Here‘s a link to my speaking notes for a talk that I gave tonight at the McGill Summer School. The session’s thought-provoking title was “With Huge Debt and Resulting Austerity, Is Serious Economic Growth Possible?”
Everyone knows central banks are powerful. When I used to visit Alan Greenspan’s office back when I worked for the Fed, he had a sign that said “The buck starts here.” As powerful tools go, there’s nothing that quite beats the power to print money.
So it goes without saying that ECB President Mario Draghi is powerful. He decides how much money is printed in Europe and what the cost of borrowing that money will be. But dig deeper and you’ll find that the ECB exerts far more control over events in Europe than the Fed does in the US.
For example, the ECB played a key role in the downfall of Italian Prime Minister Silvio Berlusconi. Since 2010, the ECB has had a program in which it can buy government bonds to help lower a country’s cost of funding. When Italy’s bond yields rose to dangerously high levels in August 2011, the ECB intervened to buy Italian bonds but also sent a letter to Berlusconi demanding budget cuts and far-reaching reforms. When Berlusconi failed to act with sufficient haste, the ECB eased off on its bond purchases, yields rose again to dangerously high levels and Berlusconi was forced to quit.
More obscure than the bond-buying program but far more powerful is the little-known “risk control framework”. Normally, the ECB is willing to provide loans to banks as long as they can pledge assets that are listed on its “eligible collateral list”. However, the risk control framework allows the ECB to deny credit to any bank or reject any assets as collateral should it see fit. Specifically:
the Eurosystem may suspend or exclude counterparties’ access to monetary policy instruments on the grounds of prudence
the Eurosystem may also reject assets, limit the use of assets or apply supplementary haircuts to assets submitted as collateral in Eurosystem credit operations by specific counterparties.
The ECB has used the risk-control framework to control events at a number of key junctures in the euro crisis.
Ireland: In late 2010, the Irish banks were under severe stress. With international depositors pulling their money out, the banks became heavily dependent on the ECB for funding. The Irish government has sufficient cash on hand to finance the country for about nine more months and was not seeking funds from the EU or IMF. The ECB, however, was unhappy with the banking situation and decided Ireland should apply for program funds to sort out the banks. So, after clearing their throats by revising the risk control framework with Ireland in mind, the framework was put to devastating use. Faced with ECB threats to withdraw funding and thus trigger a full-scale banking meltdown, Ireland quickly agreed to enter an EU-IMF program.
Spain: By late May of this year, it had become clear to all that Spain’s banks needed substantial recapitalization, starting with Bankia, a recently-created conglomerate of a number of cajas. The Spanish government decided that its preferred method for recapitalizing Bankia was to directly provide it with Spanish government bonds. This approach is perfectly legal and would have been approved by Spain’s banking regulators. However, the ECB didn’t like this approach and effectively vetoed it. What gave it such a power of veto? The risk control framework. ECB could simply threaten to refuse credit to Bankia thus triggering the type of crisis the recapitalization plans were attempting to avoid. Since Spain could not raise the sums involved, this decision effectively forced Spain to apply to the EU for aid with recapitalising its banks.
Leveraging the EFSF\ESM: Perhaps the most powerful suggestion for easing the sovereign debt crisis has been Daniel Gros and Thomas Meyer’s proposal to provide Europe’s bailout funds with a banking licence, thus allowing them to borrow from the ECB. This ESM bank could potentially purchase trillions of euros worth of government bonds and its existence would provide Italy and Spain with the kind of “bond buyer of last resort” that the Fed has provided for the US government and the Bank of England has provided for the UK government.
However, this plan currently stands little chance of getting off the ground because the ECB opposes it. Now you might argue that the EU can go ahead and give its bailout funds a banking licence anyway and indeed they could do just that. But, by now, you know the tool that Mister Draghi can use to undermine this plan: The risk control framework. The ECB can simply refuse to accept the ESM bank as an “eligible counterparty”.
