystem’s willingness to provided unlimited security at the official policy rate (OPR) of 1.5 percent has flooded the system with short-term liquidity to such an extent that the unsecured overnight interbank rate is now close to the ECB’s deposit rate of 0.5 percent (the deposit rate is the rate at which banks can deposit funds overnight with the Eurosystem).  The difference between the effective overnight interbank rates in the Eurozone, the UK and the US  is therefore much smaller than the difference between the OPRs (1.5 percent, 0.5 percent and 0 to 0.25 percent respectively).

Why no QE in the Eurozone?

Good question.  There is no Treaty-based obstacle to the ECB/Eurosystem buying Eurozone government securities in the secondary markets.  Indeed, both the ECB and the 16 national central banks of the Eurosystem hold Eurozone government securities on their balance sheets.  Article 101.1 of the Consolidated version of the Treaty Establishing the European Community reads as follows:

“Overdraft facilities or any other type of credit facility with the ECB or with the central banks of the Member States (hereinafter referred to as ‘national central banks’) in favour of Community institutions or bodies, central governments, regional, local or other public authorities, other bodies governed by public law, or public undertakings of Member States shall be prohibited, as shall the purchase directly from them by the ECB or national central banks of debt instruments.”

So, no ‘ways and means advances’ to national governments and no direct purchases by the Eurosystem of Eurozone government debt in the primary issue market, but nothing about the secondary market.  Governments sell their debt to any party other than the Eurosystem, and the Eurosystem can buy any amount of this debt from these parties in the secondary government debt markets.  There is the minor complication of deciding on how much of each of the 16Eurozone governments’ debt to buy, but resolving that should take no more than five minutes.  Obvious national government debt shares in some sovereign debt basket purchased by the Eurosystem would be the shares of these nations’ central banks in the capital of the ECB (normalised for the share of the 16 Eurozone member states in the total capital of the ECB, which is owned by all 27 EU member state NCBs).

So why aren’t they doing this?  Probably because of the intergenerational transmission of memories of Weimar in the case of some of the ECB Executive Board members and for some NCB governors, that is, because of the fear that ‘printing money’ or its electronic counterpart will ultimately lead to the Zimbabwefication of the Eurozone.  I am one of nature’s great pessimists, always ready to see a dark lining around a silver cloud, but the fear that unbridled monetisation of public debt and deficits in the Eurozone would tip the region into high inflation, or even hyperinflation, does not exactly keep me awake at night.  The risk of deflation, on the other hand, is serious.  Time to wake up and smell the QE roses.

Perhaps a reason for the reluctance of the Governing Council to start large-scale purchases of sovereign debt is that there is a material risk of default on the debt of some Eurozone national governments.  The March 20, 2009 spreads of 10-year government bonds over Bunds were 2.76% for Ireland, 2.66% for Greece, 1.50% for Portugal, 1.27% for Italy and 1.04 percent for Spain.  In addition, sovereign CDS spreads suggest that even the German government’s creditworthiness is not beyond doubt.  Neither of course are the creditworthiness of the US and UK governments.

Because there is a non-negligible risk that, without external support, one or more Eurozone national governments will default on their debt, it is reasonable for the EBC/Eurosystem to insist on a joint and several guarantee by all 16 Eurozone governments for any Eurozone government debt acquired by the ECB.  Indeed, I would extend this requirement for a joint and several guarantee to any sovereign Eurozone debt accepted as collateral by the ECB in its reverse operations and collateralised loans.  Such a joint and several guarantee does not exist at the moment – a reflection of the absence of a fiscal Europe and a fiscal Eurozone.  More about that later.

Finally, it is clear that any large-scale quantitative easing has to be reversed when the economy recovers and the demand for base money returns to levels that are not boosted by the extreme liquidity preference of a panic-stricken banking system. Without such a reversal of QE, unacceptable inflationary consequences are likely. If the reversibility, when needed, of the QE is not credible, longer-term inflationary expectations will be boosted and these inflation expectations, as well as possible inflation risk premia, can raise longer-term nominal and real interest rates.

Credibility of the future reversibility of QE ought not to be an issue for the Eurozone.  The ECB is the world’s most independent central bank.  When it decides it wants to contract its balance sheet again – reverse the QE – it will simply dump the surplus-to-its-requirements government debt into the open market.  The government debt becomes the problem of the respective Eurozone governments again.  These governments are either capable (and perceived as capable by the markets) of generating the primary (non-interest) budget surpluses required to make the debt sustainable or they will default on their sovereign debt.

