There is a lot of talk recently about the possibility that the European Central Bank (ECB) could act as a "lender of last resort" to mitigate the European sovereign debt crisis. The Germans are against it, and the southern Europeans (who might stand to gain from such as policy) are for it. France may be sympathetic.
What is a lender of last resort? A key role for a central bank of course, is in acting as a lender-of-last-resort to the private banking system. The conventional view of banking is that the key function of banks - transforming illiquid assets into liquid liabilities - leaves an individual bank open to runs. According to the standard logic an otherwise sound bank could fail due to an illiquidity problem. Depositors run to the bank to withdraw their deposits under the assumption that everyone else will do so. The bank is unable to sell its assets at their "full value" so as to satisfy withdrawal demand, and it fails. However, a central bank willing to accept the bank's assets as collateral can lend to the bank, allowing deposits to be converted into currency, and this can quell the panic. In a full-blown systemic financial panic, the central bank can extend this credit to the entire banking system.
The key problems for a central bank are in determining what will qualify as eligible collateral for a central bank loan, what the haircut might be on such collateral, and at what rate the central bank should lend. Moral hazard comes into play, and central banks are leery of extending the lives of banks which are actually insolvent and not simply illiquid.
The Diamond-Dybvig model is thought by some to justify a lender-of-last-resort role for a central bank, but that is incorrect. The original model, and its extensions, does not incorporate anything that resembles central banking - indeed the basic model is not monetary (Diamond Dybvig also has no role for deposit insurance, but that's another story). Some things though, such as the the liquidity transformation role of banks and moral hazard problems in banking, I think are well understood.
In general, there are not many complaints about the Fed's lender-of-last-resort role in the financial crisis. Though the Fed may have been overzealous in lending in unconventional ways to unconventional borrowers, mainstream opinion seems to be that the Fed's lending during the crisis was necessary.
But are demands that the ECB play a "lender of last resort" role in Europe simply requests for the central bank to perform its conventional role? The argument seems to be that Italy and Spain, for example, because they are not running primary deficits, are like the bank that is suffering from an illiquidity problem, and not like the bank that is actually insolvent. According to this argument, bondholders are "running" on Italy in the sense that they are demanding very high interest rates. In this sense, an Italian default could be self-fulfilling, just as failure could be self-fulfilling if there is a run on a bank. Then, according to the argument, it makes sense for the ECB to step in and buy Italian government debt - or the debt of any other European government subject to this "liquidity" problem.
But hold on here. In the case of conventional central bank lending, for example as one might envision in response to a pre-Federal Reserve or Great-Depression-era banking panic, the central bank is replacing the liquidity that the public has lost confidence in - bank deposits - with liquidity that it views as roughly equivalent - currency. Is that the case if the ECB buys debt issued by European governments? Well, maybe so. Deposits at the ECB are not quite the same as the safe government debt which the bondholders want, as central bank deposits are not as widely traded as government debt (not all financial market participants can hold an account with the ECB). But, anyone can hold a deposit with a bank in the EU, and banks in the EU hold reserve accounts at the ECB, so this does not seem to be a problem. Thus, it seems the ECB can indeed convert "illiquid" government debt into liquid central bank liabilities.
But to actually quell the panic, the ECB must be able to lower the bond yields on the debt it is purchasing. Is this actually possible? Let's take a look at the current ECB balance sheet. The size of the balance sheet is about 2.3 trillion Euros, as compared to about 1.5 trillion Euros in January 2008. Thus, the expansion in the ECB balance sheet is nothing like the tripling that occurred in the United States, but there are features that are qualitatively similar. For example, there has been an expansion in the debt obligations of ECB member countries held by the ECB(much like QE2, though a smaller intervention) and the ECB currently holds reserves in excess of requirements. On its most recent statement, the quantities apparently in excess of reserve requirements are 144 billion Euros in the deposit facility and 183 billion Euros in term deposits.
These quantities of excess reserves are not as large as in the United States, but I think you can see the effects of these reserves on interest rates in the European overnight market. Recent data shows the overnight rate near the bottom of the interest rate "channel," with the lower bound determined by the interest rate on the ECB's deposit facility, currently at 0.5%. Note, for example in early 2008, that the overnight rate would typically be close to the middle of the band.
Thus, my working hypothesis is that, given a sufficiently large stock of excess reserves in the EU, the interest rate on ECB deposits is determining the overnight rate in Eurpope, much as the interest rate on reserves in the United States is determining short-term interest rates here. Just as in the US then, purchases of government securities by the ECB do not matter, at the margin. The ECB can buy government debt, but in spite of the fact that the debt they are buying may be risky and the liabilities they are issuing may be much less so, the ECB has no advantage over the private sector in intermediating Italian debt, for example. Buying Italian debt will not change the path for prices, and cannot change the prospects for a default on Italian debt.
If the ECB were to lower the interest rate on its deposits, this would indeed raise the price level and allow all EU members to implicitly default on a piece of their debt outstanding. Some EU members obviously want this. Others, like Germany, understand that the reason they can borrow at low rates is because the ECB made a commitment in its charter to price stability.
In any event, just as quantitative easing is currently not a solution to anything in the United States, "lender-of-last-resort" lending by the ECB will do nothing for Europeans.
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