MPI Gemeinschaftsgüter
Martin Hellwig
W.A. Macintosh Lecture,
Kingston, October 2015

 Late June 2015: The Greek government calls a referendum
 The euro group breaks off negotiations
 The ECB freezes emergency liquidity assistance to
Greek banks, which had been subject to a slow run
 The Greek government closes banks, limits payouts from machines, imposes capital controls
 Early July: The referendum tells the government to say „no“ to the creditors
 Mid July: The government says „yes“ anyway
 WHY? Fear for the banking system and society?

 ECB had cut lending to Greek banks at the time of the Greek elections; this was replaced by emergency liquidity assistance from the Bank of
Greece, needed because banks were run upon
 Freeze illegal?
 Treaty: Nonmonetary operations of national central banks are doen on their own account, can be prohibited by the ECB Council if they conflict with the objectives of the eurosystem (monetary policy)
 Previous instance: Ireland 2010
 What does this do to democracy?

 Protection from greedy politicians eager to use the printing press for funding government activities
 Germany 1923, 1933-45
 Time consistency problem of money issue
 Experience of 1970s and 1980s
 Enshrined in the EU Treaty
 Criticized today: How does this independence go with democracy?
 What about risks to the public budget if they make losses?
 Who do they benefit? Insolvent governments and banks? AIG?

 A central bank is a bank
 ... Which benefits whoever it does business with, through lending or buying securities
 ... And harms whoever it competes with
 Originally: the government‘s bank and the bank of banks, with a monopoly on the note issue
 Bagehot 1873: Serving as Lender of the Last
Resort is necessary and is good business because it protects the central bank‘s own assets: „lend freely at penalty rate to solvent institutions against good collateral“

 Being a bank provided for some independence all along
 Except for mandates to smoothe interest rates
 But: constraints were imposed by the obligation to redeem notes in gold (or in dollars in a fixed exchange rate regime)
 ... Ended only in 1973 with the end of the Bretton
Woods system of fixed exchange rates
 The shift from redeemable money to paper money provided for a huge change in the scope of central banking

 Interest rate stabilization (government funding?)
 Lender of the last resort (Bagehot)
 ... Not done in the Great Depression – fear of being unable to redeem notes
 Macro mandates (price stability employment) a sequel to the Great Depression, made feasible by the departure from Gold and from fixed exchange rates
 ... Followed in the Crisis of 2007-2009 and beyond
 Was this macro-stability or financial stability?
 Or are they the same?

 Ex post, the success in fighting the crisis raises the question whether the intervention was at all necessary
 It raises questions about the central bank‘s power,
 ... about its mandate (financial stability?)
 ... about its ability to subsidize the industry
(debtors) – distributive effects of low interest rates
 ... about the fiscal risks involved in intervening without following Bagehot‘s rule.
 Mistrust by laissez-fair ideoloques (Hayek)

 In the Great Depression, central banks did not intervene because they were constrained by the
Gold Standard
 Example: Germany 1931, Support to the banking system stopped when currency outflows made the stop necessary
 But: At least one of the banks was already insolvent (Danat)
 If it had not been for the Gold Standard, should they have been supported?
 Modern examples: Greenspan‘s turnaround in
1990, Draghi‘s LTRO in 2011

 Trichet 1997: A central bank is only responsible for price stability
 Schizophrenic policy in 2008 and 2011
 Interest rate increases to ensure price stability
 Unorthodox measures to help financial stability
 Neglect of stability impact of interest rates
 Ended by Draghi: LTRO: Give banks cheap 3 year funding to maintain financial stability
 .... Even if this means that (probably) insolvent banks are subsidized („The greatest carry trade ever“) and fund insolvent governments

 Treaty only has a price stability mandate
 2008/11/12: This implies preventing a financial crisis – banks are part of the monetary transmission mechanism (long tradition in macro)
 2014: Targeted Long Term Refinancing Operation:
Lend to banks only if they pass the money on to
SMEs
 2015: Quantitative Easing: Lower long term rates even if this means that banks cannot earn profits and get more deeply into the morass
 The relation between „price stability“ (macro) and
„financial stability“ is unclear and subject to abuse

 The No-Bailout clause of the Maastricht Treaty and the SGP seemed to provide for proper governance of fiscal policy
 The Treaty also pledged the ECB to abstention from government finance
 Banking regulation was governed by the principle that solvency problems were for the sovereign, liquidity problems of individual institutions for national central banks, liquidity problems of the system for the ECB to handle

 April/May 2010: Greece has a liquidity problem, no market access
 October 2010: Deauville: Private Sector
Involvement, not now, from 2013
 November 2010: PSI only in cases of insolvency, not in cases of illiquidity
 March 2011/July 2012: PSI now, but only 20%
 October 2011/March 2012: PSI now, over 50%
 Late 2012/early 2013: Debt buyback flop
 When and how will we get another haircut?
 ... or Grexit?