The option of forcing the central bank not to reverse the QE is not present in the Eurozone, because of the independence-on-steroids of the ECB.  Short of sending a tank column to surround the Eurotower in Frankfurt and blast it into submission, the ECB cannot be forced to monetise government debt against its will.  This is why, given obvious doubt about the ability and/or willingness of some Eurozone sovereigns to pursue and achieve long-term fiscal sustainability, default on the public debt is considered by the markets and by expert observers to be a distinct possibility for some Eurozone nations, but little if any likelihood is attached to the scenario where the ECB colludes in inflating away the real value of Eurozone government debt.

I consider the opposite outcome to be more likely for the country with the least independent of the leading central banks – the USA.  The Fed has always acted like what it is: a creature of Congress: “..the Federal Reserve is subject to oversight by Congress, which periodically reviews its activities and can alter its responsibilities by statute.” More recently, it has also consented to become an off-balance sheet and off-budget dependency of the US Treasury.

If, as I consider likely, the US Federal government will not be able to commit itself credibly to future tax increases or future public spending cuts of sufficient magnitude, US public debt will, during the next two or three years, build up to unsustainable levels.  When faced with the choice between sovereign default and inflating away the real value of the public debt, there is little doubt about the alternative that will be chosen by the US Executive and the US Congress.  The Fed will be instructed to inflate the public debt away.  Either Ben Bernanke or a more pliable successor will implement these instructions.

It is surprising that even at a horizon of 5 years or more, the markets are not yet pricing in a distinct possibility of double-digit inflation in the US.  The announcement of QE in the US did weaken the external value of the US dollar, but long-term sovereign interest rates fell for the maturities targeted by the Fed (two to 10 years) and did not rise materially for longer maturities.  At some point, probably not too far into the future, the future inflation expectations effects of QE that is unlikely to be reversed when required to maintain price stability, should overcome the immediate demand effect of the Fed’s QE on the prices of longer-term nominally denominated US sovereign debt instruments.

The UK is somewhere between the Eurozone and the US as regards central bank independence and as regards the likelihood that current QE will be reversed in time to prevent inflation and inflationary expectations from escalating.  The UK Treasury can take back the power to make monetary policy using the Reserve Powers granted in the Bank of England Act 1998.  This only requires retroactive approval by Parliament.  However, the degree of polarisation of the UK polity and of UK society in general is probably rather less than that of the US.  In addition, because the UK political regime is an elected dictatorship, the UK Executive is subject to minimal checks and balances and may well be able to impose the future tax increases (I am less sure about future spending cuts) required to maintain government solvency without the need to inflate away much of the real burden of the public debt.

Why no CE in the Eurozone?

When asked this question, the members of the ECB’s Governing Council tend to reply that the Eurozone is much more dependent on banks than on capital markets for financial intermediation.  This is in contrast to the US and the UK where the markets-mediated or transactions-oriented model of financial capitalism has achieved a much greater degree of prominence than in the Euro Area, where the relationships-oriented model of financial capitalism still rules the roost.

It is true that banks are a more important source of funds for households and non-financial enterprises in the Eurozone than in the US or the UK.  However, there is an analogue to outright purchases of private securities (the expression of CE in the transactions-oriented model) in the relationships-oriented model.  This is unsecured lending by the ECB/Eurosystem to the banks.  Unsecured lending by the central bank to the commercial banks is the straightforward expression of CE in the relationships-oriented or banking model of financial intermediation.  There is an even more aggressive version of this, which has the central bank lending directly and unsecured, to non-bank counterparties, bypassing the banks completely.

The ECB/Eurosystem are not lending without collateral to the banks, let alone to non-bank counterparties (indeed the ECB/Eurosystem is not lending even with collateral to non-bank counterparties).  The only valid reason for the ECB/Eurosystem not to make unsecured loans to the banks would be that the banking system is in such good shape, and that financial intermediation through the banks remains sufficiently functional, that unsecured lending is redundant.  If that is indeed what the ECB/Eurosystem believe, they should have gone to Specsavers.   It is clear that even those Eurozone member states whose banks were by-and-large not involved directly in the financial excesses that brought us the financial collapse of the north-Atlantic border-crossing banking and shadow-banking system, are now gasping for financial air.  The quality and size of banks’ balance sheets are declining swiftly, as the rapid contraction of real economic activity feeds back on the financial intermediaries.  With both the demand for credit and the supply of credit collapsing, the ECB/Eurosystem may be deriving misplaced comfort from the fact that bank finance is not necessarily the binding constraint on economic activity.

