UNIVERSITA` DEGLI STUDI DI PADOVA

Transcription

UNIVERSITA’ DEGLI STUDI DI PADOVA
DIPARTIMENTO DI SCIENZE ECONOMICHE ED AZIENDALI
“MARCO FANNO”
CORSO DI LAUREA MAGISTRALE IN ECONOMIA E FINANZA
TESI DI LAUREA
“EURO AREA CRISES AND THE INTERVENTIONS OF THE
EUROPEAN CENTRAL BANK”
RELATORE:
CH. MO PROF. BRUNO MARIA PARIGI
LAUREANDO: MARIO FRANZON
MATRICOLA N. 1039987
ANNO ACCADEMICO 2013/2014
“Central Banking [...] thrives on a pervasive
impression that [it][...] is an esoteric art. [...] to this
art and its proper execution is confined to the
initiated elite. The esoteric nature of the art is
moreover revealed by an inherent impossibility to
articulate its insights in explicit and intelligible
words and sentences”.
Karl Brunner (1981)
Contents
1.
Introduction .................................................................................................................. 1
2.
Euro zone troubles. Facts and potential solution ..................................................... 3
2.1. A foreword ............................................................................................................... 3
2.2. Greece ....................................................................................................................... 4
2.3. Ireland ....................................................................................................................... 5
2.4. Common symptoms for different illness ................................................................ 7
2.5. The competitiveness issue ..................................................................................... 13
2.6. Restore competitiveness across the EZ ............................................................... 15
2.7. Government debt influence on the crisis ............................................................. 16
2.8. What stands behind the surge in the sovereign yields
2.8.1. Evidence on Japan and Spain ................................................................. 17
2.8.2. Over the fundamentals. Panic as a driver for Euro Area sovereign debt
yields ......................................................................................................... 18
3. TARGET2 .................................................................................................................. 21
3.1. Theoretical framework .......................................................................................... 21
3.2. Some evidence on TARGET2 functioning ........................................................... 24
4.3.1. TARGET2 and fixed exchange rate regimes: a comparison .................. 26
3.3. The missed target: the economic debate over the payment system ................... 28
3.3.1. The ‘conservative’ theses of Sinn and Wollmershäuser ...................... 30
3.4.2. Germany: current accounts and TARGET2 imbalances ..................... 34
3.3.2. The Interdistricts Settlement Account framework as a solution for
TARGET imbalances ............................................................................... 37
4. ECB response to the crisis ........................................................................................ 41
4.1. Institutional background of the ECB and Eurosystem financial structure ..... 41
4.1.1. Institutional framework ......................................................................... 42
4.1.2. Financial structure of the Eurosystem ................................................... 44
4.2. ECB response to the crisis .................................................................................... 45
4.2.1. North Atlantic crisis and ECB reaction ................................................ 45
4.2.2.
Response of the ECB to the Euro Area sovereign debt crisis ............47
4.2.3.
Shortcomings of the Securities Market Programme ...........................49
4.3. The third phase ......................................................................................................50
4.3.1.
ECB response. Innovations from the past ............................................52
4.4. The ‘stealth bailout’ of the Euro area ..................................................................54
4.5. Does the ECB act only as a price stabilizer? .......................................................55
4.6. ECB as a lender of last resort ...............................................................................58
4.6.1.
Need for a lender of last resort? ............................................................59
4.6.2.
The means of a modern lender of last resort .......................................60
4.7. Fiscal dominance in the Euro zone ......................................................................64
5. Targeting the villain: the quest for fiscal discipline .......................................................67
5.1. Austerity budgets and counterfactuals ................................................................67
5.2. Has austerity gone too far? ...................................................................................70
5.3. Cyprus ....................................................................................................................72
5.3.1. The ‘half salvage’ ......................................................................................73
5.3.2. Repercussions on Cypriot depositors .....................................................74
5.4. Risks after Cyprus bailout ....................................................................................76
5.4.1. Bank runs and deposit insurances ..........................................................76
5.4.2. Which future for insurance schemes? ....................................................77
5.4.3. The urgent need for a banking union in the Euro area ........................79
6. Conclusions ........................................................................................................................83
References ................................................................................................................................85
Web sources ............................................................................................................................90
1. Introduction
There is a lot of confusion about the events that have hit Euro area countries since 2008. With
this paper we want to show that have not been issues regarding ‘competitiveness’ to drove
some Euro zone countries into the void of a prolonged crisis. The source of the problems has
been the increase in government spending − in order to contrast the adverse effects of the
chaos created on the capital markets. In fact, as a result of the sovereign debt explosion, some
members of the Euro zone, the so-called ‘peripheral’ countries, were felt risky, as confidence
on their sovereigns decreased. This caused an extraordinary upward surge in sovereign debt
yields, indicating the increasing panic on the markets. Moreover, similar yields started to
represent the rise of unprecedented tail risks, such as default or, worse, the exit of some
countries from the Euro zone.
Faced with similar events, and resolute to save the monetary union, the European Central
Bank (ECB) started to act as a lender of last resort (LoLR) for the sovereigns of the
Eurosystem. It has been acting in this role since it first started its purchases of Euro area
peripheral sovereign debt, in May 2010, under the Securities Markets Programme (SMP). The
scale of such an intervention has notably increased since then, as its range of instrument has
expanded. This fact is recognized by a large part of economist (Buiter et al. (2011), Buiter and
Rabhari (2012a,b), De Grauwe (2011a,b), Sinn (2012), Sinn and Wollmershäuser (2011),
Wyplosz (2012)).
Some economist, however, gave a different interpretation to the turmoil in the Euro area.
Accordingly to this narrative, structural weaknesses are due to the absence of exchange rates.
It has happened that peripheral countries have registered increasingly large current account
deficits for almost a decade. Another feature of these countries has been their inflation rates,
which have exceeded those in the rest of the Euro zone. These sequence of events has led, in
our opinion, to the following line of reasoning. High inflation, coupled with the common
currency, has made some countries uncompetitive, which has then led to external deficits.
Nevertheless, these countries faced the need to bring their inflation rates below those of the
rest of the Euro zone. This, most likely, requires slow growth and, as a consequence, has
weaken budget deficits. Markets have then concluded that the situation was not manageable,
hence the crisis. As a further consequence of this narrative, the role of the ECB in managing
the crisis has been harshly criticized. This line of reasoning, mainly represented by the
‘seminal’ work of Sinn and Wollmershäuser (2011), argues that ECB would have allowed to
finance the balance-of-payments deficits of peripheral countries. This should have happened
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by tolerating and supporting a voluminous money creation and lending by the National
Central Banks (NCBs) of these sovereigns. As a consequence, in the ‘core countries’ of the
Euro area a contraction of the monetary creation and credit lending should have happened.
Once this view is accepted, the policy conclusions we will see on section 2.6 follows. It is
our ambition to show that their claims were weak.
Nevertheless, considerations on the role of the ECB cannot be definitive, as some market
uncertainty was still ongoing when this thesis was draft and new ECB interventions are
among the possibilities. The sovereign debt crisis has seriously undermined, as economically
as politically the Euro area. Nonetheless, in our opinion the range of measures the ECB has
implemented, especially during the past twelve months have been correct and, mostly,
necessary. Not only banks, but also sovereigns needs a lender of last resort. Then, to allow for
a LoLR to be completely effective, is necessary to implement the so-called ‘banking union’
for the Eurosystem. With banking supervision concentrated in a unique institution, ECB
would then allowed to intervene promptly and with the necessary resources, in the case of
market distress somewhere in the Euro area. This would help to improve the approach that
ECB and European Union have taken during the crisis. Certainly, peripheral countries were
obliged to face the strong disequilibria on current accounts, budget deficit and, mostly, on
public debt. Nevertheless, in our opinion, adopt fiscal austerity measures is, per-se, a non
optimal choice when economy is declining. Cyprus ‘half salvage’ has been the proof that an
improvement in the regulation and supervision at the supranational level is indispensable. An
entity with 17 − or more, in the future − different members needs for a greater policy
coordination.
This thesis is organized in five parts. First, we give some evidence on the ‘problems’ that are
afflicting some Euro area members. Second, we set out the simplest possible representation of
payments flows through TARGET2 and, after that, we examine the themes of the debate and
evidence for the interpretation of the increase in German TARGET2 balance. Third, we
explain how the ECB acted in order to get rid of the increasing default and redenomination
risks in the area. Fourth, we interpret the effects that conditionality programmes, imposed on
rescued Euro area members, has provoked on these economies. Moreover we propose some
considerations about Cyprus’ bailout and we invoke the need for a banking union. Finally we
conclude.
~2~
1. Euro zone troubles. Facts and potential solutions
2.1. A foreword
A multitude of events have shocked the Euro area in for the last five years. The first “stage”
of the financial crisis started with Lehman Brothers collapse in 2008, and involved the whole
financial sector of the “Atlantic” area. Turmoil have then shifted, approximately from 2010,
to some peripheral countries of the Euro zone, since then known as GIIPS (as these countries
were Greece, Ireland, Italy, Portugal and Spain). On the Subprime financial crisis a lot was
written (Reinhard and Rogoff (2009)). On the other step we are already discussing how we
will come out. On the first months of the 2013 we even assisted to the Cyprus banking sector
bail out. What is surprising is the fact that Euro zone debt crisis had presented itself into two
different patterns within the GIIPS. Indeed, the symptoms for the most severe economic crisis
from the Great Depression are not similar across the countries hit by those events.
The most important ones are indeed well represented by two indicators, which have always
been well known, in the past as in present times. Loosely speaking, we can say that what has
happened from 2010 is a ‘last duel’ to the continuous infringement of the rules governing
public finance in the Euro area. Rules that allowed the birth and, for almost 15 years the
oversee of the European monetary union. As is broadly known, in the Treaty on the
Functioning of the European Union (Maastricht Treaty, or TFEU hereafter) two were the
major criteria that member states were called to respect, in order to join the last stage of the
European Monetary Union:

annual government deficit not exceeding 3 percent of GDP;

government debt not exceeding 60 percent of GDP.
As these fundamentals were the precondition for the participation in the European integration,
have been preserved in full also in the revision of the Maastricht Treaty, the Stability and
Growth Pact (2005). The main idea, indeed, was to preserve stable economic conditions
within the EU by guaranteeing a far- sighted control of the general accounts. The consequence
of the continuous infringement of these rules means that Euro area crisis brought some
countries to definitely deal with high deficit and sovereign debt levels, in order to cut it.
An effective fiscal structure, as designed in the TFEU, would have forced ‘careless’ countries
to adopt the policies of the fiscally prudent ones, e.g. Germany. This view would assure the
convergence of the economies of the European union member states to the one of the
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dominant country. Nevertheless, it has some backlash. In fact it implies that a group of
governments must follow a unique approach to monetary and financial stability, i.e. the
German one. This meant, that all would be going to behave like the Germans, thus a) have to
adopt price stability as one of the fundamental pillars and b) have a central bank only focused
on that policy goal.
This showed to be possible in the short and medium run, but very difficult on the long. We
share Eichengreen (2012) opinion, which states that the Euro area crisis is dated at 1999, not
2011. The juxtaposition of different visions about some countries and the byzantine design
considered for the Euro area made that at the first serious quake, the European monetary
union (EMU henceforth) suffered a serious crisis. Nevertheless, considering the
“Bundesbank” model, indeed, is correct when dealing with a single country, since it is
designed on the separation between fiscal and central bank actions. Neither of them should
impede the fair policies of the other organism.
A similar scheme is not possible in a monetary union, where structural characteristics of
member countries are severely different and no fiscal union nor a basic policy coordination −
about which measures to adopt when a crisis hits the economic area − exists. EMU − as it is
actually designed − is a poor build-up, since only some selected of the seventeen countries
could, and effectively have, fully join the “German style” approach for the last ten years. As a
consequence, especially for the last four years, we assisted to an explosion of the public
spending across the Euro zone. In the 2011, only Germany and Finland − between the major
members − respected the deficit/GDP criteria, as figure 8 shows. Certainly governments were
obliged to take exceptional measures, in order to front the crisis. Nevertheless, this trend
shows a simple fact: lack of coordination. There had been coherent policies between the area,
there would not have been such disequilibria across different countries. Two country cases
helps us to describe very well why the risk is exceptionally increased in the Euro area.
2.2.
Greece
What brought the Hellenic economy to collapse is an handful of bad administration and
severe public sector restructuring measures. Since the Greek government was not satisfying
both of the Maastricht Treaty requirement in 1999, Greece joined the European Monetary
Union only in 2001. Nevertheless, the economy was growing steadily. In the 1999-2007
period, an average gross growth of 4% was registered. Unemployment was decreasing;
similarly for interest rates, which approximately converged to the Euro area level.
As
previously enlightened, Greek government was not so honest: the deficit/GDP and debt/GDP
levels enlarged in a harsh way, showing an attitude to fiscal recklessness. The current account
~4~
balance, moreover, was sinking steadily since 2001, after the changeover with the Euro. This
was the perfect environment for a debt crisis: since 2008, with the North- Atlantic crisis
crushing the banking sector first, the Greek government started a huge spending campaign in
order to sustain the economy. This worsened the already beaten macroeconomic indicators.