Why were the principles broken?
 Crisis was more than the system could handle
 Not a currency crisis!
 BUT
 A traditional sovereign debt crisis in Greece,
Portugal, and perhaps Italy,
 A traditional real-estate and banking crisis, in
Ireland and Spain,
 And a latent banking crisis in Germany and
France where the mess of 2008 had not been cleaned up

Sovereign Debt Crises and Banking
Crises
 Sovereigns that don‘t make ends meet
.
 ... ask/coerce banks into funding them
 ... cause bank insolvency from haircuts – Argentina,
Greece
 Banks that fund a real-estate bubble get in trouble; rescuing them can overtax the power of the sovereign especially if they are indebted in „foreign“ currency
 ... and cause sovereign a debt crisis (Iceland,
Ireland, Spain)
 ... Which may cause the sovereign to lean on healthier banks....

 Poorly capitalized 2 – 4 % of total assets
 Excess capacity, low margins
 No cleanup in 2008/2009, rescue of everybody
(except WestLB)
 Significant exposure to..... toxic assets, sovereign debt, cross-border bank debt, shipping loans...
 Public support for Greece gave them time to selle their Greek debt
 .... Greek and Cypriot banks

 Lack of Market integration
 Lack of Market discipline
 Lack of fiscal discipline
 Lack of effective supervision

 Separate goods markets
 Different inflation rates
 Equal nominal interest rates
 Different real interest rates
 as drivers of imbalances and bubbles

 No exchange rate discipline (exchange rate as an indicator of current developments, brake on foreign borrowing)
 No consciousness of risk on the side of creditors (zero risk weights as a basis for asking for bailouts)
 What discipline in a regime where the supervisor represents funding and political interests of the state? ... and is influenced by pressures from local and national elites?

 Illusions about enforcement (SGP, Agent
General in the Weimar Republic)
 Lack of political legitimacy
 Differences in fiscal traditions
 Financial Repression, monetary funding of government in G-I-S-P
 Differences in traditions as to what is the role of the state
 Industrial policy, services publiques in France
 Why should the fiscal pact work better?

 „Banks are where the money is“
 Use of banking regulation to obtain funding
 Sovereign carve out in banking regulation
 Long tradition of financial repression pre 1990
 Government funding – resurgence since 2008
 Real estate funding – concerns about voters and about local elites
 Industrial policy concerns – national champions

 Buildup of risks was not checked, Zero risk weight rule for sovereign exposures; Dangerous business practices (shadow banking activities) were allowed
 Procrastination in dealing with problem banks;
Forbearance („extend and pretend“) was and is tolerated; Insufficient downsizing of the industry
 ... all in the name of national interests, sovereign funding, political and economic elites, competitiveness of „our“ banks
 ... the desire to avoid a credit crunch
 ... And the political inability to have a cleanup à la
Suédoise

 Treatment of sovereign debt in banking regulation
 Sovereign carve-out in large exposure and equity regulation
 „Sovereign debt is riskless“
 „If it is not riskless, banking regulation is unsuitable for reducing the risk“
 „ESM will do the job“
 „If not, we must have eurobonds“
 ... or the ECB will bail us out

 Moral hazard from ECB availability: The
Greenspan put
 Many politicians have learnt that inspite of
Maastricht they can get access to the printing press if they borrow from banks and the banks get into difficulties
 Strength of the central bank is a weakness
 Monetary Policy can smooth over the crisis but cannot provide for a cleanup let alone deal with the root causes

 Without a cleanup of the banking system, there is a risk of a Japan-type experience
 A cleanup was not to be expected under national competence
 ECB would permanently act as a source of funding
 Back to the regime of Italy in the seventies and eighties?
 Banks as a source of funding
 - a cause for low growth

Banking Union to the Rescue?
 Supervision
 How effective can the SSM be with 16+ different national supervisors involved, and national laws implementing EU directives? Asset Quality Review – a success?
 Resolution: Can we get rid of zombies?
 Do governments want to give up the power to determine which banks are there and which are not?
 Is a viable resolution regime feasible? The Lehman legacy is still with us – issue of cross-border resolution
 Problem of liquidity in resolution -

 Recovery and resolution require funding
 Contributions to deposit insurance and/ or restructuring funds
 ... Take too much time to build up
 ... Are insufficient in a crisis (US S&L‘s: $123 bn. from taxpayers, $ 29 bn. from industry)
 ... Need to bail in bank creditors – raises financial stability issues – and political economy issues
 ... Need for a fiscal backstop – with insolvent governments?

 Banks are part of the monetary system
 SSM establishes a relation between banks and the
ECB, presumably in order to eliminate the abuse of banks to blackmail the ECB
 Do banks have a claim on ECB support – contrary to what happened in Greece?
 How do we curb the power of the central bank over banking systems and, indirectly, our polities and societies?
 Yet, Mr. Varoufakis wanted to nationalize th ebanks and go for exit – the sovereign does have power over its banks!

 Power over banks is part of sovereign power
 Will member states be willing to give that up?
 Or will they use other means to impose financial repression?
 The mayor of Leukerbad... and the President of the
French Republic
 And how will member states deal with the de facto power of the Central Bank over their polities?
 But: Without a REAL banking union, the monetary union will likely fall apart
 ... and the event can be very ugly