All told, the story of ECB’s serial use of its risk control framework raises pretty serious questions about whether it is has been a good idea for Europe to provide this much power to a single unaccountable institution.
The byzantine complexities of the IBRC’s promissory note-emergency liquidity assistance arrangements are such that it is inevitable that even the smartest of people will get confused. Unfortunately, Irish Times reporter Arthur Beesley (who does excellent work covering Brussels) came a cropper in this morning’s article on the negotations over restructuring Ireland’s bank-related debt.
Arthur’s article discusses the issues as follows:
On the table is the provision of about €30 billion in bonds from a European bailout fund to the former Anglo Irish Bank to replace expensive State-funded promissory notes …
The release of European bonds to the former Anglo would be in addition to the €40.2 billion Ireland is receiving from European sources under the original bailout agreement.
This is one element of the package which would certainly necessitate parliamentary votes in a number of countries.
The key issue in this part of the negotiation is the rate of interest which would be charged on any bonds from the temporary European Financial Stability Facility or its successor, the ESM.
The basic idea is that the Government would remain on the hook for EFSF or ESM bonds given to the former Anglo but that the annual interest rate charged would be far lower than the 8.2 per cent which applies now.
Precisely what rate would be charged remains subject to negotiation, the official said.
Under present arrangements the State would pay €16.8 billion in interest by 2031, bringing the total cost of the Anglo note scheme to €47.4 billion.
This description misses the key issues at stake here in a number of ways.
The problem with the promissory note arrangement is not that it causes the state to incur high interest costs. In fact, the opposite is the case. The 8.2 percent interest rate quoted here relates to interest payments that the state is making to IBRC, a state-owned institution. This is one arm of the state paying another so the interest rate has no impact on the state’s underlying debt situation.
In the same way, the IBRC uses its promissory note payments to repay its ELA debts to the Central Bank of Ireland (another arm of the state) and the (lower) interest rate it pays on ELA also has no relevance. The Central Bank returns the profits it makes on these ELA loans to the state (see its 2011 annual report).
What is the interest cost to the state of the current arrangement? As I described in detail in this paper, the Central Bank takes in the principal payments on ELA and then retires the money that it created when granting the ELA in the first place. This reduces the balance sheet item “Intra-Eurosystem Liabilities” which the Bank currently pays 0.75% percent on.
So the effective interest rate to the state of the promissory note arrangement is 0.75%, not 8.2%. The problem with the current arrangement is not the interest rate but rather the schedule for repayment of the principal, which will see a punishing 2 percent of GDP paid over each year over the next ten years.
The article mentions a figure for the total cost of the promissory notes of €47.4 billion. However, because most of the interest cost is returned to the state, the true net cost is far lower. Effectively, the total cost will be the €31 billion in principal on the notes that were issued plus the cumulated interest costs calculated at the ECB refinancing rate. This will be far less than €47.4 billion.
In relation to substance, the article suggests the negotiations are focused on replacing the promissory notes with bonds from the EFSF and or ESM, which could then be repo’d with the ECB allowing most of the ELA borrowings to be paid off. The state would then provide EFSF\ESM with the funds to cover the annual interest on the bonds with funds.
One version of this arrangement could see the bonds pay out €30 billion in 2042, with the Irish state providing the principal to EFSF\ESM and IBRC finally repaying the ECB. A more likely scenario would see a gradual repayment of the principal via repayment of ECB and retirement of the EFSF bonds.
If these bonds are placed directly rather than borrowed from the market, then one could argue that they should carry an interest rate of close to zero, since the EFSF is no longer adding a profit margin to its cost of funds (and the cost in this case is zero).
An arrangement of this type could mimic the low interest cost to the state of the current arrangements while adding a long-term schedule for repayment of principal. However, it carries with it some serious political complications. As the Times article notes, this arrangement would require political approval throughout Europe and that may be difficult obtain. In addition, this debt would have to be repaid even if Ireland left the euro because of its official status, while a post-euro Central Bank of Ireland would have the option of agreeing to a unilateral restructuring of the promissory notes.