Events came to a head since 2009, when the market realized that the Greek government would
not be able to repay its debt. This lead the sovereign debt yields to soar, thus increasing the
implicit possibility of default of the Greek sovereign. To avoid a similar event, ECB, EU and
IMF jointly signed a rescue plan, where funding was submitted to strong conditionality on
various reforms, from public expenditure cut plans to labor market and other structural
reforms. As a consequence, Greek government has to cope with three issues.
First, it has to avoid to call for a new second default, which would lead to its exclusion from
the Euro area. Second, it has to deal with massive social inequalities, partly born from the
recklessness if the public mismanagement, partly from the austerity plans imposed by the EUECB-IMF troika in order to restore normal conditions in the national accounts. Third, it has to
partially restore its competitiveness. In fact, after the monetary integration, huge amounts of
credit flowed into the country, allowing a spending boom in the private as in the public
sectors. However all this funds have not benefited the tradable sector. Conversely, the credit
boom went to the non tradable one, e.g. real estate, making the former relatively expensive
with respect to the latter. This process is already working. This support our opinion that the
current account imbalance was not more justified by a the need of catch up the other Euro
area members.
2.3.
Ireland
As in Greece, the growth of the Irish economy was outpacing that of all the other of the Euro
zone countries. With an average 5.6% growth, during the period 1999-2007, Ireland surely
was the most performing in the European Union as well. By looking at figures 1 and 7, we
see, at a first sight, that the causes of the Irish slump were different with respect to the one
that caused the Greek drama. From 1999 to 2007, Ireland was, similarly as Spain, one of the
few country that fully accomplished the budgetary conditions imposed by the Maastricht
Treaty. In fact, we can draw the conclusion that the Irish government never breached both
deficit/GDP
and
debt/GDP
requirements,
thus
getting
rid
of
EU
commission
recommendations.
We cannot point to the recklessness of the Irish sovereign as cause of its crisis. At one point it
seemed that this country could be the proof that EU will be a successful experiment. Since
monetary conditions were more or less the same across the Euro zone and without an
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incumbent exchange rate risk, the expectations about the green island were more than
optimistic. Though, the route for the EU countries to become like the United States of
America was far yet. In fact, the crisis exploded on the island. The common pattern with the
Hellenic drama is precisely the incredible amount of credit that flowed into the country.
Figure 1. Deficit/GDP in selected countries, 1998-2007 (% change)
8.0
6.0
Greece
4.0
Ireland
2.0
Italy
0.0
Portugal
-2.0
Spain
-4.0
Germany
-6.0
Netherlands
-8.0
Finland
-10.0
1999 2000 2001 2002 2003 2004 2005 2006 2007
Note: A decrease in the deficit/GDP shows an increasing surplus in the government balance
Source: Eurostat, authors own evaluation
This happened because Ireland, with a striking tax rate of 12.5%, was seen more as a tax
haven than a truly fiscal partner by the other Euro area members. In Ireland, like in Greece
too, this flow of credit moved massively to finance investments. However, this has not
improved the tradable sector. The main recipient of this amount of money was the financial
sector, which registered an incredible expansion. This helped to inflate, during the years, an
huge housing bubble, very similar to the one expanded in the USA during the same period. It
is not surprising that after the Lehman Brothers bankruptcy even the Irish banks, guided by
the most famous Anglo-Irish bank, risked seriously to go bust, throwing the country in front
of a void. Only an involvement of the public government was possible to rescue this sector.
However, as in the worst nightmares, this intervention was not sufficient. In fact foreign
investors did not believe the Treasury assurances which, from 2007 to 2011, raised their
indebtedness in a so severe way to purchase the ailing financial institutions. This forced the
Central Bank of Ireland first and ECB, EU and IMF later to intervene in order to save the
country. It was in the 2011, few months later the first Greek bailout.
~6~
2.4.
Common symptoms for different illnesses
The facts reported in the previous paragraphs explains well the two different pattern that
brought ECB to respond in a massive way into the government debt market in order to face
the debt crisis in the Euro zone. The Spanish case is a partial copy of the Irish one: in Ireland
and Spain the stunning flood of credit, thus of private spending, turned into a bulky real estate
bubble, with whopping implications for their banking sectors, with the only difference that the
Spanish sovereign was beloved for its credibility and Spain was indeed perceived as a
stronger economy in that period. In contrast, in Portugal and Greece, problems were not
originated by a real estate expansion. These last two countries, indeed always had an
excessive level of indebtedness, coupled with a bloated non-tradable sector, due to a mix of
lack of reforms and proper level of investments. This put the banking sectors in a vulnerable
position.
Turmoil about the Italian sovereign were more similar to the latter. However, from 1999, the
deficit/GDP ratio has been under control more than Greece and Portugal. From 2007 its
public spending was even more virtuous then the one of the French or the Dutch government.
Its banking sector was and is stronger with respect to other in the Euro zone (e.g. Belgium and
Netherland). We ascribe most of the frictions to a fall of political credibility, after a standstill
in the government action from the Berlusconi re-election in 2008.
Turmoil regarding Cyprus economy instead are a consequence of both symptoms, since this
country showed a banking system out of control (estimated to be seven times bigger than the
GDP), within an economy not able to generate a stable and sustainable growth, as in the last
ten years. These countries realized to have taken the wrong route only when foreign investors
refused to finance them again, since they have understood that GIIPS were not financially
sound as they seemed to be only one year before. Then two are the common issues of such a
wave of financial distress: fiscal recklessness and a lack of competitiveness and growth.
2.5.
The competitiveness issue
The more important cause seems to be represented by a lack of competitiveness, for one
important reason almost. Restoring growth indeed is much more difficult if the obstacles are
caused by a misallocation of resources, with excessive growth in the non-tradable sector and a
very fragile situation in the banking sector. Moreover, the economic situation of a country
plays a harsh influence in the fiscal planning of a sovereign. At a first sight, a straightforward
indicator of the competitiveness of a country is given by the nominal labor unit cost. Figure 2
shows this measure for Germany and peripheral Euro area countries. Seemingly, it shows that
GIIPS countries have an huge gap about labor cost with respect to Germany, even if in the last
~7~
four years it had diminished substantially for these countries except Italy. This is surely true.
However it is not fully correct refer to this data, as a comparison based on nominal cost
between different countries is valid only if two assumptions are fully satisfied.
Figure 2 . Nominal unit labor cost index (2000=100)
150.0
140.0
130.0
Germany
Ireland
120.0
Greece
Spain
110.0
Italy
Portugal
100.0
90.0
Source: Eurostat, authors own elaborations
First, for a similar comparison, we should have a single goods market but a separate labor
markets between Euro area countries. Second, we do not need consider influences of
exchange rates in the labor count, as Euro is the common currency in the Euro zone countries.
These conditions however, are not completely credible in the environment we are analyzing.
The former condition is clearly plausible, since no links between the labor markets of the
Euro zone members have never been demonstrated. Nonetheless, evidence tells us that labor
bargaining is deeply related to economic conditions of a country and the economic area in
which it trades (Freeman (1987)), implying a certain grade of fragmentation. The fact that EU
is driving at two different speeds, with northern area in a fastest recovery and less significant
recessions has certainly some links with the first assumption. On the contrary, we deem that
the second hypothesis is not credible for almost two reasons. First, European Union and,
overall, Euro area countries are not only trading within them, but also with the rest of the
world. This makes impossible to compare the nominal cost with countries in which different
measures would be adopted. Second, nominal unit labor cost considers only the evolution of
tradable goods. We already know, however that the competitiveness problem was mainly
given by capital flowing into the non tradable sector. Thus considering the nominal unit labor
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cost leads to biased conclusions, not allowing us to show something about loss of
competitiveness between core countries and peripheral ones.
Figure 3. Real Effective Exchange Rate, 2000-2012 (2000=100)
112.0
110.0
108.0
Germany
106.0
Ireland
104.0
Greece
Spain
102.0
France
100.0
Italy
98.0
Portugal
96.0
Cyprus
94.0
Source: Eurostat, authors own elaboration
For this strong reason, we pointed out that a proof may be given by another well known
indicator, the real effective exchange rate (REER). Wyplosz (2012) also comes to this fact
and the conclusions he drew were similar to the one we have given above. Moreover he had
also set up an analysis of the REER, which leads to the conclusion that the real effective
exchange rate of the GIIPS countries has gone over valuated for the last ten years, whereas for
Germany and other few northern countries this has been under valuated. We only accord
partially to his view. In fact by looking at figure 3 we have found only some evidence of this
fact. For Ireland there are signs of an explosive effective over valuation, vanishing the fall in
nominal unit labor cost.
Nevertheless, other countries shows to be quasi-balanced with
respect to Germany. Some other interesting information may come from the productivity per
employee, as shown on figure 4. Notice how this indicator has grown in the last eleven years
in almost all peripheral countries and is exploded for the “late entries” of the Euro group, i.e.
Estonia and Slovakia, whereas remained stable or has even decreased in the core ones. What
is more, we see sharp fall in productivity only for Italy and Belgium, and a moderate one for
Greece. It is interesting that in the period 1999-2011, competitiveness decreased at the highest
~9~
rate only in those countries which presents the highest average Debt/GDP ratio in the Euro
area1.
Figure 4. Change in productivity per employee, 2000-2011 (%)
-20.0%
-10.0%
0.0%
10.0%
20.0%
30.0%
40.0%
50.0%
Estonia
Slovakia
Ireland
Cyprus
Slovenia
Portugal
Spain
Germany
France
Netherlands
Luxembourg
Greece
Finland
Austria
Belgium
Italy
With the exceptions of Finland, this trend seems to be confirmed. However if we look to the
index value, we discover high discrepancies for Portugal and Spain 2. Thus this relative
changes for GIIPS countries seems to be more justified by the catch up with the rest of the
area than from a real competitiveness problem, which could stand only for some selected
countries. The major issue indeed, clearly a consequence of some loss of competiveness for
some countries, is represented by the deteriorations of the external balances. We evidence this
facts in figure 5, showing the current account balance for some selected countries in the Euro
area. Figure 6 shows for these sovereigns the severe slump of the GDP after the subprime
crisis. What is irrefutable is that for the last 10 years the external balances for some countries,
e.g. peripheral ones, have had a strong decrease, counterbalanced by a strong growth in the
accounts of some partners in the Euro area. This, clearly, is not due to the accounting nature
of the external account and of the balance of payments. As the Euro area is not the world,
current accounts of its members do not have to sum up to zero. This is the strongest signal of
the scarcer performance of some countries to export its product abroad. Notice as from 2000,
1
2
We assume an high debt/GDP ratio if is over 70 percent of the GDP of that country.
Notice how Ireland presents a high level of productivity per employee.
~ 10 ~
the accounts were negative for Spain, Portugal and Greece, and also for Austria and Germany.
Italy and Ireland instead presented at the time an account almost in balance.
Figure 5. Current account balance for some selected countries, 1999-2011 (% GDP)
a. Core Countries
-4.0
-2.0
0.0
2.0
4.0
6.0
8.0
10.0
12.0
1999
2000
2001
2002
2003
2004
2005
2006
2007
2008
2009
2010
2011
Germany
Netherlands
Finland
Austria
b. GIIPS
-20.0
-15.0
-10.0
-5.0
1999
2000
2001
2002
2003
2004
2005
2006
2007
2008
2009
2010
2011
0.0
5.0
Greece
Ireland
Italy
Portugal
Spain
If we look at the year before the third stage of EMU, for these last two countries, we even
notice that stable surpluses in the external accounts were registered. Nonetheless, the only
cases of external surpluses for these selected countries were registered in Finland an
Netherlands, which presented, for the whole period, a strong current account surplus.
~ 11 ~
Figure 6. Real GDP growth, 2007-2012 (%)
8
6
4
Germany
2
Ireland
Greece
0
Spain
Italy
-2
Portugal
-4
Cyprus
-6
-8
2003 2004 2005 2006 2007 2008 2009 2010 2011 2012
From the depicted figures we are able to recognize that a part (the periphery) of the Euro area
suffers of some structural problem about foreign misbalancing with respect to some partner
countries (the core). Nevertheless, we have no clear explanations of the reasons that has led
to this situation. In fact, since we have not seen strong patterns about missed competitiveness,
excluding the fact that core countries register higher growth rates on average and shows better
capacity in recovering growth after a slump. In fact, notice that, almost from 2003, all GIIPS
countries started to achieve a clear deterioration in their external account, while some
countries, like Germany, the Netherlands and Austria started to gain greater surpluses. This
happened with a partial deterioration of the real exchange rate for these countries based in the
periphery of the Euro zone. Thus the ongoing revaluation of the periphery’s effective
currencies could have well had an impact on this decline. Notice indeed, in figures 2 and 3, a
partial recovery about these ‘competitiveness’ indicators, for the last three years. The effect is
shown on figure 5, as we can notice a slow but stable decrease of current accounts deficits in
the peripheral countries. We agree that relative unit costs have diverged in the Euro area,
since the creation of the Euro. Nevertheless, the reason of the severe misbalancing through
core and peripheral countries is represented by a mixture of causes. In fact, every country
presents different structural issues. This is the reason why it is difficult to represent
~ 12 ~
‘competitiveness’ in a single figure. The fact that GIIPS economies suffer a more rigid labour
market indeed cannot be attributed as unique cause of such a divergence.
