18 August 2011

Paul de Grauwe: The European Central Bank as a lender of last resort

With the eurozone crisis casting doubt over the solvency of Spain and Italy, the ECB has once again intervened to provide liquidity in the government bond markets. This column asks the question: Is there such a role for the ECB as a lender of last resort?

Fragility of a monetary union: It is useful to start by describing the weakness of government bond markets in a monetary union.

• Eurozone governments issue debt in a “foreign” currency, ie one which they do not control by fiat.
• Thus governments cannot guarantee to the bondholders that they will always have the necessary liquidity to pay off the bond at maturity.

This contrasts with “stand-alone” countries that issue sovereign bonds in their own currencies. This feature allows these countries to guarantee that the cash will always be available to pay out the bondholders. This is why a stand-alone country can provide an implicit guarantee—the central bank is a lender of last resort in the government bond market. The absence of such a guarantee makes the sovereign bond markets in a monetary union prone to liquidity crises and contagion—very much like banking systems were before central banks backstopped them as lenders of last resort.

How the existence of a lender of last resort prevents bank runs: In banking systems without such backstopping, one bank’s solvency problems can quickly lead deposit holders of other banks to withdraw their deposits (in other words, a bank run). This sets in motion a liquidity crisis for the banking system as a whole. The next step comes as banks try to sell off their assets—thus pushing down their prices. This asset-price collapse can go on until the point when the banks owe more than they own. This is how the liquidity crisis triggered by a bank run can degenerate into a solvency crisis—thus justifying the fears that led depositors to run in the first place.

Buyer of last resort for government bonds: The single most important argument for appointing the ECB as a lender of last resort in the government bond markets is to prevent countries from being pushed into this sort of bad equilibrium—a self-fulfilling debt crisis. In a way it can be said that the self-fulfilling nature of expectations creates a coordination failure, ie the fear of insufficient liquidity pushes countries into a situation in which there will be insufficient liquidity for both the government and the banking sector. The central bank can solve this coordination failure by providing lending of last resort.

Backstopping banks without backstopping government debt may be expensive: Failure to play the lender of last resort role for government bond carries the risk of forcing the ECB to actualise their lender of last resort promise to banks in the countries hit by a sovereign debt crisis. And this sort of lending is almost certainly more expensive than backstopping the government debt. The reason is that typically the liabilities of the banking sector of a country are many times larger than the liabilities of the national government.

Risk of inflation: A popular argument against an active role of the ECB as a lender of last resort in the sovereign bond market is that this would lead to inflation. By buying government bonds, it is said, the ECB increases the money stock thereby leading to a risk of inflation. Does an increase in the money stock not always lead to more inflation, as Milton Friedman taught us? A key distinction is the difference between the money base and the money stock. When the central bank buys government bonds (or other assets) it increases the money base (currency in circulation and banks’ deposits at the central bank). This does not mean that the money stock increases. In fact during periods of financial crises, the monetary base and money supply tend to become disconnected.

Fiscal consequences: A second criticism is that lender of last resort operations in the government bond markets can have fiscal consequences. The reason is that if governments fail to service their debts, the ECB will make losses. Thus by intervening in the government bond markets, the ECB is committing future taxpayers. The ECB should avoid operations that mix monetary and fiscal policies (see Goodfriend 2011).

All this sounds reasonable. Yet it fails to recognise that all open market operations (including foreign exchange market operations) carry the risk of losses and thus have fiscal implications. When a central bank buys private paper in the context of its open market operation, there is a risk involved, because the issuer of the paper can default. This will then lead to losses for the central bank. These losses are in no way different from the losses the central bank can incur when buying government bonds. Thus, the argument really implies that a central bank should abstain from any open market operation. But then it stops being a central bank.

What about moral hazard?: Like with all insurance mechanisms there is a risk of moral hazard. By providing lender of last resort insurance, the ECB gives an incentive to governments to issue too much debt. This is indeed a serious risk. But this risk of moral hazard is no different from the risk of moral hazard in the banking system. It would be a terrible mistake if the central bank were to abandon its role of lender of last resort in the banking sector because there is a risk of moral hazard. In the same way it is wrong for the ECB to abandon its role of lender of last resort in the government bond market because there is a risk of moral hazard.

Separate the regulation of moral hazard and lender of last resort functions: In general it is better to separate liquidity provision from moral hazard concerns. Liquidity provision should be performed by a central bank; the governance of moral hazard by another institution, the supervisor. This has been the approach taken in the strategy towards the banking sector—the central bank assumes the responsibility of lender of last resort, thereby guaranteeing unlimited liquidity provision in times of crisis, irrespective of what this does to moral hazard; the supervisory authority takes over the responsibility of regulating and supervising the banks.

What about insolvent states?: Ideally, the lender of last resort function should only be used when banks (or governments) experience liquidity problems. It should not be used when they are insolvent.

EFSF and ESM: Poor surrogates: The ECB has made it clear that it does not want to pursue its role of lender of last resort in the government bond market. This has forced the eurozone members to create a surrogate institution (the European Financial Stability Facility or EFSF and the future European Stability Mechanism or ESM). The problem with that institution is that it will never have the necessary credibility to stop the forces of contagion; it cannot guarantee that the cash will always be available to pay out sovereign bondholders. Even if the resources of that institution were to be doubled or tripled relative to its present level of €440 billion this would not be sufficient. Only a central bank that can create unlimited amounts of cash can provide such a guarantee.

In addition, the EFSF and the future ESM have a governance structure that makes them ill-suited for crisis management. Each country maintains a veto power. As a result, the decisions of the EFSF and the future ESM will continuously be called into question by local political concerns (“true Finns” in Finland, Geert Wilders in the Netherlands, and so on). The EFSF and the future ESM can simply not substitute for the ECB. It is therefore particularly damaging that the ECB has announced it wants to transfer its lender of last resort function to that institution. This is the surest road to future crises.

Conclusion: The ECB has been unduly influenced by the theory that inflation should be the only concern of a central bank. It is becoming increasingly clear that financial stability should also be on the radar screen of a central bank. In fact, most central banks have been created to solve an endemic problem of instability of financial systems. With their unlimited firing power, central banks are the only institutions capable of stabilising the financial system in times of crisis.

In order for the ECB to be successful in stabilising the sovereign bond markets of the eurozone, it will have to make it clear that it is fully committed to exert its function of lender of last resort. By creating confidence, such a commitment will ensure that the ECB does not have to intervene in the government bond markets most of the time, very much like the commitment to be a lender of last resort in the banking system ensures that the central bank only rarely has to provide lender of last resort support.

While the ECB’s lender of last resort support in the sovereign bond markets is a necessary feature of the governance of the eurozone it is not sufficient. In order to prevent future crises in the eurozone, significant steps towards further political unification will be necessary. Some steps in that direction were taken recently when the European Council decided to strengthen the control on national budgetary processes and on national macroeconomic policies. These decisions, however, are insufficient and more fundamental changes in the governance of the eurozone are called for. These should be such that the central bank can trust that its lender of last resort responsibilities in the government bond markets will not lead to a never-ending dynamic of debt creation.

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