4 Lectures on the €uropean
crisis
Lecture 3: Monetary Policies
The philosophy of the EZ economic policy
• Independent CB with 2% inflation has its only target (monetary
policy ineffectual in the long run)
• Prohibition to use budget policy (fiscal expansions compete with the
private sector for scarce resources)
• Full employment is a national issue (total deny that it is an
international issue)
• Issing
Monetary policy: the ECB and Eurosystem
• The European System of Central Banks (ESCB) comprises
• the European Central Bank (ECB) and the national central banks
(NCBs) of all 28 EU Member States.
• The Eurosystem as the central banking system of the euro area
comprises:
• the ECB; and the national central banks (NCBs) of the 17 EU Member
States whose common currency is the euro.
• The ECB has two main bodies which take all the decisions: the
Governing Council, the Executive Board,
• The Governing Council of the ECB is the main decision-making body
of the Eurosystem. It comprises all the members of the Executive
Board of the ECB, and the governors/presidents of all the national
central banks (NCBs) of the euro area, i.e., those EU Member States
that have adopted the euro.
• The Executive Board comprises: the President of the ECB, the VicePresident of the ECB, and four other members (selected by the Heads
of State on recommendation from the EU Council).
Monetary policy: objectives and pillars
• Two main characteristics of the ECB: independence with 2% inflation
target; no bail-out clause
• Two pillars of the ECB monetary policy ( determination of the
interest rate):
• M3  quantitative theory of money (less important)
• A variety of economic and financial indicators (including indicators of
the real activity, current and expected inflation, exchange rate,
financial markets indicators, agents’ expectations, labour market
indicators)
Monetary policy: objectives and pillars
• It is not clear which monetary rule the ECB adopts
• Monetary targeting: from MsV = PYn we get:



Mˆ S
* Yn V
  
S
ˆ
Yn V
M
• And the rule is:

M Mˆ S
it  it 1   (  S )
M Mˆ
(whenever money is growing above target, the CB increases i)
Monetary policy: monetary rules
• Taylor rule
•
Inflation targeting
Y  Yn
i  in   (   *)   (
)
Yn
it  it 1   ( te T   *)
(the CB changes the interest rate when expected inflation is different from target
inflation  the idea is that this stabilises output too)
Good criticism of IT Fontana & Palacio-Vera
http://www.levyinstitute.org/pubs/wp_430.pdf
• Forward guidance
(the CB tries to guide markets expectation about the CB long term interest rate
policy)
• ECB: not clear rule (but see again to next graph)
Taylor rule? (studies suggest the ECB might have followed the TR
giving a higher weight to  compared to the Fed). Difficulty for the ECB
to have a “one fits all” monetary policy
Two aspects of the crisis: banking crisis and sovereign
crisis
• The crisis has not a fiscal origin (with the possible exception of
Greece).
• Once the housing bubbles exploded the crisis became a banking
crisis
• Once banks were bailed out the crisis became a sovereign crisis
• The fiscal crisis magnifies the banking crisis (given that banks own a
lot of sovereign bonds).
•  doom loop between banking and sovereign crises.
• (particularly German banks were also plenty of American toxic
assets and they were bailed out by the government).
• The EZ crisis is also a balance of payment crisis.
• Can you have a BoP crisis in a CU? Yes, of course.
The EZ crisis as a BoP crisis
• Any region, in a CU or not, can sustain a current account deficit as
long as it receives loans or subsidies from other regions.
• The EZ went through the typical pattern of a BoP crisis (the “This time
is different” story)
• In the typical story, however, the crisis is followed by the abandonment
of pegged exchange rates, default in the foreign obligations, IMF
intervention, austerity etc.
• In the EZ we had a little of these things, but no a Euro break up.
• However, the EMU monetary arrangements prevented the BoP crisis
to explode as in a typical BoP crisis.
• When the sudden stop of capital flows took place, a payment system
called TARGET2 permitted the repatriation of capitals, while the
Eurosystem monetary instruments permitted peripheral countries to
refill the lost reserves.
