Fiscal dimensions of central banking: The fiscal vacuum at the heart of the Eurosystem and the fiscal abuse by and of the Fed: Part 2

Willem Buiter 24 March 2009

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Why has there not been quantitative easing in the Eurozone? Good question.

No treaty-based obstacle

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 16 Eurozone 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 national central banks).

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 Zimbabwe-ification 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 quantitative easing roses.

There is a material risk that some Eurozone national governments could default

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 20 March 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% 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.

Need for an exit strategy to avoid inflation

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 quantitative easing, unacceptable inflationary consequences are likely. If the reversibility, when needed, is not credible, longer-term inflationary expectations will rise 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 quantitative easing 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 quantitative easing – 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. Either these governments are capable of generating the primary (non-interest) budget surpluses required to make the debt sustainable (and perceived as capable by the markets), or they will default on their sovereign debt.

The option of forcing the central bank not to reverse the quantitative easing 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.

The Fed exit strategy? Or will Congress tell them to inflate away the debt?

I consider the opposite outcome to be more likely for the country with the least independent of the leading central banks – the US. 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.

Double-digit inflation in the US at a horizon of 5 years or more

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 quantitative easing 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 quantitative easing that is unlikely to be reversed when required to maintain price stability should overcome the immediate demand effect of the Fed’s quantitative easing on the prices of longer-term nominally denominated US sovereign debt instruments.

The UK’s exit strategy

The UK is somewhere between the Eurozone and the US as regards central bank independence and as regards the likelihood that current quantitative easing 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 credit easing 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 Eurozone, 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 credit easing 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 credit easing 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 go to the eye doctor. 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.

A dangerously shortsighted belief

That would be dangerously shortsighted. 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 national central banks of the Eurosystem to become universal counterparties for inter-bank lending and borrowing.

Banca d’Italia example

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 Eurozone 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 Eurozone 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 Eurozone, it would be a helpful measure, which would strengthen the Eurosystem rather than threaten to deconstruct it into a collection of imperfectly linked subsystems.

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Topics:  Monetary policy

Tags:  ECB, Fed, quantitative easing

Willem Buiter

Chief Economist of Citigroup and CEPR Research Fellow