2.6.
Restore competitiveness across the Euro zone.
We agree on the point that an external burden problem exists (for the sake of knowledge, see
Sinn (2011a,b), Sinn and Wollmershäuser (2011), Schnabl and Wollmershäuser (2013)).
Some economists, mostly German or from other institutions core countries’ based, proposed
some solutions for a rebalancing of similar discrepancies between Euro area economies.
Notably, three are the possible solutions to correct the current account imbalances:

exit the Euro and realize an external devaluation;

realizing an internal devaluation by falling prices in the periphery countries;

achieving an internal devaluation by raising prices in the core countries.
The first alternative implies actions certain to provoke severe disorders in the periphery, and
probably with incalculable costs for the whole area.
The second has similar risks; indeed it accepts a prolonged social misery in such countries.
Thus is not so much advisable, since it would hurt the aims for what it was implemented. The
third will never be implemented, as it asks mainly to Germany to face a level of inflation
unconceivable for their electoral base and politicians.
These possibilities with no doubt are theoretically right and possible. Nevertheless, it would
literally exclude some countries from the Euro area, and throwing other countries into a void
of deep measures and social distress before these could see a possible recovery and an
adjustment with the rest of the Euro zone. We argue that these proposals are theoretically
simplistic. Some words from a work of Wyplosz (2012) are cited there, as these describes
very well this dramatic situation created in the Euro zone and the debate that has grown about
the measures to adopt:
“[…]Such drastic policy implications run against the salt of economics as a field
designed to improve welfare. Of course, tough adjustment is sometimes unavoidable
but one would expect that such policy prescriptions be based on actively investigated
evidence, not superficial observations.”
The first option, exit of a member country from the Euro area club, would be seriously
problematic since it requires the redenomination of assets, liabilities and prices into the new
~ 13 ~
currency in a midst of a crisis. Another problem would be given by the fact that the National
Central Bank could indeed remain into the Eurosystem, as to take advantages of such a
membership, but creating political issues at the European level. What is more, the exit-andredenomination process must be performed in a quick. This will allow to get rid of negative
consequences, like large losses of output, if not to the country’s default and the raise of other
tail risk. In fact, an “exit from the Euro” option was never taken into consideration in any EU
treaty. As a consequence, market reaction would be dramatic. The main problem of such an
option stands on the debt: if this remains denominated in Euro, a troubled government would
not be able to sustain it with new depreciated currency, leading the authority to take this last
decision. A similar event would be very different from a negotiated debt restructuring, like the
one that took place in Greece in 2011, as this option never considered the exit option and the
redenomination. Nevertheless, exits from the currency unions have not been uncommon in the
history. Greece has already performed one in its history3. Rose (2007) compared countries
leaving currency unions to those remaining within them, finding that formers tend to have
higher inflation when they take the decision. He has even found that, on average, there are no
sharp macroeconomic movements after exits. However, since redenomination is hard to
happen in a democracy4, a default is practically inevitable if a similar decision is taken5.
The alternative of a internal devaluation is not less drastic of the exit-and-redenomination, as
these has important economic consequences on the economy too. In fact, this sort of
devaluation is obtainable almost in a way: by cutting workers’ wages. A similar option, taken
in the midst of a recession is as painful as the previous alternative for almost three reasons.
First, it distorts the balance sheets of the economy where the measure are taken, and the
measure needed to correct them are even more expensive. Second, the countries will run in
economic stagnation, thus will suffer a period of high unemployment. Since barricades and
riots have been common in Greece and even in Spain in the last months, the social
consequences of a similar plan would be disastrous and will lead maybe to a disruption of the
euro area, if not of the European union. Third, banks and companies will face a non negligible
probability to fall in bankrupt, since their foreign debt will rise with respect to the value of
their assets. Hence, a successive rise of the government debt is not impossible, undermining
the efforts implemented.
3
See Bank of Greece (2003). Link available on the Web sources.
See EEAG (2013) for the problems involving this events.
5
Indeed it can even happen the exit of a strong currency from the union (i.e. Germany to adopt the Deutsche
mark), thus avoiding the run on assets in the outgoing country.
4
~ 14 ~
The third solution seems to be the ‘most viable’, since it does not concern huge losses for
companies6 nor high unemployment or default probability. The only consequence, for the
“core countries”, would be to accept an higher inflation, thus an internal wealth redistribution,
in order to rebalance the expectations about future growth in the different euro zone’s areas.
This solution however is not viable, as it is not acceptable to discharge the weights and costs
of the past fiscal recklessness on countries and citizens that have always been fiscally prudent
and correct.
2.7.
Government debt influence
As we have seen before, competitiveness has some grades of influence in the Euro area crisis.
In fact it is an important cause of instability for some Eurosystem countries. Nevertheless, in
our opinion, it does not represent a crucial problem. In fact, all the sovereigns involved in the
sovereign debt crisis, are slowly gaining some grades of recovery. The problem actually is
represented by debt. Most of the peripheral countries have, in the period 1999-2007, tried to
reduce their debt level on average. Spain and Ireland were able to pull down the debt/GDP
ratio of more than 20 percentage points in that period, as we can see from figure 7. Belgium
instead reduced the ratio almost of 10 percentage points. This was very important, as this
sovereign has always been characterized by high debt levels. In the considered period, Italy
and Cyprus and also Greece maintained it at a high but stable level. Portugal instead
augmented it a stable rate, as well as France and Germany.
Figure 7. Debt/GDP growth, 2000-2011 (2000 = 100)
350
300
Germany
Ireland
250
Greece
200
Spain
France
150
Italy
100
Cyprus
Portugal
50
Belgium
0
2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011
Source: Eurostat, authors’ own evaluations
6
It does not concern nor recession for the periphery economies nor for the core countries as well.
~ 15 ~
However, the 2008 financial turmoil obliged many Euro zone governments to intervene as to
avoid the banking sector collapse. Thus a sharp rise of public spending and, consequently of
debt, has taken place. Figure 7 shows how the trend about debt reduction has had a stop and
then an inversion from 2008. This pattern is also confirmed by comparing figure 8 with 1.
Figure 8. Deficit/GDP in selected countries, 2007-2012 (% GDP)
10
5
Greece
0
Ireland
-5
Italy
-10
Portugal
-15
Spain
-20
Cyprus
Germany
-25
Netherlands
-30
Finland
-35
2007
2008
2009
2010
2011
2012
Neither of the selected countries, registered a positive deficit/GDP ratio in the last four years.
In Ireland the increase of the Debt/GDP ratio has been dramatic. Nevertheless, even if the
debt levels of some countries are the highest in the world, e.g. Greece and Italy, we deem that
these sovereigns would not suffer such difficulties in refinancing if they would not stand in a
currency union, without monetary sovereignty.
2.8.
What stands behind the surge in the sovereign yields
Accordingly to what we present in the next paragraphs, we can affirm that it is now a
commonplace to argue that a high level of public debt leads to indeterminacy for risk premia.
In fact, even a relatively high level of public debt could be sustainable if the government only
had to pay the low interest rate corresponding to riskless investments. However, the same
level of debt might become unsustainable, forcing a liquidity crisis or, worse, a default, if the
interest rate on public debt were much higher. Many authors, following the seminal work of
Calvo (1988), have therefore argued that there might be multiple equilibria. If the market
thinks the government can pay, it will be able to pay because the risk premium will be low.
~ 16 ~
However, the converse can be true. When the market assumes that a sovereign cannot pay, it
will not be able to pay, as the risk premium will increase so severely that debt service will
become too expensive for the government to be finance. In this way we affirm that panic
about the ability of a government to service its debt could thus become self-fulfilling. As we
will see on the simple example on section 2.8.2, within the Euro area all national governments
are in this situation and that a crisis could arise when the market just switches from the good
(low interest rate) to the bad equilibrium (high interest rates), thus forcing a default. To
understand what kind of factors have brought to the Euro zone debt crisis escalation, a simple
example will be presented in the next paragraph, by referring to two countries, Japan and
Spain.
2.8.1. Evidence on Japan and Spain
After the first Greek bailout, in February 2011, Japanese Government received from Moody’s
Investor Service and Standard & Poor’s a negative outlooks on Japanese debt’s rating. The
Japanese Prime Minister Naoto Kan publicly announced that high debt problem was so an
“urgent” situation that, in a short time, could have led the country in a Greek-like situation. In
this scaremongering job Prime Minister Kan was then assisted by the Bank of Japan
Governor, Masaaki Shirakawa which tried to “reassure” the market with this single
declaration7: "As history shows, no country can continue to run fiscal deficits forever”.
They were wrong. Figure 9 shows the different path of the debt/GDP level for Spain and
Japan. We can see that the former country, since the start of the third phase of EMU in 1999
has put in place several measure to reduce his debt, even if it registered some significant
current deficits in the period. Japan instead has always seen his debt/GDP level soaring,
coupled with strong current deficit in all the years of the considered time interval. This trend
has taken place especially since 2008. Facts evolved differently in the financial markets
however, since market operators attached a much higher default risk on Spain than on Japan
government, even if it appears that Japan faces an enormous sovereign debt and a much less
favorable deficit pattern.
This difference in the evaluation of the sovereign default risks is due to the fact that Spain
belongs to a monetary union while Japan not, and therefore it has control over the currency in
which it issues its debt. Members of a monetary union issue debt in a currency over which
they have no control. Then financial markets gain the power to force default on these
countries, whenever they worry about it.
7
Taken from the Wall Street Journal, 26 February 2011.
~ 17 ~
Figure 9. Japan and Spain gross government debt, 2000-2011 (% GDP)
250.0
200.0
150.0
Japan
Spain
100.0
50.0
0.0
2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011
Source: Eurostat, reinhartandrogoff.com
Instead, countries that are not part of a monetary union cannot easily be forced into default by
financial markets. If investors will doubt of Japan straightness, they would sell their Japan
government bonds, driving up the yield. After these operations, investors would have Yen.
Probably they would want to get rid of by selling them in the foreign exchange market. As a
consequence, the price of the Yen would drop until somebody else would be invest on it.
However, the Yen money stock would remain unchanged. Probably some of that stock would
be reinvested to buy other Japanese securities. On the contrary, if investors would not use Yen
to invested in securities, thus allowing the yield on debt raising, the government could force
the Bank of Japan to buy it up, thus getting rid of a sovereign default.
2.8.2. Over the fundamentals: panic as a driver for Euro area sovereign debt yields
Spanish government would not have chances the Japanese government has. Financial markets
know this and will test the Spanish government in a “race to the bottom”. In fact, after having
sold the Spanish Bonos, investors who have acquired Euro probably will decide to invest
them in another country of the Euro zone, e.g. in Luxembourg. As a consequence, these Euro
leave definitively the Spanish banking system. Since neither a foreign exchange market nor a
flexible exchange rate system exists, the amount of liquidity of the Spanish government will
shrink, increasing the probability of putting it in front of a liquidity crisis.
This happens because ECB, which is responsible for the money supply, would not buy a
single Bonos under its standard operative framework, as we will see after, on section 4.2.1..
~ 18 ~
Nor the government would force the Bank of Spain to do it, since is no more responsible for
the monetary policy. Then, if the liquidity crisis is strong enough, it can force the Spanish
government into default. In practice the country fall in insolvency for a self fulfilling
prediction of the investors. Theoretically an additional difference between currency union
members and stand alone countries is then given by the fact that as investors sells Yens in the
foreign exchange market, the national currency depreciates.
This means that the Japanese economy is given an additional boost. This mechanism is absent
in the Spanish scenario. The proceeds of the Bonos sales leave the Spanish money market
without any relative movement. This dynamic however is difficult to prove here, as Japan is
in a delicate situation regarding GDP growth, currency price and inflation8.
The conclusion is that, paradoxically, distrust should lead to an equilibrating mechanism in
Japan, e.g. in stand-alone countries, whereas to a potentially destabilizing movements in
Spain. Nevertheless, this recalls the role of the efficient market, which creates the necessary
expectations and acts as a regulatory force. According to this view, we argue that two
different explanations well fits the trend that characterized money markets in some peripheral
countries. The dominant opinion underlying the two points of views has been that some
governments have spent too much, thus producing unsustainable debt levels. There would be
no point in providing financial assistance, as this gives them only incentives to enlarge the
moral hazard risks, as the crisis would be entirely caused by their misbehavior and fiscal
recklessness. This caused to make them insolvent and has lead markets to consider a default
or, worse, redenomination risks as possible for some of these countries.