An alternative arrangement that avoids these political risks is to simply alter the current arrangements to have the promissory note schedule be far more back-loaded than at present. This requires only the agreement of the ECB. As I wrote here a few weeks ago, there is a strong argument that it is time the ECB could Ireland some slack.
This is the class website for University College Dublin module International Money and Banking (ECON30150) being taught by Professor Karl Whelan in Spring 2020.
Source Material and Readings
A Comparative Chronology of Money. Website based on A History of Money from Ancient Times to the Present Day by Glyn Davies.
Milton Friedman: The Island of Stone Money
R. A. Radford: The Economic Organisation of a P.O.W. Camp
Charles Goodhart: Two Concepts of Money
A History of Money: From AD 800 by John F. Chown. Google Books version. Chapter 5 is “The Great Debasement of Henry VIII’s Reign”
Karl Whelan: How Is Bitcoin Different From The Dollar?
Karl Whelan: So What’s So Special About Bitcoin?
Bank of Ireland 2018 Annual Report
Cleveland Fed: Bank Capital Requirements: A Conversation with the Experts
Patrick Honohan’s Report: The Irish Banking Crisis Regulatory and Financial Stability Policy 2003-2008.
Bank of England: Understanding the fair value of banks’ loans
Bad Journalism on Bank Capital Example One: London Review of Books
Bad Journalism on Bank Capital Example Two: Fortune
Bad Journalism on Bank Capital Example Three: Article on Reserve Bank of New Zealand
Federal Reserve: Recent Balance Sheet Trends
The weekly consolidated balance sheet of the Eurosystem from the ECB.
Karl Whelan: Is the ECB Risking Insolvency? Does it Matter?
Paul De Grauwe and Magdalena Polan: Is Inflation Always and Everywhere a Monetary Phenomenon?
Steve H. Hanke and Nicholas Krus: World Hyperinflations
New York Times: Venezuala Issues New Banknotes Because of Hyperinflation
Todd Keister and James McAndrews Why Are Banks Holding So Many Excess Reserves?
ECB Protocol (i.e. the legal statute underlying the ECB and Eurosystem).
ECB monetary policy meeting accounts
San Francisco Fed: Information on the Fed’s role in banking supervision.
Joseph Gagnon and Brian Sack: Monetary Policy with Abundant Liquidity: A New Operating Framework for the Federal Reserve
New York Fed (2019). Stressed Outflows and the Supply of Central Bank Reserves
Steve Cechetti and Kermit Schoenholz (2019). The Brave New World of Monetary Policy Operations
Karl Whelan: The Secret Tool Draghi Uses to Run Europe
The ECB’s ELA Procedures
Vítor Constâncio (2018). Past and future of the ECB monetary policy
Karl Whelan (2019): Recommendations for the ECB’s Monetary Policy Strategy Review
Philip Lane (2019). Monetary Policy and Below-Target Inflation
Ben Bernanke: Nonmonetary Effects of the Financial Crisis in the Propagation of the Great Depression (American Economic Review, June 1983. Not available outside UCD. Go through UCD Connect and the Library Page.)
Karl Whelan: Banking Union and the ECB as Lender of Last Resort
Press Release: A single rulebook for the resolution of failing banks
Bloomberg: Testing Europe’s Resolve on Failing Banks
Piergiorgio Alessandri and Andrew Haldane (Bank of England): Banking on the State
Douglas Diamond and Raghuram Rajan: The Credit Crisis: Conjectures about Causes and Remedies
Documentation for the Basle 2 Internal Ratings Based model.
Philipp Hildebrand: Is Basel II Enough? The Benefits of a Leverage Ratio
New York Times: Risk Mismangement
Patrick Honohan: Bank Failures: The Limits of Risk Modelling
Andrew Haldane and Vasileios Madouros. The Dog and the Frisbee.