That would be dangerously short-sighted.  First, there are always otherwise viable enterprises for which external finance is the binding constraint on production, employment and investment, even when the surveys indicate that for most firms demand is the binding constraint.  Second, if and when the recovery starts, non-financial enterprises will have to fund their expansion plans to a large extent from external sources – retained profits will be few and far between.   Banks will be more likely to meet these demands from the non-financial enterprise sector if they can fund themselves unsecured through the Eurosystem.

One particularly useful form of unsecured lending by the ECB/Eurosystem to the banks would be for the NCBs of the Eurosystem to become universal counterparties for inter-bank lending and borrowing.  The Banca d’Italia has implemented such a scheme, the MIC, but only for banks with head-offices, subsidiaries or branches in Italy, and for banks from other Euro Area jurisdictions that have reciprocal arrangements for Italian banks. This of course means a deplorable balkanisation of Eurozone monetary and liquidity management.  Indeed, it undermines the essence of the Eurosystem as an institutional arrangement setting and implementing a common monetary policy for 16 Euro Area member states.  It is surprising that the Banca d’Italia has been permitted to create such a distortion of the monetary and liquidity level playing field.

But if a scheme like the MIC were to be implemented uniformly across the Euro Area, it would be a helpful measure, which would strengthen the Eurosystem rather than threaten to deconstruct it into a collection of imperfectly linked subsystems.

The fiscal hole at the heart of the Eurosystem

An entirely valid reason for the ECB/Eurosystem to refuse to engage in either outright purchases of private securities or in unsecured lending to the banking sector (or to the non-financial enterprise sector directly), is that there is no ‘fiscal Euro Area’, just as there is no fiscal EU.  The absence of a fiscal Europe that matters here is a narrow one.  I am not talking about the absence of a significant supranational fiscal authority in the EU (or in the Eurozone ), with significant tax, spending and borrowing powers -one capable of material system-wide fiscal stabilisation and cross-border redistribution.  I am talking instead about two related fiscal vacua.

The first vacuum is that there is no single fiscal authority, facility or arrangement which can re-capitalise the ECB/Eurosystem when the Eurosystem makes capital losses that threaten its capacity to implement its price stability and financial stability mandates.

The second related vacuum is that there is no single fiscal authority, facility or arrangement which can re-capitalise systemically important border-crossing financial institutions in the EU or the Euro Area, or provide them with other forms of financial support.

When the Bank of England develops an unsustainable hole in its balance sheet, Mervyn King knows he only needs to call one person: Alistair Darling, the UK Chancellor of the Exchequer.  If the Fed were to become dangerously decapitalised, Ben Bernanke also needs to call just one person: Tim Geithner , the US Secretary of the Treasury.  It is possible that no-one in the US Treasury will pick up the phone, as none of the senior political appointments below Geithner are in place yet, but Geithner clearly would be the man to call.

Whom does Jean-Claude Trichet call if the Eurosystem experiences a mission-threatening and mandate-threatening capital loss?  Does he have to make 16 phone calls, one to each of the ministers of finance of the 16 Euro Area member states?  Or 27 phone calls, one to each of the ministers of finance of the 27 EU member states whose NCBs are the shareholders of the ECB?   I don’t know the answer, and I doubt whether Mr. Trichet does.

This situation is intolerable.  We need a fiscal Europe, at least at the level of the Eurozone, to fill the first vacuum.  If we are to fill the second vacuum, we need a fiscal Europe at the EU level also.

I see three alternatives. In decreasing order of desirability but increasing order of likelihood they are:

(a)  A supranational Eurozone-wide tax and borrowing authority, specifically dedicated to fiscal backing for the ECB/Eurosystem.

This could be extended to include the provision of financial support to systemically important border-crossing financial institutions.  In that case, the supranational fiscal authority would have to encompass all of the EU, not just the Eurozone. This might require a two-tier authority, with a Eurozone-only tier to back up fiscally the ECB/Eurosystem, and an EU tier for financially backing up systemically important border-crossing financial institutions.