As for the former explanation, the surging spreads observed from 2010 to July 2012 (until the
“invisible” intervention of the ECB) were only the result of weak fundamentals (i.e. domestic
government debt, current account deficits, competitiveness), such that the market was just a
messenger of bad news. The latter one, characterizing the period from August 2012 to date, is
different. It identifies collective movements of panic as the main cause of the massive effects
on spreads. Like in the stock markets when prices are engrossed by a bubble, pushing them
away from the fundamental, panic-driven movements drive the spreads away from underlying
fundamentals. Our point of has been shared by some economist (see De Grauwe and Yi
(2013) and Buiter et al. (2011)), which have proposed similar reasoning about the Euro area
sovereign debt crisis escalation.
8
Maybe there would be more evidence by considering the USA: even by a running deficit and debt, they have
registered an average 2 percent growth in the last four years and an higher inflation level with respect to Spain.
Japan is in a deflationary crisis for years. Moreover his Yen has appreciated during the crisis, as all the other safe
currencies, adding other shadows on the Japanese economy.
~ 19 ~
~ 20 ~
3. TARGET2
Competitiveness, as we have already underlined, has been important in the evolution of the
Euro area debt crisis. This incapacity to grow, coupled with an attitude to fiscal recklessness,
inflated panic in some other Euro area countries. In fact this lack of innovation was felt as a
threat for the whole Eurosystem. Two German economist, Sinn and Wollmershäuser − as we
have pointed out before − prospected that it was the lack in competitiveness to cause and then
fuel the crisis. Eurosystem interventions into the market, in order to limit the effect of the
panic, would have been particularly dangerous. In his opinion − as a consequence of these
interventions − the so-called ‘core’ countries were bearing too much counterparty risk by
financing the current accounts of the ‘peripheral’ countries. This sort of activity would have
exposed into too much risky positions the cautious ‘core’ taxpayers. The mechanism through
which this ‘stealth financing’ would have been in place was represented by the Eurosystem
payment system, TARGET2. With the complicity of the European Central Bank, operating
through a strong monetary creation by the National Central Banks (NCBs), this system would
have allowed peripheral liabilities to be converted into claims for the core countries.
Moreover, they have also proposed some harsh measures to be taken in order to reduce such
increasing risks for this endangered partners. What they have not realized are the possible
consequences of such proposals. This has led to a vigorous economic debate. In fact, the real
source of risk for core countries has surged for causes different to that they have proposed, as
we will demonstrate later. Other economists (for the sake of knowledge, see Bindseil and
Kӧnig (2012) and Buiter et al. (2011)) have reached similar results with different approaches.
3.1.
Theoretical framework
The adoption of the Euro as a common currency by ten countries in 1999 required that,
within the monetary union, cross-border payments should be treated like normal intra-state
payment flows, so within the border of a single country. In fact, without this condition, we
would see no differences between a system of fixed exchange rates and a monetary union.
The establishment of a currency union therefore required that deposits of banks should satisfy
almost two characteristic. First, accounts by banks with the central bank must be fully
available at any time. Second, such deposits, in one country of the currency area, must be
exchanged at the lowest possible cost against similar instruments in another member country.
To satisfy these conditions, a new payment system for the whole euro area was created, in
order to substitute the national ones previously adopted.
~ 21 ~
TARGET2, an acronym that stand for Trans-European Automated Real-Time Gross
Settlement Express Transfer, a Real Time Gross Settlement system (RTGS), is the evolution
of TARGET, the first scheme put in operation on the 1999. It provides payment and
settlement services between its participants. We can define it as an open system, as market
participants are free to make use of other payment and settlement systems and arrangements.
The best way to understand how the TARGET2 mechanism works is to focus on a simplified
single period model, focusing on balance sheets and identities. We do not want to build a
detailed model as other authors have done9. We want to explain the functioning of TARGET2
with a simple current account transaction model, inspired to that of Bindseil and Kӧnig
(2012), but deeply simplified.
Let us assume that someone in the Euro area Country A purchases a good or service from
someone in euro area Country B, i.e. think of an Italian purchasing some cultivated flowers in
Holland.
Figure 10. Current account transaction with Eurosystem
Authors own elaboration
Then the buyer needs to make the payment to the seller. This will involve two commercial
banks, e.g. the one of the country A (Italian) and the one of the country B (Dutch), and two
9
For analytic reasoning, see Buiter et al (2011).
~ 22 ~
national central banks (Banca d’Italia, or BdI, and De Nederlandsche Bank, DNB) since this
is an interbank-cross border transaction. In fact, as from figure 10, we can see that payee bank
reserve account with its NCB (country A) decreases while, on the other side, reserves at its
NCB (country B) of the beneficiary bank will rise. However, the transaction to be completed
has to be passed by the ECB balance sheet.
When the transaction is settled, NCB of country A (BdI) owes more to the ECB, while the
ECB owes more to NCB of country B (DNB). At this point, Bank α, the payee bank, has
suffered a deposit outflow and consequently a reserve loss. Then the commercial bank of
country A has multiple options to cover that imbalance. It can try to attract deposits from
abroad, it can borrow on the interbank market, it can sell its own assets, or it can go to the
central bank to ask marginal lending. We can deem the first three ones as “normal”
operations, since these are normally involved in the activity of a bank: they have in common
that the bank has to resort to the market for a refinancing. The latter one instead is less
ordinary. Marginal loans provided by the central banks in fact comes at a cost higher with
respect to the other alternatives, since no market risk is implied in these provisions.
Assume that Bank α will respond to the shortfall by borrowing on the interbank market. Then,
for the sake of simplicity, consider the case in which it will borrow directly from Bank δ, e.g.
the Italian bank borrows directly from the Dutch bank. This is a simple cross-border capital
account transaction, which was the normality in the pre-crisis pattern. In this case, reserves of
the two commercial banks remained unchanged since Bank δ funded the deposit outflow from
Bank α after the payment had been executed. When we assume that banks operate in the
interbank market, theoretically no intermediate passages with national central banks are
involved. What happens in a interbank operation is showed on figure 11.
Figure 11. Interbank refinancing operation
~ 23 ~
But with the onset of the crisis, interbank borrowing became increasingly difficult. During the
North Atlantic crisis, in the aftermath of the Lehman crash in September 2008, interbank
lending in most developed countries temporarily came to a halt. As it is widely known, as the
money market comes to a standstill, banks are no longer able to fund their asset holdings. This
is likely to cause investors to clear up their risky positions and call loans ahead of the preestablished expiration. This sort of asset sale can therefore generate a self-sustaining spiral,
terminating in a collateral value erosion and in a severe liquidity deficiency. This is what
really happened in the years from 2008 to 2011. In order to maintain the stability of the
banking system and to avoid macroeconomic repercussions, in many countries central banks
took over the role of an interbank market-maker. This resulted in unprecedented expansions
of their balance sheets, as we can see on figure 22. This new framework in fact made all the
operations pass within the NCB’s of both countries, thus with ECB. It was the point in which
the Euro zone central bank began its full allotment refinancing operations, which are various
measures, different from “helicopter money” operations10, tailored to impede the interbank
market to block. This however was not without costs. On the following sections of the
chapter we will focus on the tensions generated around the rise of TARGET imbalances of
some Euro area countries. As this sort of ‘credit expansion’ is accompanied with an increase
in risk exposure, these facts reopened the debate on financial crisis management in the Euro
area.
3.2.
Some evidence on TARGET2 functioning
Besides having the possibility to increase liquidity support during crises, most central banks
today avoid a direct intervention into the market. These institutions alternatively provide
additional absorbing facilities that can substitute for the market's borrower side (the role
conducted by country’s B bank on our interbank example). The use of such facilities by banks
comes usually at the cost of a lower remuneration for credit institutes. However these
accounts by the central bank are deemed as totally risk free. In fact banks will rely on it only
if interbank counterparties are perceived as rather risky. Broadly speaking, over the previous
case seen before, when a systemic liquidity crisis takes place, a general drainage of liquidity
will be a straightforward consequence. In this context, a central bank's balance sheet
expansion is seen more than justified. In such cases, by seeing how the NCB monitors the
market, we can say that the governing institution assumes the role of interbank market-maker.
Moreover, this intervention can even have the indirect consequence that some banks, knowing
that they would be able to resort to the ECB in the case of short term financing shortages, may
10
Then under its normal operational framework.
~ 24 ~
have been more willing to make interbank loans than would have otherwise been the case in
such a situation. Returning on our simple framework, and focusing on Eurosystem, we can
say that it is what really happened. The period from 2008 to 2009 was the momentum in
which ECB began its full allotment refinancing operations. With this new sort of transactions,
Bank α would be able to refinance its reserve shortfall by going to the central bank for funds
over a given term, by giving suitable collateral11.
Figure 12. Bank refinancing by the central bank
The introduction of this new framework in fact allowed for

a “maturity” transformation, since long term refinancing operation (LTRO) were
introduced, (longer than one year and, what is more, different from MRO, main
refinancing operations). This allowed a substitution of the short term financing, thus a
less dependency from short term dynamics of the market;
11
In fact banks' liquidity buffers are essentially determined by the collateral framework of the central bank, i.e.
by the eligibility of bank assets to be used as collateral in liquidity providing monetary policy operations and by
the haircuts applied to these assets.
~ 25 ~

a “liquidity” transformation, since a huge amount of collateral deemed illiquid has been
transformed into liquidity at a price lower with respect to the one quoted on the market
on that period;

has reduced the adverse selection on the market, thus reducing counterparty risk, by
absorbing indeed the previously recalled collateral.
To further explain what has happened in the Euro area since 2009, we have to deepen our
simple model. Assume things will be a bit more complicated. Consider that bank α
participation in the refinancing operation leads to a change in the balance sheets of both the
the BdI and DNB. This fact calls for the intervention of TARGET2 balances, which will do
the job previously done by the interbank capital flow and the capital account. To explain what
is changed with respect to the previous structures, where no central bank intervention was
requested, it is useful to recall the balance of payments identity:
Current account + Capital account + Official settlements ≡ 0
In this identity, the last term is important when we consider a gold standard or other fixed
exchange rate regime. For example, in the Bretton Woods system this term is the one where
changes in foreign exchange reserves showed up. If we look at figure 12 we can clearly see
that this identity is satisfied as the process comes at its conclusion.
3.2.1. TARGET2 and fixed exchange rate system: a comparison
In the functioning of the Euro monetary scheme, the term ‘official settlements’ is that where
changes in TARGET2 balances show up, that is, TARGET2 is a balance of payments
equilibrating mechanism inside the common currency area. With the current operational
framework of the Eurosystem, given the full-allotment refinancing and the collateral rules,
this official settlements balance is going to move automatically. Specifically, if the capital
account should go into reverse, then this reversal forces the official settlements in the balance
of payments identity to become even more positive. This mechanism is the typical one
described in macroeconomics manuals, e.g. Mankiw (2003).
Assume the case of a country with fixed exchange rate. When a capital flight, arising from a
combination of a loss of investor confidence and an attack on its currency, will start, the
country will begin to experience a currency crisis. Outflows will be limited by the size of the
country’s foreign exchange reserves. Once its reserves are exhausted, the country will be
forced to change the exchange rate level or, in the case of a currency union that adopted a
~ 26 ~
similar system, to exit it12. In the case of the Eurosystem instead, where devaluation nor exit
are considered, TARGET2 performs a role similar to creating foreign exchange reserves for
the country which is suffering the balance of payments crisis. For this sort of monetary
creation, the only limit put regards the collateral that banks in a single country have available
to take part in the refinancing operations. Collateral, in fact, is the precondition for
participating in the refinancing operations of the ECB. After the North Atlantic financial
crisis, the full allotment reform has allowed banks in countries like Greece, Ireland and
Portugal to overcome in a easier way the refinancing issue. With this non-standard monetary
measures, ECB cooled the overheated conditions of the banking sector in the peripheral
countries, allowing their institutions to fully participate at the central bank open market
operations. However, accepting collateral with a higher implicit credit risk, involves a greater
hazard (see Sinn (2011a,b)). In fact, with the standard rules, if the collateral requirements
would not be satisfied, then banks would not be allowed to participate at the auctions. Then, if
in a distressed situation, the only option for that banks would be to apply for the Emergency
Liquidity Assistance (ELA).
Table 1. Central Banks balance sheet distress
Assets
Outright
holdings
26/06/07 (pre-crisis)
14/01/99 (post Lehman)
09/03/11 (recent)
09/03/11 (recent)
11/03/11 (recent)
09/03/11 (recent)
Source: Bindseil and Kӧnig (2012)
Liquidity
providing
operations
Bank of England (billion GBP)
33
47
45
190
231
13
Federal Reserve System (billion USD)
790
20
495
583
2538
21
Eurosystem (billion EUR)
0
463
0
857
139
454
Riksbank (billion SEK)
0
4
0
266
0
1
12
Liabilities
Liquidity
absorbing
operations
Autonomous
factors
(net liability)
Reserves
of banks
60
78
106
0
101
0
20
56
138
763
143
942
30
89
56
17
846
1831
230
353
266
1
291
93
182
213
234
3
80
6
1
186
7
0
0
0
This is what was happened during the EMS, when Britain and Italy in 1992 withdrawn their participations. For
details on the EMS collapse, see Eichengreen and Wyplosz (1993).