Dan Davies. Facts and Myths About Bank Leverage Ratios
Samuel Hanson, Anil Kashyap and Jeremy Stein: A Macroprudential Approach to Financial Regulation
Basle 3 Agreement
Andrew Haldane: The Bank and the banks.
Financial Stability Board press release on TLAC.
Basel Committee on Banking Supervision: High-level summary of Basel III reforms
McKinsey: Basel “IV”: What’s next for banks?
Selected Interest Rates from the Federal Reserve.
NTMA Bond report website.
Spreadsheet with bond yield examples
Historical yield curve data from the Federal Reserve
Ben Bernanke: Why are interest rates so low, part 4: Term premiums
Chicago Fed: Why Does the Yield-Curve Slope Predict Recessions?
San Francisco Fed: Information in the Yield Curve about Future Recessions
Ben Bernanke: The Financial Accelerator and the Credit Channel
Karl Whelan: How Does QE Work? A Picture Worth a Thousand Words
Joseph Gagnon, Matthew Raskin, Julie Remache, Brian Sack: Large-Scale Asset Purchases by the Federal Reserve: Did They Work?
Stefania D’Amico and Thomas B. King: Flow and Stock Effects of Large-Scale Treasury Purchases
Milton Friedman: The Role of Monetary Policy.
Ben Bernanke: The Benefits of Price Stability
Olivier Blanchard (2016). The US Phillips Curve: Back to the 60s?
Olivier Blanchard, Giovanni Dell’Ariccia, and Paolo Mauro: Rethinking Macroeconomic Policy
John Taylor: Discretion Versus Policy Rules in Practice
Glenn Rudebusch: The Fed’s Monetary Policy Response to the Current Crisis
Karl Whelan (2013): Sovereign Default and the Euro
Karl Whelan (2019): The Euro at 20: Successes, Problems, Progress and Threats
Stephen Cecchetti and Kim Schoenholtz (2018). Sudden stops: A primer on balance-of-payments crises.
Bénassy-Quéré et al (2018), Reconciling risk sharing with market discipline: A constructive approach to euro area reform
Barry Eichengreen (2007). The Breakup of the Euro Area
Phoebus Athanassiou (2009). Withdrawal and Expulsion from the EU and EMU, ECB Legal Working Paper.
The Wall Street Journal is reporting that the ECB has changed its position on the need to protect all senior bond holders at European banks. My current thoughts here. I will write more later about the implications of this development for Ireland.
With the release of a draft Memorandum of Understanding for Spain, it appears that the EU may be preparing to protect senior bondholders of insolvent banks in Spain, just as they did in Ireland. My thoughts here.
Last night’s Euro group meeting failed to resolve any of the uncertainty about the ultimate liability for ESM bank recaps and provided a commitment to do nothing about it until September. My thoughts here.
After some reasons to be optimistic that Europe’s leaders were ready to finally grasp the bank debt\sovereign debt nettle, the developments of the last few days have been exasperating to watch. My latest thoughts here.
I have written a new briefing paper for the European Parliament’s Economic and Monetary Affairs committee. The paper discusses the ECB’s role in Ireland’s financial assistance programme. Here’s the abstract:
This paper reviews the role the ECB has played in financial assistances programmes in the Euro area, focusing in particular on Ireland. The ECB’s involvement in Ireland—in particular its policy in relation to senior bank debt—has raised questions about whether it has over-stretched to act beyond its mandate. The ECB is not providing official assistance to the Irish government and its involvement in monitoring the programme has confused the public about the nature of the programme’s conditionality and contributed to undermining its legitimacy. I recommend that future financial assistance programmes should not feature the ECB as a member of a Troika tasked with monitoring the programme. The ECB’s relationships with other crisis countries are reviewed. I conclude that Europe needs to clarify its policies on bank resolution and systemic risk—and the role of the ECB in relation to these policies—before it is too late.
The other briefing papers (some more on the ECB’s role in financial adjustment programmes and others on the response of central banks around the world to the crisis) can be found here. Click on 09.07.2012.