Last week the Eurosystem performed a €442bn injection of one-year liquidity into the Euro Area banking system. They did this at the official policy rate – the Main refinancing operations (fixed rate) – of 1.00 percent, against the usual collateral accepted for Longer Term Financing Operations, effectively anything euro-denominated, not based on derivatives and rated at least BBB-. It was a fixed-rate tender, that is, the ECB was willing to meet any demand at the 1 percent interest rate, as long as eligible collateral was offered; 1121 banks participated in the operation.
You will not be surprised to hear that this was the largest one-day ECB/Eurosystem operation ever. Even more remarkable than its scale are the terms on which the one-year funds were made available. There can be no doubt that this operation represents both a subsidy and a gift from the Eurosystem to the banks that participated in the operation. I hope to clarify the distinction between a subsidy and a gift in what follows.
For the past week, I have put the Green Shootometer in the garden and have taken regular readings. The upshot is: the glass is definitely half empty – or half full. Let me explain.
Old papers never die, they just get recycled. The Den Uyl lecture I gave in Amsterdam on 15 December 2008 has been under continuous redevelopment since then. Its latest outing was as background paper for a lecture I gave at the 25th anniversary Workshop ” The Global Financial Crisis: Lessons and Outlook”, of the Advanced Studies Program of the IFW, Kiel, Germany, on May 8/9, 2009. The whole current enchilada can be found here. For those with lives, I reproduce below the Introduction, Section 1, the Conclusion and the 16 recommendations in between.
“Never waste a crisis. It can be turned to joyful transformation”. This statement is attributed to Rahm Emanuel, US President Barack Obama’s White House Chief of Staff. Other versions are in circulation also, including “Never waste a good crisis”, attributed to US Secretary of State Hilary Clinton. The statement actually goes back at least to that fount of cynical wisdom, fifteenth century Florentine writer and statesman Niccolo Machiavelli “Never waste the opportunities offered by a good crisis.” Crises offer unrivalled opportunities for accelerated learning.
I believe that the current crisis teaches us two key lessons. The first concerns the role of the state in the financial intermediation process and in the maintenance of financial stability. The second concerns the role of private and public sector incentives in the design of regulation. Unless these lessons are learnt, not only will the current crisis last longer than necessary, but the next big crisis, following the current spectacular example of market failure, will be a crisis of state ‘overreach’ and of government failure. Central planning failed and collapsed spectacularly in Central and Eastern Europe and the former Soviet Union. The next socio-economic system to fail, after the Thatcher-Reagan model of self-regulating market capitalism with finance in the driver’s seat – finance as the master of the real economy rather than its servant – may well be a stultifying form of state capitalism, with initiative-numbing over-regulation and overambitious social engineering.
(1) The autodafé of the unsecured creditors is coming to a US bank near you
A binding budget constraint sure concentrates the mind, even for the US Treasury. There is just one way to make the US government’s policy towards the banks work. That is for the Congress to vote another $1.5 trillion worth of additional TARP money for the banks – $1 trillion to buy the remaining toxic assets off their balance sheets, and $0.5 trillion worth of additional capital. The likelihood of the US Congress voting even a nickel in additional financial support for the banks is zero.
There is no real money left in the original $700 bn TARP facility – somewhere between $ 100 bn and 150 bn – to do more than stabilise a couple of pawn shops. The Treasury has been playing for time by raiding the resources of the FDIC (which, apart from the meagre insurance premiums it collects, has no resources other than what the Treasury grants it) and of the Fed. The Fed has taken an open position in private credit risk to the tune of many hundreds of billions of dollars. Before this crisis is over, its exposure to private sector default risk could be counted in trillions of dollars.
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.
Nobody home in Washington DC
Since the Obama administration took over on January 20, the US Treasury has effectively been out to lunch. As widely reported (see e.g. this account in the Financial Times), Sir Gus O’Donnell (as cabinet secretary the top UK civil servant) has attacked the “absolute madness’ of the US spoils system, where a new Federal administration replaces the entire top stratum of the civil service with new officials possessing the right political connections and leanings. Quite a few of these top officials need to be confirmed before they can start working. This can take months. Many of the new officials have no political, government or administrative experience and spend most of their first months in office trying to figure out where the washroom is instead of designing and implementing policy.