(b) A Eurozone-wide fund, funded by the 16 Eurozone governments (in proportion, say, to their relative shares in the ECB’s capital, that the ECB/Eurosystem could draw on (subject to qualified majority support in the Eurogroup) if it were to suffer losses as a result of Eurozone-wide monetary policy operations, liquidity operations and credit easing operations.  This fund could be capitalised by the 16 Eurozone national Treasuries, say in proportion to their shares in the ECB’s capital.  Around € 2.5 trillion to € 3.0 trillion would  be enough initially to cover the likely losses of the Eurosystem if the downturn is prolonged and deep and requires large-scale credit easing.

As an interesting extra, the fund (let’s call it the Eurosystem Fund) could be allowed to borrow with its debt guaranteed joint and severally by the 16 Eurozone member states.  This is permitted under Article 103.1 of the Treaty:

“The Community shall not be liable for or assume the commitments of central governments, regional, local or other public authorities, other bodies governed by public law, or public undertakings of any Member State, without prejudice to mutual financial guarantees for the joint execution of a specific project. A Member State shall not be liable for or assume the commitments of central governments, regional, local or other public authorities, other bodies governed by public law, or public undertakings of another Member State, without prejudice to mutual financial guarantees for the joint execution of a specific project.”

What gets the camel’s nose of a joint-and-several guarantee in the tent is the reference to “…mutual financial guarantees for the joint execution of a specific project.” What, after all, is a ‘specific project’? Anything can be a project.  To my wife, I am a project.  Certainly the creation of a special fund dedicated to the specific purpose of providing the ECB/Eurosystem with additional capital, should the need arise, would qualify as a specific project.

You could even create the Eurosystem Fund as an activity of the European Investment Bank (EIB).  According to the Treaty’s Article 267: “The task of the European Investment Bank shall be to contribute, by having recourse to the capital market and utilising its own resources, to the balanced and steady development of the common market in the interest of the Community. For this purpose the Bank shall, operating on a non‑profit‑making basis, grant loans and give guarantees which facilitate the financing of the following projects in all sectors of the economy:
(a) projects for developing less-developed regions;
(b) projects for modernising or converting undertakings or for developing fresh activities called for by the progressive establishment of the common market, where these projects are of such a size or nature that they cannot be entirely financed by the various means available in the individual Member States;
(c) projects of common interest to several Member States which are of such a size or nature that they cannot be entirely financed by the various means available in the individual Member States.”

The Eurosystem Fund would fit quite snugly into category (c) above.  The EIB borrows on the international capital markets, under something practically equivalent to a joint-and-several guarantee of the 27 EU member states.  If joint-and-several borrowing by the Fund is considered a bridge too far, each of the 16 Euro Area member states could guarantee just a share of the losses of the Fund equal to its share in the ECB’s capital.

A larger fund, separate from the Eurosystem Fund, could also be set up to provide financial support for border-crossing systemically important financial institutions for the EU as a whole.  Let’s call it the CBF (for Crippled Bank Fund).  We certainly will need something like that to retain meaningful border-crossing banking activity in the EU.  This crisis has reminded us that there is no such thing as a safe bank, even if the bank is sound in the sense that its assets, if held to maturity, could cover its liabilities.  This crisis has also reminded us that there may no such thing as a sound bank any longer, but that is a separate story.

To be viable, a bank needs to be scrutinised by a supervisor/regulator, have access to the short-term deep pockets of a central bank as lender-of-last resort and market maker of last resort, and have access to the long-term non-inflationary deep pockets of a Treasury.  If we are to continue to have meaningful cross-border banking, we will need a European supervisor/regulator for border-crossing banks, and a European fiscal authority or, at least a European fiscal facility like the CBF.

(c) An ad-hoc, hastily cobbled together fiscal burden sharing rule for the 16 Eurozone national governments, to restore the capital adequacy of the ECB/Eurosystem.  This may well be the best we can hope for in practice.  The experience of the Fortis debacle makes me doubt whether it will work.  When the three-country banking and insurance group Fortis (Belgium, the Netherlands and Luxembourg) was about to go under, the authorities of the three countries agreed a joint plan to save the institution as a border-crossing bank, with Belgium putting in 50% of the agreed funds, the Netherlands 40% and Luxembourg 10%.  The agreement lasted less than a week. Fortis was broken up according to the national location of its activities, with the Dutch state buying 100% of Fortis Nederland and Belgium and Luxembourg doing the same for their local subsidiaries.  This repatriation of cross-border banking will become a floodwave if more cross-border banks go under and country A’s tax payers refuse to stand behind the balance sheets of subsidiaries of their banks in countries B and C.