~ 27 ~
In such a situation, the central bank will provide financial support against non-eligible
collateral (i.e. the total of the remaining assets of the banks can be security pledged).
Otherwise, if no assets to be pledged are left, the central bank can demand a guarantee to the
sovereign, to protect itself against potential default risk. This is the root mechanism to avoid a
run on the accounts. If the central bank declines the request for ELA, to bank α two
possibilities remains.
At the first glance the bank can try to manages the closure of the funding gaps through asset
sales (by implementing a “fire sale” bank tries to raise liquidity, in order to exert an upward
pressure on prices). Alternatively, it will default and its entire assets will be seized by its
creditors, which are likely to incur losses. This is what has really happened in Ireland and in
Greece where, for different causes, their banking sector was facing the default. In such a
distressed situation, the most exposed banks were obliged to ask for ELA support. In August
2011, Bank of Ireland ELA exposition amounted to € 44bn.
In this troubled period, full allotment operation were at the peak. Notice, however, that
emergency loans were given at an interest rate significantly above the main refinancing rate.
A similar penalty rate is set to contrast moral hazard incentive. Nevertheless, to allow banks
for a similar operation, the taking of these loans can only be explained with a further
downgrading of the collateral requirements on the part of the involved NCB. Borrowing at an
higher cost without a “compensation” would be impossible for such troubled credit
institutions. With a similar financial background, a further downgrade of the level of eligible
collateral was needed. This loosening, happened parallel to the full allotment reform, made
that the credit quality deteriorated dramatically13. What is more, ECB never increased its
accountability standard, by widening a disclosure on the accepted collateral. These facts gave
the impression that the central bank intervention was more extensive than it was.
Nevertheless, the involvements on the markets have been severe. Table 1 is a clear example of
the massive the intervention of the ECB to alleviate the interbank market intermediation on
the years from 2008 to 2011.
3.3.
The missed target: the economic debate on the payment system
Sinn and Wollmershäuser (2011), in their ‘seminal work’ have predicted that TARGET2
would be the real “target” in the discussions about the Euro area crisis. These contributions
have been about intra-Eurosystem imbalances in money and credit flows. As we have seen in
the previous sections, transactions between the NCB’s and between NCB’s and the ECB are
13
To point out some details, ELA loans are for the most part outside the control of the ECB Council. Their
liability rests firstly only with the NCBs and their sovereign. Thus the remaining NCBs are liable only in the
case that the government itself defaults.
~ 28 ~
all recorded and settled via the payment system. This give rise to (gross and net) national
central bank claims on, or liabilities to, other national central banks in the Euro zone. Due to
the financial crisis and the successive sovereign turmoil in the peripheral countries, payment
system imbalances within the Eurosystem have risen substantially. In a detailed work, Garber
(2010) discussed the mechanics of an intra-euro area capital flight. Explaining the structure of
TARGET2 claims and liabilities, he pointed out how these would change if a Euro area
member is subject to a capital outflow.
Since end-2010, the main imbalance14 within the Euro zone periphery has been in place with
the Central Bank of Ireland, which has seen its TARGET liabilities skyrocketing, while
Bundesbank and DNB sharply expanded their net claims. Indeed, this disequilibria worsened
even more when the Italian and Spanish capital markets went under attack, leading this
particular imbalances to a massive level. By looking at figure 13, we clearly deduce the
pattern of TARGET2 claims and liabilities. On the creditor side, the most recent data indicate
that claims of the Bundesbank have roughly doubled over the past year to reach €764bn in
August 2012 but fell back to €708bn in September. Till May 2013 the decrease has continued,
reaching €589bn.
Figure 13. TARGET 2 Net Balance, (billions €)
Source: Euro Crisis Monitor (University of Osnabrück)
14
With TARGET imbalance we imply a net debt positions of a national banking system vis-à-vis the whole
Eurosystem.
~ 29 ~
On the debtor instead, we can thus notice the sharp reduction of Banco de Espãna liabilities,
from €484bn to €284bn on May 2013. Similar trend, but less powerful in magnitude, has been
in place in other GIIPS countries. In September 2012, cumulated TARGET2 balances for
peripheral countries were close to €1trn. In May 2013, these amounted nearly to €700bn.
As previously affirmed, not only the trend has changed overtime, but even main drivers of the
imbalances have considerably changed over time. From 2008 to 2010, Ireland accounted for
most of the change in the GIIPS’s aggregate TARGET2 balance. This can be due mainly
because of the heavy use of the Irish Central Bank’s ELA credit lines by the strained Irish
banks (see section 3.2.1). Since mid-2011, however, the increase in the TARGET2
imbalances for the peripheral countries has been driven almost exclusively by Spain and Italy.
At that point, the overall GIIPS stood at around €340bn, of which Spain accounted for €50bn,
whereas Italy moved from being a TARGET2 creditor to a TARGET2 net debtor. Since then,
the balance of Spain and Italy jointly increased in a continuous way. Approximately, until
September 2012, it has enlarged by more than €650bn. Notice how this pattern had amplified
mainly after the ECB established the first tranche of the 3 years Long Term Refinancing
Operations. However, it must be clear that to have a correct idea of the entity of the
imbalances, these must be analyzed relative to the own country GDP. In this way we can
observe how the supposed risk has been much higher for countries other than Germany. De
Grauwe (2012) estimated that Luxembourg was the country in the Euro zone with the highest
exposition at the date, with a stunning 278% TARGET2/GDP claims, whereas Germany was
“only” exposed for the 24% of GDP.
Similar estimates were presented in Deutsche
Bundesbank (2011).
3.3.1. The ‘conservative’ thesis of Sinn and Wollmershäuser
Whittaker (2011) in its analysis of TARGET2 mechanism, showed the evolution of the
statistical data, without drawing conclusions about this particular pattern, completely
neglected before the North Atlantic financial crisis and European sovereign debt escalation. A
different line of reasoning was conducted by two German economists, Sinn and
Wollmershäuser. Their theses can be summarized in three main points.
i)
Increases in TARGET2 net liabilities in Euro area peripheral central banks were used
to finance the current account deficits of Ireland, Portugal and Greece;
ii)
the increases in those central banks TARGET2 net liabilities, connected with
increases in GIIPS central bank financing, facilitated a crowding out in credit to the
banking system in core EA countries;
~ 30 ~
iii)
Bundesbank net claims by some means reflects the raw exposure to risk and financial
losses for the German NCB, thus for German’s taxpayers.
They even proposed some solutions for the problem. They commented that it is the whole
design of TARGET2 that had lead to a similar bias. Thus, for Sinn and Wollmershäuser, an
alternative clearing and settlement system should be similar to the Interdistrict Settlement
Account (ISA) procedures of the Federal Reserve system in the US, based on timed gold
settlement transactions, which should prevent the persistence of large imbalances in credit
flows between different areas of the currency union15. Our opinion is that these theses were
too hasty. We are not arguing that intra-Eurosystem imbalances, thus reflected in TARGET2
outstanding net balances -for the mechanism seen before- are benign, or that they carry no
significance. We are only reasoning that the causes for these disequilibrium can be different
from current account problems. If symptoms are different than prospected ones, then even
necessary cures can be different from that prospected by the German economists.
On the first point, on a economic reasoning, theoretically no one could exclude that rising net
debt of central banks in peripheral countries to TARGET2 is consistent with imbalances in the
current account balance of their respective states. In fact, by definition, a country can
accumulate TARGET claims as a result of current account surpluses and/or capital inflows16.
Conversely, countries that accumulate TARGET2 liabilities must have a combination of
current account deficits and/or capital outflows. If we look at figure 13 and simply compare it
with figure 5, we can even support this thesis while referring at the 2005-2009 period. In
those years most of the peripheral countries were characterized by large current account
imbalances. Nevertheless, if we look to the striking figure 13, we notice that for a large
interval of the recalled period, TARGET2 imbalances were not so serious.
Imbalances had a dramatic increase from 2010. This striking rise in TARGET2 net debt levels
of some GIIPS’ central banks reflected difficulties of the local banking systems in obtaining
funding in the private markets. Then such disequilibria may or may not be associated with
current account deficits, and even when they are the causation may or may not run from
current account deficits to TARGET2 financing. This can be seen also by looking to the
middle part of the considered period. Actually, only focalizing on the large discrepancies in
years from 2008 does not help understanding the problem. In fact, notice how the imbalances
of some of the GIIPS seems to move, slightly, only from 2009. Instead, what is strange in the
15
We will deepen the argument on section 3.5.1
Recalling the example presented in the section before, this is similar to the process with which a central bank
in a fixed exchange rate system acquires international reserves as a result of current account surpluses and/or
capital inflows.
16
~ 31 ~
figure is the unjustified severe movement in the net claims of Germany even in 2008, when
about all countries were at par. Moreover, in years 2005 and 2006, when current account
imbalances in some periphery states were deeply negative, these “Bundesbank claims” were
at the same level of the counterparts. This basic analysis enforces our thesis, arguing that the
first point of Sinn thesis was wrong. Then has not been TARGET2 net debt to have financed
peripheral countries’ current account deficits. Empirical evidence, provided by De Grauwe
and Yi (2012), add strength to our idea. Increases in this net debt can result from transactions
that do not fund the current account of the balance of payments or the trade balance. Another
simple proof of this statement comes from other evidence. Notice how the largest increase in
the recalled net debt for the Central Bank of Ireland was recorded at the end of 2010. If we
look to the current account, on figure 5, we can see that the Irish one was almost in balance on
that year. Not a striking proof for the contrary thesis. The only evidence brought by Sinn is a
based on some graphs, about some indicators for which we are not sure that strong links exists
by these different variables. In our opinion, as we have previously argued in section 2.8,
deposit flight from peripheral banks (especially from Italy and Spain) are the more relevant
causes that determined these severe imbalances on the payment system.
The crowding out effect is described by the German authors as the fact that the shift in the
Eurosystem credit from ‘core countries’ to the GIIPS is the consequence of a limited demand
for central bank money by the commercial banks in the core countries. They point out that,
given the main refinancing rate of the ECB, base money demand is determined by the
economic activity and the payment habits prevailing in the country. Then, the inflowing
liquidity from core crowds out the refinancing credit in the periphery, without a consequent
visible change in the monetary base in both countries, leaving it unchanged in the aggregate.
Loosely speaking, money creation of the countries more hit by the sovereign debt crisis has
absorbed the share of monetary creation that was proper of other (core) countries. However,
this does not seem to have created interferences in the German nor in other banking system.
At most we can notice that the monetary base expansion has been much more sizeable in the
periphery, but this is even a consequences of a own choice. To explain it, we recall the
functioning of the money creation in the EMU. ECB controls a series of rates17 in the Euro
area. This makes possible that credit from the central bank and the base money are demand
driven by the needs of commercial banks. So an endogenous system. Then increases in the
TARGET2 net liabilities of one NCB cannot imply a reduction of funds to banks of other
countries. Central bank credit to German banks can have registered sharp contraction.
However this drop could reflects less attractive funding conditions and higher costs for central
17
A corridor in which three interest rates moves.
~ 32 ~
bank credit with respect to alternative and more attractive funding sources. More evidence is
given in Bindseil and Kӧnig (2012), or Buiter et al. (2011) where a model based on a balance
sheet analysis is used, showing that the falling credit of the Bundesbank by the ECB would be
the result of a choice made by German banks of not using more ECB refinancing, and not a
consequence of an increase in the TARGET2 liabilities in the debtor country. There are plenty
of reasons for a similar choice. From mid-2010, ECB decided to suspend the “exceptional
measures” taken in the middle of the 2008 financial crisis. These were at most represented by
the LTROs, conducted under the regime of full allotment. At this point, however, Bundesbank
credit was a lot less attractive to banks, giving one good reason to reduce this source of credit
refinancing. Another reason for this unattractiveness of central bank credit could be that
German commercial banks could, access other sources of financing, relatively more attractive,
e.g. domestic or foreign private deposits.