It is a system designed to produce protracted policy paralysis. Often this does not matter much. It may even be helpful to the greater good at times – “That government is best which governs least.” – but in times of war and deep economic crisis, when the world we thought we knew may be falling apart, it is not a bad idea to have a government that can both think and act. The current US administration neither thinks nor acts much, judging from the results.
The discussions around the family dinner table in the Buiter-Sibert household are about to become even more fascinating for the adults and even more mind-numbingly tedious for the children. My wife, Anne Sibert, has just been appointed an external member of the provisional Monetary Policy Committee of the Central Bank of Iceland (CBI). The five-member provisional MPC has three executive or internal members: CBI Governor Svein Harald Øygard, Deputy Governor Arnór Sighvatsson and Þórarinn G. Pétursson, the CBI´s Chief Economist, and two external experts, Anne Sibert and Gylfi Zoëga. This Monetary Policy Committee will operate on a provisional basis, with formal appointments for the next five years likely to be made following national elections in Iceland in April.
Iceland’s largest three internationally active banks collapsed during the autumn of 2008; its currency collapsed and tight capital and foreign exchange controls are now in place. That this was the likely outcome of Iceland’s unsustainable credit boom and banking sector over-expansion had been predicted in a paper by Anne Sibert and myself, written in April 2008 (for fruit flies, a shorter version can be found here).
The country now faces an extremely difficult and painful restoration of internal and external balance, with high and rising unemployment, declining activity and falling living standards. Even the best-designed and competently-implemented monetary and exchange rate policies cannot alter that sombre reality. But competence and courage can help avoid unnecessary, avoidable economic distress and dislocation, thus minimizing the economic cost and human suffering that are bound to follow what may well have been (relative to size of the underlying economy and population) the biggest banking boom and bust in history.
The Obama administration today unveiled the Homeowner Affordability and Stability Plan – measures to help financially challenged homeowners to avoid foreclosures. The program has three key components. The first is $75 bn of Federal government money to subsidise the modification of home loans (I believe $50bn of this was already in Treasury Secretary Geithner’s earlier announcements on the Financial Stability Plan). The Federal government is also making an additional $200 bn of capital available to Fannie Mae and Freddie Mac, so they can expand their mortgage lending and guarantee activities. The second is to “Institute Clear and Consistent Guidelines for Loan Modifications”: a standardized framework for dealing with troubled mortgages. The third is an overhaul of bankruptcy laws to allow judges to force the writedown of principal on mortgages for bankrupt homeowners or to force lenders to reduce mortgage rates.
When Iceland’s banking system and currency collapsed last September, a key component of the emergency package that was introduced under the auspices of the IMF were controls on capital outflows, implemented through rigorous foreign exchange controls. This made sense. The currency was in free fall. The foreign exchange markets had seized up. There was no level of domestic interest rates the Central Bank of Iceland (which had zero credibility at this stage) could set that would induce domestic and foreign investors to hold on to their Icelandic kroner rather than converting them into euro, US dollars, sterling or any other serious convertible currency.
Capital controls in CEE
Iceland is about to have company. The most likely candidates for the imminent imposition of capital controls are in Central and Eastern Europe (CEE) and among the CIS countries. We can expect to see capital controls imposed even by some of the EU members from Eastern Europe that have not yet adopted the euro as their currency (the Baltics, Bulgaria, the Czech Republic, Hungary, Poland, and Romania).
Dr Fabrizio Saccomanni, Director General of the Banca d’Italia (the Central Bank of Italia) and I have been engaged in a bit of a ding dong in the ‘Letters to the Editor’ section of the Financial Times. The issue is whether a recently established collateralised interbank lending scheme (the MIC) promoted by the Banca d’Italia (1) represents a balkanisation of the monetary policy implementation and liquidity management of the Eurosystem (the European Central Bank and the 16 national central banks (NCB’s) of the Eurozone member states), and (2) involves the Banca d’Italia assuming credit risk and therefore potentially implies the need for recourse by the Banca d’Italia to the Italian sovereign, through the Italian Treasury.