How much fiscal backing do the key central banks have?

The Bank of England

When the Bank of England gets around to making outright private asset purchases, it will do so with an indemnity provided by HM Government to cover any losses arising from the use of the Facility.  This is as it should be. In principle, a central bank should only take the credit risk of its sovereign – the state.  If its monetary operations, liquidity operations or credit easing operations expose it to the credit risk of the private sector, it ought to do so with a full indemnity (guarantee for any losses) from the Treasury.

The Bank of England has a full indemnity for outright purchases of private securities, but not for the private credit risk it assumes through repos and other forms of collateralised lending to banks where the collateral offered consists of private securities.  I believe the UK Treasury should insure – for free – the Bank of England against all losses incurred as a result of the Bank of England taking private credit risk on its portfolio.

The Fed

The Fed does not have a full indemnity from the US Treasury even for its outright purchases of private securities. It has no guarantee or indemnity for private credit risk assumed as a result of its repo operations and collateralised lending.

For the Fed’s up to one trillion dollar potential exposure to private credit risk through the TALF, for instance, the Treasury only guarantees $100bn.  They call it 10 times leverage.  I call it the Fed being potentially in the hole for $900 bn .  Similar credit risk exposures have been assumed by the Fed in the commercial paper market, in its purchases of Fannie and Freddie mortgages, in the rescue of AIG and in a host of other quasi-fiscal rescue operations mounted by the Fed and by the Fed, the FDIC and the US Treasury jointly.

I consider this use of the Fed as an active (quasi-) fiscal player to be extremely dangerous and highly undesirable from the point of view of the health of the democratic system of government in the US.

There are two reasons for this. First, it undermines the independence of the Fed and turns it into an off-budget and off-balance sheet special purpose vehicle of the US Treasury.  Second, it undermines the accountability of the Executive branch of the US Federal government for the use of public resources – tax payers’ money.

As regards the threat to the independence of the Fed (whatever is left of it), first, even if the central bank prices the private securities it purchases appropriately (that is, there is no ex-ante implicit quasi-fiscal subsidy involved), it is possible that, should the private securities default, the central bank will suffer a capital loss so large, that the central bank is incapable of maintaining its solvency on its own without creating central bank money in such quantities that its price stability mandate is at risk.  Without a firm guarantee up front that the Federal government will fully re-capitalise the Fed for losses suffered as a result of the Fed’s exposure to private credit risk, the Fed will have to go cap-in-hand to the US Treasury to beg for resources.  Even if it gets the resources, there is likely to be a price tag attached – that is, a commitment to pursue the monetary policy desired by the US Treasury, not the monetary policy deemed most appropriate by the Fed.

As regards democratic accountability for the use of public funds, even if the central bank has sufficient capital to weather the capital losses it suffers on its holdings of private securities, the central bank should never put itself into the position of becoming an active quasi-fiscal player, nor a debt collector.  The ex-post transfers or subsidies involved in writing down or writing off private assets are (quasi-) fiscal actions that ought to be decided by and accounted for by the fiscal authorities.  The central bank can act as a fiscal agent for the government.  It should not act as a fiscal principal, outside the normal accountability framework.

The Fed  can deny and has denied information to the Congress and to the public that US government departments like the Treasury cannot withold .  The Fed has been stonewalling requests for information about the terms and conditions on which it makes its myriad facilities available to banks and other financial institutions.  It even at first refused to reveal which counterparties of AIG had benefited from the rescue packages (now around$170 bn with more to come) granted this rogue investment bank masquerading as an insurance company.  The toxic waste from Bear Stearns balance sheet has been hidden in some SPV in Delaware.

The opaqueness of the financial operations of the Fed in support of the financial sector (which are expanding in scale and scope at an unprecedented rate) and the lack of accountability for the use of tax payers’ resources that it entails, threaten democratic accountability.  Even if it enhances financial stability, which I doubt, democratic legitimacy and accountability are damaged by it, and that is too high a price to pay.


The ECB has no fiscal back-up.  There is no guarantee, insurance or indemnity for any private credit risk it assumes. This huge error and omission in the design of the ECB and the Eurosystem threatens to make the ECB significantly less effective than the Bank of England and the Fed as regards its capacity to engage in unconventional monetary policy, including QE and CE.