TARGET2. What is it? (courtesy of Eladio Febrero)
• Acronym: Trans – European Automated Real- time Gross settlement
Express Transfer System.
• TARGET2 has to be used for all payments involving the
Eurosystem. Operated by the Eurosystem.
• TARGET2 mainly settles operations of monetary policy and money
market operations.
In essence, TARGET2 makes possible the transfer of bank deposits
and reserves between countries within the Euro Zone.
TARGET2. Implications for MP implementation
• Credits make deposits, and then, banks borrow reserves from the
central bank. The central bank lends all demanded reserves, but it
fixes the interest rate at which it lends them.
TARGET2. How does it work?
• When a bank deposit is transferred from Spain to Germany, it has to be
done with central bank money.
• At the end of the day, the Banco de España acquires a liability against
the Eurosystem (T2 liability) whilst it reduces the Reserve account held
by the Spanish bank. Simultaneously, the Buba increasese the reserve
account of the German bank when it acquires a claim against the
Eurosystem.
TARGET2. Implications for MP implementation
• After the deposit transfer, the Spanish bank does not comply with
the reserve requeriment (10% deposits). However, the German bank
has excess reserves, amounting to 9 monetary units.
TARGET2. Implications for MP implementation
• The German bank will not lend in the interbank money market its
excess reserves at a rate below the MLF.
• The Spanish bank will not borrow in the interbank market at an
interest above the MCF.
• Under normal circumstances, banks agree on an intermediate
interest rate, which is in the middle of both facilities.
TARGET2. Implications for MP implementation
• TARGET2 claims and liabilities (almost) cancel each other out when
the German bank lends its excess reserves to the Spanish bank.
• The Spanish bank complies with the reserve requirement.
• The interest rate that prevails at the interbank market is that of MRO.
TARGET2. Implications for MP implementation
• What happens when the German bank does not wish to
roll over its lending to the Spanish bank?
(Hyp: the maturity of the loan granted by SPB is longer
than that of the loan granted by GPB to SPB)
– TARGET2 imbalances return, and…
– The Spanish bank does not fulfil the reserve requirement.
TARGET2. Implications for MP implementation
• The Spanish bank needs 10 monetary units as the reserve
corresponding to its 100 m.u. of deposits.
• The demand for reserves is rather inelastic. A deficit of
reserves in Spain would lead to a rocketing interest rate there.
• If the interbank market has dried up, only the Eurosystem can
provide required reserves.
TARGET2. Implications for MP implementation
• The Banco de España, part of the Eurosystem, lends
reserves to the Spanish banking system. It has no other
option if :
– NCBs have to contribute to the smooth working of the payment system.
– The interest rate has to be the same in the whole Euro Zone.
– All banks must have the same access to CB funding.
N.B. MROs are implemented by National Central Banks.
• What happens with the excess reserve in Germany?
– The German bank can pay back prior liabilities to the Buba.
– It may try to lend them at an interest rate below the MRO official rate,
but this means that the Eurosystem loses control of the interest rate.
TARGET2. Some evidence.
• There is a large correlation between GIPS’ T2 liabilities and
Germany’s T2 claims. When we add Italy to GIPS, the degree of
correlation is a little lower. This indicates financial capital flights from
the EZ periphery towards Germany.
TARGET2. A stealth bailout?
• Hans Werner Sinn, president of the highly influential CES Ifo,
Munich based Economic Research Institute, has pressed the alarm
buttons in the mass media, arguing that TARGET2 imbalances are a
stealth bailout of the Euro Zone (EZ) periphery by the ECB.
• Sinn interprets the current crisis in the EZ as a typical balance of
payments crisis in a pegged exchange rate system.
• According to Sinn, peripheral countries (PIIGS) are experiencing a
BoP crisis (capital outflow) and, therefore, they should adopt the
usual measures of economic policy to solve this problem: fiscal
austerity –cum- devaluation, with temporary interest rate hikes.
• In his view, T2 liabilities are Eurosystem loans to the EZ periphery,
providing them with some relief in a protracted balance-of-payments
crisis.