Table 2. Euro area members ECB capital subscription
NCB
Capital key
(%)
Adj. capital key
(%)
Paid-up capital
(€)
Nationale Bank van
België/Banque Nationale
2.43
3.47
261,010,384.68
de Belgique
Deutsche Bundesbank
18.94
27.06
2,037,777,027.43
Eesti Pank
0.18
0.26
19,261,567.80
Central Bank of Ireland
1.11
1.59
119,518,566.24
Bank of Greece
1.96
2.81
211,436,059.06
Banco de España
8.30
11.87
893,564,575.51
Banque de France
14.22
20.32
1,530,293,899.48
Banca d'Italia
12.50
17.86
1,344,715,688.14
Central Bank of Cyprus
0.14
0.20
14,731,333.14
Banque centrale du
0.17
0.25
18,798,859.75
Luxembourg
Central Bank of Malta
0.06
0.09
6,800,732.32
De Nederlandsche Bank
3.99
5.70
429,156,339.12
Oesterreichische
1.94
2.78
208,939,587.70
Nationalbank
Banco de Portugal
1.75
2.50
188,354,459.65
Banka Slovenije
0.33
0.47
35,381,025.10
Národná banka Slovenska
0.69
0.99
74,614,363.76
Suomen Pankki – Finlands
1.25
1.79
134,927,820.48
Bank
Total
69.97
100.00
7,529,282,289.35
Note: Adjusted capital key adjusts for the capital of shareholders of the ECB which are not
currently part of the Eurozone. With effect from 29 December 2010, the ECB increased its
subscribed capital from €5.76 billion to €10.76 billion. It was agreed that the euro area NCBs
would pay the resulting additional capital contributions in three instalments. They paid the first
and second such instalments on 29 December 2010 and 28 December 2011 respectively, while the
final instalment was paid on 27 December 2012.
Source: ECB
Finally, the two German economists pointed out that TARGET2 net claims of single national
central banks reflect the exposure to risk and financial losses of their sovereign. In practice
~ 33 ~
the amount of these imbalances should reveal if the country is risky or not. Clearly, this is not
true. In fact, losses and profits from the conventional monetary policy, but also liquidity and
credit operations are pooled and shared between all NCBs in the Euro area according to their
respective ECB capital shares. This happens irrespective of where a loss occurs in the Euro
zone. Therefore, exposure of a central bank, e.g. the Bundesbank, to risk and financial losses
from operations within the Eurosystem is given by the total exposure of the Eurosystem
multiplied by the Bundesbank’s ECB capital share. Table 2 shows the normal and the single
adjusted contributions.
3.3.2. Germany: current accounts and TARGET2 imbalances
The reason why Germany has strong TARGET2 surpluses is simple: since mid-2011,
Germany has been a net receiver of private capital flows. However, its current account surplus
has not fallen much. Germany’s TARGET2 balances have therefore increased severely. The
main cause of the increase in the risk for Germany then cannot be attributed to the
dysfunction of TARGET2.
Figure 14. Germany: TARGET claims vs. GIIPS external deficits, 2007-2012 (€bn)
Note: With external deficits we mean current account imbalances, whereas the other voice shows the
payment system claims’ of Germany versus the debtor countries.
Source: Bundesbank, Euro Crisis Monitor (University of Osnabrück), authors own elaboration
As we have asserted before, this is only a payment system, not a credit creation system like
some economists have argued (on this Sinn(2011a,b) or Schnabl and Wollmershäuser (2013))
and for which they have therefore proposed harsh regulation. GIIPS countries have notably
~ 34 ~
reduced their current account deficits in the last two years, both towards rest of the world, and
with respect to Germany. We can notice on figure 15 a contraction by about half from the
peak in 2008. In the same period, conversely, TARGET2 claims of Germany started to
increase substantially. This fact is shown on figure 13 and 14. Most probably the strong
contraction of domestic demand in the periphery has driven the strong reduction in the current
accounts of peripheral countries. This fact raises further evidence that GIIPS current account
deficits are not likely to be the cause of the German TARGET2 claims to soar. The
combination of German current account surpluses versus the rest of the Euro area and
significant net inflows from the rest of the Euro zone (as reflected from TARGET2 claims)
means that there have been strong private financial inflows to drive a similar upsurge. These
private sector financial inflows either represent residents of the rest of the Euro area investing
in Germany or German investors in the rest of the Euro zone repatriating their investments.
According to Deutsche Bundesbank (2013), total private capital roughly matched total
inflows until 2007. German private capital outflows generally continued, until mid 2011, with
a little more variation.
Figure 15. Germany: bilateral current account balance, 1998-2011 (% GDP)
Source: Buiter and Rabhari (2012a)
These outflows continued to be smaller than Germany’s current account surpluses. Recalling
the identity seen on the previous section 3.2, the difference was covered with increasing
TARGET2 balances. Germany has run a global current account surplus every year since the
euro started except for the period from 1999 to 2001. Moreover, Germany’s current account
~ 35 ~
balances with the Euro zone and in particular with the Euro area periphery have also been
persistently positive for the past decade. Figure 15 shows that with the exception of Ireland,
Germany has run bilateral current account surpluses with the peripheral countries in each year
over the last decade. In any of the past years, net foreign claims have increased as a current
account surplus was registered. This is the proof that the ‘current account problem’ is opposite
to that indicated by Sinn and Wollmershäuser. In the case of our interest, as a consequence of
the strong current account surpluses we have evidenced on figure 15 and 14, we are able to
affirm that the only reason why Germany has registered net TARGET2 claims on the rest of
the Euro zone is that Germany has accumulated current account surpluses against these
countries in the past. The current account balance represents a country’s net saving. It could
have decided to reduce its current account surpluses but did not do so. Yet, in our opinion,
with a quickly ageing population, Germany is raising massive sums as to fund resources in
order to allow for an orderly demographic transition. It is a optimal choice. Nevertheless, the
increase in the risk of foreign exposure was entirely a country’s own decision.
There exist another possible explanation, for the German positive TARGET imbalances, very
similar with the former one. Prior to mid-2008, private German agents (mainly represented by
financial institutions), held huge claims versus Euro area peripheral countries.
Figure 16. Germany: External claims of banks, 2008-2011 (€ bn)
600
500
400
Spain
Portugal
300
Italy
200
Ireland
Greece
100
2007-01
2007-04
2007-07
2007-10
2008-01
2008-04
2008-07
2008-10
2009-01
2009-04
2009-07
2009-10
2010-01
2010-04
2010-07
2010-10
2011-01
2011-04
2011-07
2011-10
2012-01
2012-04
2012-07
2012-10
0
Note: Excluding participating interests
Source: Bundesbank, authors own elaboration
~ 36 ~
From that date, German banks have considerably reduced their exposure to the GIIPS
countries, as we can see from figure 16. This trend is more evident for Spain and Italy. In the
same way, liabilities of the peripheral countries were held by similar agents.
However, with the sovereign debt crisis, a shift in the ownership of these rights took place. As
a result of the breakdown of the interbank market, a large part of these private claims and
liabilities were transformed into TARGET2 claims and liabilities without however changing
the total net foreign claims and liabilities of these countries. What changed dramatically is the
nature of these claims. We interpret the driving forces of the increase in TARGET2 net debt
for the peripheral central banks as the inability of their public and private sector, other than
the central banks, to sell assets to the rest of the Euro area or, alternatively, to increase their
liabilities to them to fund their current account deficit.
Then, the upsurge in the payment system imbalances cannot be blamed on the TARGET2
system and on other partners in the Euro area. Moreover, from early 2012 an increase in
redenomination risk has taken place. Given these facts, last upsurge in TARGET2 balances
reflected something more akin to a currency attack than current account financing or a credit
reversal, as Sinn and Wollmershäuser have argued. Of course, these conclusions applies to all
Euro zone countries as well.
We focus on this point because it is important to understand that if a country like Germany
has net financial claims against Euro area peripheral countries (and also the rest of the world),
this can only occur in consequence of own decisions taken in the past. There is no other way
to explain how Germany can accumulate claims on the rest of the Euro area. Only if capital
flows will revert back from countries with positive balances into countries with negative
balances in a there will be reduction in the balances. This is what has started to happens, after
the strong intervention of the ECB on the money markets. With the one year LTROs and the
full allotment collateral revision first, and the stronger intervention brought with the three
years LTROs then, normal market conditions were restored only intermittently. Nonetheless,
the true ‘stealth bailout’ announced by ECB Governor Draghi on July 2012 seemed to have
brought the necessary confidence on the Euro area capital markets. The decreasing trend,
from mid- 2012, shown on figure 13, in fact is the proof of the success of this ‘new’ ECB
monetary policy operations. We will return on this point on section 5.4.
3.3.3. The Interdistrict Settlement Account framework as a solution for TARGET
imbalances
We devote a sub section to the last point of the ‘thesis’ of the two German economists. As
previously anticipated, for TARGET2 mismatches, Sinn and Wollmershäuser (2011), have
~ 37 ~
repeatedly recalled that the best possible solutions to the imbalances would be to put in use
the supposedly stricter rules adopted between the individual Reserve Banks of the twelve
districts of the Federal Reserve System in the United States.
As in Sinn and Wollmershäuser (2011):
“in our opinion, the Eurosystem ought to adopt the rule of the United States, according
to which the Target debts are to be serviced annually with marketable assets.”
In all the mentioned works they argue that in the United States, single states can draw
TARGET-like credit, but with an important difference with respect to the European system: in
fact this borrowing has to occur at market conditions. Then they compare balances of Interdistrict Settlement Account (ISA) in the United States as analogous of our TARGET2 ones. In
this way they state that the settlement process of the Fed is helpful in restraining the negative
balances of the ISA, equivalent to TARGET2 liabilities, as the former must be paid for in
April of each year by the transfer of ownership shares in gold-backed or other marketable
securities that offer a similar risk specific interest rates. In this way a District Central Bank is
only allowed to create more money than is used in its district if this district hands over
marketable assets to other districts for the amount of
money flowing from it to them.
However, as by simply reading on the Fed accounting manual and thanks to the remarkable
work of Koning (2012)18, we can argue that proposing the ISA is somewhat useless and
nonsensical.
First, Sinn's proposal to limit TARGET2 balances essentially implies that a Euro in the form
of a deposit with one (peripheral) national central bank is no more similar to a euro held as a
deposit with another (core) NCB. This contradicts the constituting element of our monetary
union, that is “one Euro is equal to one Euro”. This throw also doubts on the monetary base
definition in that currency area. Moreover, when announced in advance, such a policy would
probably lead to an intensification of capital flight away from countries being potentially
constrained. There is plenty of evidence of
potential consequences in that case (see
Danielsson and Amasson (2011) for the Icelandic case, or Frattianni and Spinelli (2001) for
the Italian currency crisis in the seventies). What is more, if a block to the payment system
will make automated transfer impossible, accounts could be substituted by withdrawing
banknotes from the same accounts. This would increase the amount of banknotes in
circulation in the “limited countries”, therefore increasing the liquidity deficit of the banking
18
Link available on the Web sources.
~ 38 ~
sector. This will cause the central bank to intervene to close a similar gap by intensifying
refinancing operation to those institutes. By looking at figure 17, indeed we can see this is
what happened in Germany before 2007, as Jobst (2011) showed.
Second, settling TARGET2 liabilities once a year by transferring gold, exchange reserves or
other marketable assets from TARGET2 debtor national banks to TARGET2 creditor NCBs is
equivalent to an abandon of the monetary union. In fact this proposal implies that all countries
that may end the year with net TARGET2 liabilities face the risk of being cut off from the
monetary union.
Figure 17. Bundesbank balance sheet in % of Eurosystem balance sheet
Source: Jobst (2011)
Third, as Bijlisma and Lukkezen (2012)19 has proven (see figure 18), even on ISA system
settlement imbalances are possible. In fact, as Koning (2012) affirmed, the Federal Reserve
System experienced significant imbalances between 1917 and 1921 and in 1933. Moreover he
noted that at the date − February 2012 − it appeared that the Federal Reserve system was
relaxing requirements so as to allow some districts to borrow longer than they would
otherwise be allowed, out of causing discussions between Federal Reserve districts. Figure 18
shows that Koning was correct.
19
~ 39 ~
Figure 18. Fed ISA imbalances, 2005-2011 ($ bn)
Source: Bijlisma and Lukkezen (2012)
We see this debate as a misunderstanding, mostly raised as adverse byproduct of two things.
First, the decision to create a Eurosystem consisting not of one but of eighteen legal entities:
the ECB and the 17 NCBs. If the national central banks had been turned into branches of the
ECB, like the Fed districts, the intra-Eurosystem distribution of credits and debits would be a
matter of indifference. In the Euro zone, in fact, the ECB is owned by the national
governments via the national central banks, not by the European Union. In the United States,
all the Federal reserve banks are instead owned by commercial banks. So in the Euro area,
when one would change the settlement rules – for example on eligible collateral– this means a
transfer across countries. The true innovation has to consist in reorganizing procedures and
policies for accepting similar collateral in the Eurosystem, therefore cutting down on national
difference, thus leaving that variations behind a sign will be only due to structural mismatches
in national financial systems. This innovation would be straightforward in the future (and we
hope, well-designed) banking union.
Second, some authors have considered the line of reasoning that confuses the payment system
with a credit-generating machine. This point of view comes principally from the mistaken
idea of comparing TARGET2 with a gold standard monetary system. The two have a similar
functioning. TARGET2 balances however are not open market operations. Thus these leave
the amount of money unchanged, whereas a change in a gold standard system does not.