The exposure of central banks to private sector default risk applies, of course, not only to central banks making outright purchases of private securities.  It applies equally to central banks that make loans to the private sector using private financial instruments as collateral. Repos are an example.  The Eurosystem has  taken private sector credit risk onto its balance sheet ever since it was created.  It now accepts a vast collection of private securities as collateral in repos and at its discount window (just about anything issued in euro and in the Eurozone that is rated at least BBB-).

The Eurosystem has already taken some significant marked-to-market losses on loans it made to eligible Eurozone counterparty banks against rubbish ABS collateral. In the autumn of 2008, five banks (Lehman Brothers Bankhaus AG, three subsidiaries of Icelandic banks, and Indover NL) defaulted on refinancing operations undertaken by the Eurosystem.  The amount involved was just over € 10 bn. and over  € 5 billion of provisions have been made against these impaired assets, because the mainly ABS dodgy collateral is, under current market conditions, worth rather less than € 10bn.

Any losses incurred as a result of these defaults are, like all losses incurred by the Eurosystem in the pursuit of its monetary and liquidity operations, to be shared by all 16 national central banks (NCBs) in proportion to their shares in the ECB’s capital.  But while the Eurosystem as a whole shares any losses incurred by its individual NCBs, there is no mechanism for recapitalising the Eurosystem as a whole.

The ECB/Eurosystem is not yet hurting financially, however: the Eurosystem’s  income from monetary policy operations was probably around 28.7 billion euros in 2008.  A high degree of price stability and large denomination notes (including € 500 and  € 200 notes, while the best the US can come up with is a $100 bill)  make the euro the currency of choice for tax evaders and avoiders, money launderers and other criminal elements everywhere.  This makes for massive seigniorage revenue for the ECB and the Eurosystem .  Of course the ECB will tell you that the real reason for the large denomination euro bank notes is a genetic abnormality in the Iberian peninsula, which causes people there to start convulsing if they cannot make home purchases in cash.

The combination of the obvious willingness of the ECB/Eurosystem to take serious private sector credit risk through collateralised lending to banks, and its unwillingness to consider outright purchases of private securities or to engage in unsecured lending to the banking sector is difficult to rationalise.


The ECB/Eurosystem is hobbled severely by the non-existence of a fiscal Europe, and specifically by the absence of a fiscal authority, fiscal facility or fiscal arrangement that can recapitalise it should it suffer losses due to credit risk assumed as part of its monetary, liquidity or credit enhancing policies.

It has the following policy options, provided it is willing to take additional credit risk:

(1) Extend the maximum maturity of the fixed rate credit extended (against eligible collateral) from six months to up to two years.

(2) Engage in unsecured lending to banks, including acting as universal counterparty of last resort in the Eurozone interbank market.  This is credit easing in a bank-mediated credit system – the natural counterpart to the outright purchases of private securities by the central bank in a market-mediated credit system.

(3) Engage in quantitative easing by purchasing a basket of the 16 Eurozone government debt instruments.

(4) Engage in market-mediated credit easing by purchasing private securities outright.

For all these operations (including quantitative easing through the purchase of a portfolio of Eurozone sovereign securities), the ECB/Eurosystem ought to get a full, joint and several guarantee for the credit risk (default risk) involved from the 16 Eurozone national governments.  Without such a guarantee, the ECB/Eurosystem can pursue its financial stability objectives only by risking its capacity to pursue its price stability mandate.

The Fed has compromised its independence and put its ability to achieve price stability in the medium and long term.  It has done so by taking huge amounts of private credit risk onto its balance sheet without a full Treasury guarantee or indemnity.  The opaqueness of many of its arrangements, facilities and operations undermines Congressional and wider public accountability for this vast commitment of public resources.

The Fed should insist on a full Treasury indemnity for any private sector credit risk it assumes.  It should also provide a full account of the ex-ante and ex-post quasi-fiscal subsidies and transfers it has paid to a range of mainly private counterparties.

Maverecon: Willem Buiter

Willem Buiter's blog ran until December 2009. This blog is no longer active but it remains open as an archive.

Professor of European Political Economy, London School of Economics and Political Science; former chief economist of the EBRD, former external member of the MPC; adviser to international organisations, governments, central banks and private financial institutions.

Willem Buiter's website