TARGET2. A stealth bailout? Sinn is not wrong (although he had a
number of silly considerations aimed to depict Germany as the eurovictim)
• In a fixed exchange rate system (FERS) a country can finance its current
account deficit either by depleting the Official Reserves or by foreign loans.
In case of sudden stops and once the OR are depleted, it must adjust the CA
by domestic deflation and currency devaluation.
• In a currency union, as seen, a country can continue to finance a CA deficit
by collecting T2 liabilities with its banks reserves re-created by the
Eurosystem.
• In a FERS international payments lead to a loss of reserves; in a CU it is the
same and the loss is counted as a T2 liability (and the gain of reserves as a
T2 claim) while the lost reserves are re-created by the ECB.
• The Eurosystem has to lend reserves as the logical consequence of fixing an
interest rate which has to be the same across the whole EZ. Moreover,
unless it lended reserves, German investors could not repatriate their funds
to Germany.
• Similarity with the currency/clearing union proposed by Keynes in the
1940s in which the IMF should automatically recycle the CA surpluses that
surplus countries do not want to lend.
TARGET2. A stealth bailout? And a risk for Germany?
• TARGET2 loans are a potential source of risk for Germany in the case of a
disorderly euro break up.
• Reserves gained in a CU are T2 claims, not dollars or gold. Reserves lost in
a CU are T2 liabilities, not dollars or gold.
• TARGET2 claims yield an interest rate to the holder, paid by the debtor to
the Eurosystem (GIIPS). And TARGET2 claims are part of the net
international investment position (financial wealth) of a nation, like gold
reserves. In the event of a euro breakup, the Banco de España may renege
on its international debts (T2 liabilities) so that the Bundesbank will make
a capital loss.
• Sinn suggests the ECB should stop lending to the EZ periphery and cancel
T2 liabilities with marketable assetsm (gold etc).
TARGET2. A critique.
• What are the true risks for Germany?
In the event of a disintegration of the EZ, or if non-performing loans
increase in debtor countries:
– Germany will lose the interest rate on its T2 claims (an ownership
income paid by the rest of the world).
– Germany will lose part of its financial wealth (net international
investment position NIIP) if debtor nations renege on their T2
liabilities (i.e it is as if Germany had dropped its gold bullion reserves
into the ocean).
– According to Sinn, German tax payers should pay for the
recapitalization of the Buba.
TARGET2. A critique.
Sinn is right when he claims that the German economy will experience
a loss, because the income balance, in the current account balance,
will fall, due to a fall in the interest on T2 claims. And there will be a
loss of financial wealth as well.
But:
– T2 claims change the composition of NIIP without making it to rise:
German private banks reduce their exposure to PIIGS banks whilst the
Buba increases its exposure to the Eurosystem (only 27%). Dullien
and Schieritz, 2012.
– A capital loss may happen if loans are not paid back in the EZ
periphery. If the Eurosystem stops providing liquidity, the banking
systems will collapse in the periphery and with them their whole
economies. Sinn’s recommendations are a self- fulfilling prophecy.
– The value of the Buba’s reserves (denominated in new Deutsche
Mark, fiat money) is not backed by its assets; and the Buba can
‘monetize’ as much public spending as needed.
‒ The real risk is that Germany’s new D-mark shall appreciate with
regard to the already existing currencies. This is a threat for an
exporting country.
Target 2 references:
http://www.ecb.int/pub/pdf/mobu/mb201305en.pdf (chapter on T2)
http://www.bruegel.org/nc/blog/detail/article/731-sudden-stops-in-the euro-area
http://www.uclm.es/dep/daef/DOCUMENTOS%20DE%20TRABAJO/DT-2013/20132%20DT-DAEF.pdf
http://www.deps.unisi.it/it/ricerca/pubblicazioni-deps/quaderni-deps/anno2013/681the-implications-target2-european-balance
http://www.cesifo-group.de/ifoHome/policy/Spezialthemen/Policy-IssuesArchive/Target.html
in particular:
http://www.cesifogroup.de/ifoHome/publications/docbase/details.html?docId=19088305
Now, back to monetary policy
ECB monetary policy instruments
•
•
•
•
•
•
•
We focus upon:
OMO:
1) MRO and LTRO
2) Structural operations  outright purchases
Standing facilities:
MLF and DF
From 2008 the ECB (like the FED and BoE) widened its balance
sheet.