~ 40 ~
4. ECB actions during the crises
Before the north‐Atlantic financial crisis exploded, few central bankers and many monetary
economists assumed that the final task of central banking was captured by an “independent”
central bank, setting short term interest rates to pursue one or two macroeconomic stability
objectives (see Fischer (1996)). In some cases, price stability was defined as the only
macroeconomic objective (defined as the pursuit of some target rate of inflation for some
broadly defined index of goods and services), as in the European case. In other, there were
dual or triple objectives, mostly focused on real activity objectives, like for the Federal
Reserve. Nonetheless, after August 2007, with the eruption of the subprime crisis, central
banks in the developed countries have recovered the theme of financial stability. The reason is
simple: for any central bank faced with a potential conflict between price/macroeconomic
stability on the one hand and systemic financial stability on the other, the latter revealed its
primacy. Systemic financial stability in fact simply surpasses other possible policy targets
every time and anywhere. This has been true even for the European Central Bank, as it is
mandated by the Treaty to support financial stability. The direction it has taken with the last
operations conducted (nominally the 3Y LTRO, Governor Draghi announcement in July 2012
and especially the pressure for a European banking union foundation, reinforced after Cyprus
‘partial bailout’) seems to elevate its role in this direction. In our opinion, this is the core of
the debate about central banking in the Euro area. Since the TFEU has been already violated
systematically, if a explicit change in the approach will not to be adopted, at most in few years
we will see only the leftover of the actual Euro area.
There exist a controversial distinction between two typical roles in the financial stability
supervision. The first is the prevention and/or mitigation of asset and credit booms, bubbles
and busts. The second dimension of financial stability policy is the prevention and the
eventual mitigation of funding liquidity crises for financial institutions and the governments.
This is the typical lender of last resort (LoLR) role of central banks. We will not conduct a
historical review nor enter into the debate on the convenience of the role. Our analysis
conversely will focus on how the ECB has acted during the crisis on the last five years.
4.1.
Institutional background of ECB and Eurosystem financial structure
We can say that the ECB approach to the turmoil appears to be coherent to its founding
Treaty. To acknowledge this is particularly important, especially when making comparisons
with the policies of other central banks. In fact its non-standard measures adopted have been
clearly aimed not at providing additional direct monetary stimulus to the economy but, first
~ 41 ~
and foremost, at supporting the effective transmission of its standard policy. For the ECB,
indeed, non-standard measures have been and are conceived as a complement to rather than a
substitute for standard interest rate policy. This framework has been forced in our opinion, by
the specific background of the institutional set-up of Economic and Monetary Union (EMU)
and also from the financial structure of the Euro area economy, which channels the monetary
policy of the ECB in a straight manner. Before reviewing which monetary policy measures
the ECB has adopted in response to the financial crisis, it is convenient to explain the context
where the central bank operates, in terms of the institutional environment. This will be given
on paragraph 4.1.1. Some focus will also be directed to the financial structure of the Euro
area, on paragraph 4.1.2.
4.1.1. Institutional background
Five are the articles of the Treaty on the Functioning of the European Union that includes a
number of provisions on the implementation of the monetary organism in the Euro zone. The
Treaty gives responsibility for financial stability primarily to governments. In fact the
regulation and possible resolution of banks is directly in their domain. At the Article 127(5)
however the Treaty allows explicitly that the ECB, without prejudice to its primary mandate
of price stability, shall contribute to the stability of the financial system. In these
recommendations, we can ‘outline’ the ECB role as a “super partes” coordinator of financial
stability in the Euro area. However, it is strange the fact that the Treaty does not include
provisions to ensure joint action in the event of cross-border or euro area-wide risks to
financial stability. This is the fact that lead us to say that the route of its action should have a
severe steer on this theme. In fact the concept of ensuring the financial stability of the Euro
area as a whole had to be “invented” for the crisis, as Euro members were called to decide
agreement on the support programmes for Greece and on the establishment of the EFSF in
May 201020. The biggest difference that European Monetary Union presents with respect to
other monetary system however is not on the financial stability, but is represented by the lack
of a unique fiscal area as backdrop. This clearly creates a limit for the ECB to operate
monetary policy as it is universally known. The Treaty moreover includes a (wide) number of
recommendations to prevent and eventually correct for disincentives to fiscal discipline that
the single currency would otherwise imply. These provisions include the prohibition of
monetary financing by the central bank (Article 123), the prohibition of privileged access by
20
See European Council (2010), p.29.
~ 42 ~
public institutions or governments to financial institutions21 (Article 124), the “no-bailout”
clause (Article 125), the fiscal provisions for avoiding excessive government deficits (Article
126). The prohibition of monetary financing prevents the ECB from purchasing government
bonds in the primary market thus limiting the intervention to serving specific monetary policy
purposes consistent with its primary objective of price stability in the secondary market. The
prohibition of primary market intervention cannot be circumvent neither by using secondary
market intervention.
During the last three years, the ECB has implemented various operations (Securities Market
Programme (SMP), LTROs and, later, Outright Monetary Transactions (OMTs)) in order to
‘restore orderly sovereign debt markets, which are necessary for the proper functioning of the
monetary transmission mechanism’ (ECB (2011)). We agree that ECB interventions were also
advocated to this target during the North Atlantic financial crisis. Nevertheless, in our
opinion, the official declarations do not reflect the true purpose of the central bank.
Figure 19. Funding of Non Financial Companies, 2002-2011
(as share in accumulated debt transaction)
100%
90%
80%
70%
60%
50%
Bank
financing
40%
Non bank
financing
30%
20%
10%
0%
Eurozone
US
Note: Accumulated debt transactions includes a) Debt securities issued,
b) MFI loans to NFC, c) Quoted equities issued.
Source: ECB, FRED, authors’ own evaluations
21
“Prohibition of privileged access” means that the ECB may not differentiate between public and private
institutions; in particular, in its refinancing operations, must not give public institutions, e.g. development banks,
better conditions than private sector banks.
~ 43 ~
As theory (Calvo (1988)) and evidence (see section 2.7) shows, even a rather high level of
public debt could be sustainable if this is felt as a riskless investments. In this case, the
government only has to pay a low interest rate. However, even the contrary can be true. This
is what is happening in the Euro zone.
By dealing in this enviromment, the ECB has been acting as lender of last resort (LoLR) for
the sovereigns since it first started its outright purchases of Euro area periphery sovereign
debt under the Securities Markets Programme (SMP) from May 2010 (see de Grauwe
(2011b), Wyplosz (2011, 2012) and Buiter and Rahbari (2012a)). Of course, the central bank
executives denies acting as LoLR for some Euro area governments, as this would open it up
to the criticism that a open violation of Article 123 of the Treaty has been in act. Notice that at
the time this essay was drafted, a German Constitutional Court case threatens to make the
Euro zone crisis more severe as it already is, as the court will consider whether the ECB
overstepped its mandate and thus imposing undue risks on German taxpayers. We will join
back the argument on section 4.4 and succeeding.
4.1.2. Financial structure of the Eurosystem
Financial structure is the other aspect that differentiates the Euro area with respect to other
large economies. A basic review of this will be given on this paragraph.
Financial intermediaries, above all banks, are the main agents mandated to transferring funds
from savers to borrowers (ECB (2007)). In this, banks are the primary source of financing for
the economy. Obviously this is even more important in the case of households. In order to
have an idea of the weight of the financial sector in the Euro area economy, we have built
figure 19. In this, it has been evidenced the funding of non financial sector, for the Euro zone
and the United States. We can see that about the 70% of the external financing of the nonfinancial corporate sector, i.e. the financing other than by retained earnings, is provided by
banks, whereas less than 30% by financial markets (and other funding). Conversely, it is the
other way around in the United States, where bank financing accounts for a mere 20%. This
largely bank-based structure of the euro area economy is thus reflected in the way the ECB’s
monetary policy is implemented. In fact, while monetary policy decisions are centralized at
the level of the ECB’s Governing Council, their implementation is conducted by the
Eurosystem members in a decentralized way, as it is composed by 17 national central banks
of the euro area countries and, of course, the ECB. The operations generally consist of
refinancing operations (MROs), to which a large number of counterparties are granted access
so as to ensure that the single monetary policy reaches the banking system in all the euro area
countries. In the Euro area there are about 6,300 credit institutions. Of these, around 2,200
~ 44 ~
fully fulfill the eligibility operational criteria for participation in open market operations with
the Eurosystem. Notice indeed that in the Euro zone about 800 banks participated in the
second three year longer-term refinancing operation in early 2012, whereas approximately
200-400 institutions usually participate to MROs (ECB, (2013)). The US set-up vice versa is
opposed, as it is characterized by a lean structure. For the entire Federal Reserve System in
fact there exist a unique responsible for the monetary policy implementation, the Federal
Reserve Bank of New York. Operations conducted on behalf of the Fed system consist mainly
of outright purchases and sales of assets in the open market. Moreover, the number of
counterparties involved with the Fed in its refinancing operation is relatively small, compared
with that in the Eurosystem.
4.2.
ECB response to the crisis
Beyond the period of financial turmoil that preceded the financial crisis, it is useful for the
purpose of the review to distinguish between three phases, marked by the following:
i.
start of the North Atlantic financial crisis in September 2008 (Lehman collapse);
ii. start of the Euro area sovereign debt crisis in May 2010 (Greek crisis);
iii. exacerbation of the euro area sovereign debt crisis, tied with increased
banking sector strain from mid-2011 on.
Considerations on the third phase can only be tentative rather than definitive, as the stage was
still ongoing when this article was drafted.
4.2.1. North Atlantic crisis and ECB reaction
From August 2007, as at the time money market rates started to drove up, the central bank
acted in the market, accommodating the funding needs of banks, which were looking to build
up daily liquidity buffers so as to reduce uncertainty about their liquidity positions. In this
phase, the ECB de facto acted as the market maker since had provided unlimited overnight
liquidity to banks. For example, to reduce bank liquidity uncertainty, full allotment rules were
introduced. Following the bankruptcy of Lehman Brothers on September 2008, the
uncertainty about the financial health of major banks worldwide led to a possible collapse in
activity in many financial market segments. To cope with a similar situation, ECB reacted by
rapidly lowering its key interest rates to historically low levels (at the time). Moreover, its
response in influencing financial markets and monetary conditions consisted indeed of its
non-standard policy measures. As we recognized from ECB(2011), these comprised four key
~ 45 ~
elements, namely regarding full allotment and supplementary liquidity provision at longer
maturities:
i.
Fixed-rate full allotment. As previously told, a fixed-rate full allotment tender
procedure was adopted for all refinancing operations during the financial crisis. Eligible
euro area financial institutions have thus unlimited access to central bank liquidity at the
main refinancing rate. Clearly as always subject to adequate collateral.
ii. Extension in the maturity of liquidity provision. The maximum maturity of the longer
term refinancing operations (LTROs) was temporarily extended in three steps: from 3 to
6 in the first phase of the turmoil. Later it was further lengthen to 12 months, in June
2009. This, jointly with the full allotment rules, contributed to keep money market
interest rates at low levels and increased the ECB intermediation role.
iii. Collateral eligibility extension. The list of eligible collateral accepted in Eurosystem
refinancing operations was extended, in further time steps, thus allowing banks to
refinance a larger share of their balance sheet with the ECB. This had revealed one of
the most successful operations, since central bank ability to refinance even bank less
liquid assets provided a prompt remedy to liquidity shortages caused by sudden stops in
interbank market.
iv. Covered bond purchase programme (CBPP). In June 2009 the ECB committed to
purchase, gradually till June 2010, covered bonds denominated in euro and issued in the
euro area, for a value of €60 billion. This programme was implemented with the intent
to restore normal conditions in the covered bond market, as it suddenly came to a block
at the time. Notice that this market is a one of the principal source of funding for a wide
part of the banking system of the Euro area and, notably, it is the largest segment of the
fixed income market together with the public sector bond market. Such covered bonds22
are long-term debt securities, issued by banks to refinance loans to the public and
private sectors, often in connection with real estate transactions. With a size of around
2% of the total outstanding amount of covered bonds in the Euro zone markets, CBP
programme was a effective operation to restart activity in this market.
The evidence available suggests that the non-standard measures taken from October 2008
have been instrumental in stabilizing the financial system and the economy: for instance,
counterfactual scenarios to address the question of what would have happened if the ECB had
22
Covered bonds, unlike asset-backed securities (ABS, mortgage backed securities in this case) have the specific
legal characteristic of a “double protection” which allows to recourse to the issuer as well as the additional
security provided by the pledge of the assets financed.
~ 46 ~
not adopted some of its non-standard policy measures following October 2008, accentuate the
importance of the lengthening in the maturity of the operations in countering the increase in
money market spreads. In this, Giannone et al. (2012) have used a structural vector
autoregressive (VAR) model, estimating that, two and a half years after the failure of Lehman
Brothers, the level of industrial production is estimated to be 2% higher, and the
unemployment rate 0.6 percentage points lower than would have been the case in the absence
of the ECB’s non-standard monetary policy measures. Moreover, other VAR analysis have
been conducted, with different strategies. Peersman (2011) for example considered that
nonstandard measures exogenous effects on credit supply, distinguished from policy interest
rate decisions, indicates that the Eurosystem can effectively stimulate the economy beyond
the policy rate by increasing the size of its balance sheet or the monetary base.
