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.

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.

Introduction

“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.