• MRO, LTRO and Outright Purchases increased liquidity; this was
used by banks to frontload possible confidence crises (bank runs)
and to offset sudden stops and capital flows reversals. Liquidity used
to buy Gvt bonds  “diabolic” doom loop between bank and
sovereign crisis (avoided had the ECB directly/seriously sustained
gvt bonds)
• Excess liquidity parked e.g in DF.
Main monetary policy actions undertaken by the ECB
•
•
•
•
•
•
•
•
Interest rate policy
Fixed rate full allotment MRO and LTRO (2008…)
Covered bonds purchases (2008 and 2010)
SMP (May 2010 and Summer 2011)
3y LTRO (beginning 2012)
OMT (September 2012)
Forward Guidance (June 2013)
?
Marginal lending facility
0.75 %
Main refinancing operations (fixed rate)
0.25 %
Deposit facility
0.00 %
Effective from 13 Nov 2013
Fonte: http://www.ecb.europa.eu/home/html/index.en.html
Criticism to ECB and references
• Main criticism is the missed intervention to sustain sovereign debt.
• Bad equilibrium, absence of a sovereign CB (De Grauwe Bindseil
Wray/MMT)
• LTRO  doom loop (Bindseil)
• Monetary policy implementation: references
ECB 2011
http://www.ecb.int/pub/pdf/other/monetarypolicy2011en.pdf?d51bad0288e5
3a9d35f77c3a3f6674df).
ECB 2012 http://www.ecb.europa.eu/pub/pdf/scpops/ecbocp135.pdf
ECB: http://www.ecb.int/pub/pdf/mobu/mb201305en.pdf (chapter on T2)
http://www.bruegel.org/nc/blog/detail/article/731-sudden-stops-in-the euro-area
DeGrauwe 2011
http://www.econ.kuleuven.be/ew/academic/intecon/Degrauwe/PDGpapers/Discussion_papers/Governance-fragile-eurozone_s.pdf
In order not to be considered unfair, let me report some opinions from
an important German ECB economist which is, de facto, very critical
not so much of the ECB (Draghi has done all he could) but with the
prohibitions the ECB meets in doing what it should do
• Bindseil …
Banking Union
“In June 2012, euro area leaders affirmed, ―it is imperative to break
the vicious circle between banks and sovereigns.… “ (IMF 2013: 20).
•
•
•
•
Banking Union in the US
Pillars of an European BU
SSM, SRM, SRF (self-sustaining)
SSM  ECB  evaluation exercise (130 large banks) Nov. 13 - Nov.
2014 + Stress test. Problem  lack of a SRM and a SRF
• Debate about the SRM and SRF.
• SRM (130 large banks), where to locate it?
• SRF  single fund constituted by the banks themselves; bail-in before
any bail-out; role of the ESM limited to systemic emergencies (power
of veto). The system fully operational only in 2018. In the meantime
countries must rely on bail-in, national funds or loans from the EMS to
national governments (doom loop).
Banking Union: References
•
•
•
•
•
http://www.economonitor.com/dolanecon/2013/03/22/bailouts-bail-ins-haircutsand-all-that-program-notes-for-the-cyprus-banking-drama/
D. Gross http://www.voxeu.org/article/banking-union-if-ireland-were-nevada
IMF http://www.imf.org/external/pubs/ft/sdn/2013/sdn1301.pdf
Last news http://blogs.wsj.com/brussels/2013/11/15/how-europe-plans-todeal-with-bank-stress-test-results/?mod=WSJBlog&mod=brussels
http://www.reuters.com/article/2013/11/15/us-eu-bank-backstopsidUSBRE9AE0T520131115