4.2.2. Response of the ECB to the Euro area sovereign debt crisis
Began with acute market expectations about a possible Greek sovereign default, in early 2010
the Euro area sovereign debt crisis extended its impact on Ireland, Portugal and, in a marginal
way, even Spain and Italy. From May 2010 some secondary markets for government bonds in
those countries, namely GIIPS, began to dry up entirely. In primary markets, large-scale sale
offers faced virtually no buy orders. Yields reached levels that would have quickly become
unsustainable for any sovereign. Government bonds plays a crucial role as benchmarks for
private-sector lending rates. Given their importance for bank balance sheets and liquidity
operations, ECB decided to act on the secondary market, establishing the so-called Securities
Markets Programme (SMP). Similar interventions were strictly limited to secondary markets.
Moreover, these were designed in order to ensure depth and liquidity in those market
segments that were dysfunctional. In addition, all the intervention were also fully sterilized
through subsequent liquidity absorbing operations.
ECB have always justified sterilization as consequence of the fact that, by buying government
bonds the ECB increases the money stock, thus leading to a risk of inflation (ECB (2013)). In
our opinion, this operation was not necessary. In fact, it is broadly known that an increase in
the money stock not always lead to more inflation. We point on a mechanism that must be
recalled. It is always important to have in mind the difference between base money, composed
by currency in circulation and deposits of banks at the central bank (also known as M0), and
the money stock (also known as M3). When the ECB put into actions the previous nonstandard monetary policy measures (e.g. when it has bought government bond via SMP and
CBPP), it was not acting on the latter variable indeed, but the former. In fact, an increase in
the base money does not imply an increase in the money stock, as it happens in normal times.
~ 47 ~
On the contrary, during periods of financial turmoil, both monetary aggregates tend to move
in a disaggregate manner.
Moreover, when a financial crisis erupts, in a way to protect themselves, private agents are
willing to hold cash rather than assets. Whenever the central bank would not supply this cash,
it would likely inflate the financial crisis into worse events like an economic crisis (or,
possibly, a depression). This deterioration would be given by the fact that agents scramble out
for cash. When instead the bank would act on M0, the deflationary process would be stopped.
This unfounded fear of inflationary consequences continues to affect policy making in the
Euro area. For example, when the ECB in the mid-2011 decided to start buying Spanish and
Italian government bonds, it announced that it would sterilize the effect these purchases have
on the money base by withdrawing liquidity from market.
Figure 20. Base Money (M0) vs. Money Stock (M3) in the Eurosystem (August 2004=100)
350
300
250
200
M0
150
M3
100
50
2013Aug
2013Mar
2012Oct
2012May
2011Dec
2011Jul
2011Feb
2010Sep
2010Apr
2009Nov
2009Jun
2009Jan
2008Aug
2008Mar
2007Oct
2007May
2006Jul
2006Dec
2006Feb
2005Sep
2005Apr
2004Nov
0
Source: ECB Statistical Data Warehouse, authors own evaluation
This was an unfortunate decision. In fact, there was no need to do so. Since October 2008, so
with the start of the banking crisis, the yearly growth rate of the money stock in the Euro
zone has only been 1%. This have been much below the growth rate of 4.5% the ECB has
previously announced, in order to stabilize the rate of inflation at 2%. The SMP was effective
at the outset, and led to some stabilization in markets as well as to an immediate and
substantial decline of government bond yields, thus helping in that the new funding needs of a
sovereign, estimated as the sum of its financial deficit and the maturing debt, are met at a
~ 48 ~
sustainable rate of interest for that sovereign. Indeed, to front up the turmoil, ECB
implemented this new non standard operation to the other created in the 2008 for the North
Atlantic financial crisis. As with SMP introduction in fact, fixed rate full allotment and
collateral rules validity were extended, as to enforce the effect of the Eurosystem intervention
on the troubled secondary markets. The ECB has not published official data on the
composition of its purchases under this programme, but it is widely assumed that so far the
ECB has purchased GIIPS government debt securities under the scheme. Notice however that
flows of new sovereign debt purchases under the SMP have not been constant during the
operating interval. Due to a decrease in the turmoil, programme effectiveness declined
markedly during the last year; notably, has been effectively zero since February 2012, with an
upspring in August 2012. There is little doubt that the SMP purchases prevented major
financial turmoil that could have resulted in a chain of defaults of likely solvent euro area
banks and sovereigns, notably in May 2010, in the period from October to November 2011
and again in August 2012.
4.2.3. Shortcomings of the SMP
Nevertheless, purchases in the secondary markets however are an ineffective instrument for
ensuring that the funding needs of a country will be met at a tolerable yield rate.
In fact, there is a risk that the purchaser ends up owning much of the outstanding stock of debt
without doing much to save the sovereign from default by purchasing the gross new debt
issuance. This could be avoided only if the purchaser is known to be willing and able to cap
the yield to a floor under the price in the secondary markets. Nevertheless, the ECB was not
used to publicly supportingthe programme23 and have leveraged its purchases of sovereign
debt in the secondary markets (Gros et al. (2012)). We deem that the Eurosystem has spend
much more resources to achieve the same impact on market yields than it would have focused
its intervention on primary market purchases.
Another possible shortcoming of the SMP is that these purchases could cause persistent
damage to the prospects of the sovereign returning to the private markets. This can happen if
the sovereign is, as a result of the SMP purchases, left with an ‘overhang’ of effectively senior
creditors. This is a major weakness, because it undermines directly the aims of the
programme. As a consequence, it would no more carry an illiquid but likely solvent sovereign
through a period of temporary loss of market access.
23
The fact of not disclosing any data on this sort of operation is rather a serious and unexpected precedent for
the ECB, on which we will return later.
~ 49 ~
Notice that at the same time SMP has been in use, Dutch and German, along with other
“core” governments, argued strongly that a debt restructuring through ‘private-sector
involvement’ was necessary (Wyplosz (2011)), as for a desire to create a tangible default risk
for investors and thereby achieve again a differentiation of bond yields in EMU (see section
4.6). In our opinion this goes in couple with the tensions in Germany before the general
elections taken in September 2013. These developments illustrated the limits of the SMP and
more generally central bank action on government bond as conceived as isolated and
intermittent interventions in the secondary markets.
4.3.
The third phase: Euro area ongoing debt crisis
SMP support has not come with explicit fiscal or structural reform conditionality, nor is an
explicit debt sustainability analysis a prerequisite for SMP support. To cover the gap and
strengthen the ECB intervention, a further measure to put into effect central bank policy
target, has been introduced. In fact, the Euro area Economic Council unveiled a parallel
announcement the European Financial Stability Facility (EFSF) establishment. Through this
mechanism, governments, given a conditional commitment on some structural reform to be
taken, could raise mutual financing support. The couple SMP/EFSF should have provided
time for governments to find a durable solution to the crisis and restore the sustainability of
public finances. In fact, ECB executives and governing council members have been choral in
calling governments to provide for the necessary fiscal and macroeconomic adjustment and
using central bank money to support financial stabilization tools. As it turned out indeed, not
all governments did not bring into the momentum. For example, in the Greek programme,
significant implementation shortfalls emerged, new debt was discovered.
In addition to the extension of the actions to the ultra sovereign funds, the third phase indeed
coincides with the intensification of troubles about solvency of Italy and Spain. This
intensification has led to a deterioration in the balance sheets of most banks in the Euro area.
As from summer 2011, when the sovereign debt crisis hit those countries and their
government bond markets risked becoming dysfunctional, the ECB decided to ‘actively
implement its Securities Markets Programme24, previously remained in a stand-by for several
months. Official reasoning clearly pointed to the possible implications for monetary policy
mentioned above to justify the intervention. As depressed sovereign bond prices weakened
bank balance sheets, markets questioned the viability of a number of banks across a range of
24
Statement by the ECB President, 7 August 2011
~ 50 ~
euro area countries. Moreover, the strained sovereigns were seen as increasingly unable to
provide reliable safeguards on their debt and deficit situation.
The spiral led to falling sovereign bond prices also well beyond the GIIPS, as surge in the
yield has been in place for countries as France, Belgium, and Austria. Bank equity prices in
the period from September 2011 to March 2012 fell by up to 70%. In spring 2012, bank credit
default swaps spreads severely exceeded the Lehman peak, as we can seen from figure 21,
taken by Noeth and Sengupta (2012). The soar in the CDS spread is one of the consequences
of the massive round in the downgrading of ratings for most of the financial institutions in the
“distressed” and in some other Euro area countries. In fact as ratings tends to be pro-cyclical
and short-sighted, these tend to amplify a mispricing of risks, as the figure shows, and causing
thereby downturns spirals in asset prices. The interbank market became once again largely
dysfunctional. Mostly in the periphery countries, bank issuance of covered bonds was
severely constrained.
Figure 21. Five year Credit Default Swaps spreads to US Bonds, 2005-2012
Note: Eurozone distressed are GIIPS plus Cyprus. Eurozone Other include Austria, Belgium, Estonia, Finland,
France, Germany, Malta, Netherlands, Slovak Republic and Slovenia. Non Eurozone Western include UK,
Sweden, Norway and Denmark. Non Eurozone Eastern include Poland, Hungary, Russia, Latvia, Romania,
Czech Republic, Croatia, Lithuania and Bulgaria.
Source: Noeth and Sengupta (2012).
With troubles of solvency, uncovered issuance was virtually closed. Banks thus lacked
funding and their liquidity beyond the immediate horizon was also brought into question.
However, the situation of banks across the euro area countries became increasingly
differentiated. As some banking systems were facing an acceleration in net payment outflow,
with their interbank borrowing and debt securities stopped being rolled over, other banking
~ 51 ~
systems were net recipients of those inflows, thus facing excess liquidity, as we have seen on
section 3.5. Moreover, one of the impressive surges in the risk and tension was due by the
strange decision, advanced by the European Banking Authority (EBA), to raise on additional
capital buffer, calculated by marking sovereign exposures to market and raising the Core Tier
1 capital ratio to 9%. A similar measure, in times of market distress, is clearly pro-cyclical.
This created a capital need in the European banking sector of over €100 billion to be raised
within less than a year, when banks in some markets were not able to refinance existing
capital at three month. A severe credit crunch was coming up for the euro area as a whole.
This context, a response of the ECB was not only focused to provide banks with a short-term
liquidity support but also with a medium term outlook, so that these would keep credit lines
ongoing even with the market in distressed conditions.
4.3.1. ECB response: innovations from the past
From 8 December 2011, ECB announced the response, which consisted of five key measures:
i.
two LTROs with a maturity of 3 years each, scheduled for December 2011 and
February 2012;
ii.
reduction in the reserve ratio, from 2% to 1%;
iii.
increase in collateral availability by allowing national central banks to accept
additional credit claims, in particular bank loans, on their own responsibility; the set
of eligible Asset Backed Securities (ABS) was also expanded;
iv.
encouragement of the development of alternative credit assessment sources for use in
the selection of eligible collateral;
Moreover, as from July 2011, the European Council had already planned the substitution of
the EFSF, which was designed as a temporary facility, in place from May 2010, with the
European Stability Mechanism, a definitive stance, from September 2012. Points iii) and iv)
can be seen as an a extension of the previous rules on collateral, as introduced after September
2008: these included a further expansion of the set of eligible ABS in June and in July the
removal of the rating limits for Greek government. Moreover, the ECB governing council
fixed an exemption from the minimum credit rating threshold for certain paper issued or
guaranteed by the central government of peripheral countries under an adjustment
programme. This measure was implemented to give an incentive to the “return” of these
sovereign on the debt markets. Comparing this stage with the preceding two of non standard
operation however we can state that a real innovations has taken place, as ECB introduced the
~ 52 ~
three years maturity LTROs and the reduction of the reserve ratio. Two were the novelties
with respect to previous LTROs. First the duration, which added a roll-over insurance to the
existing fixed-rate full allotment procedure. Second, an attached option for counterparties to
repay amounts at any time after the end of the first year.
With this sort of operations, Eurosystem provided banks with a guarantee of having sufficient
liquidity over the medium term. This would help banks in maintaining credit lines to
reimburse bank bonds falling due. Take-up was significant in volume and in the number of
banks participating. Around €1 trillion was allotted in total for the two operations; the first of
which was implemented, to the tune of €489bn on December 22, 2011, and the second of
which amounted to EUR529.5bn allotted on February 29. Since the ECB and the NCBs are
prohibited from doing outright purchases of sovereign debt in the primary issue markets by
the Treaty, they provided half of the required mechanism by making very cheap credit to
banks. In this way the Eurosystem benefited from a indirect instrument of action in the
primary market. In some periphery countries, e.g. Greece and Ireland, during the LTROs and
SMP operative period, the national authorities forced banks and other regulated entities (such
as pension funds and insurance companies) to purchase, more of their own sovereign’s debt
on the primary markets. As these entities were incentive to purchase at lower yields than they
would voluntarily, we have had a indirect intervention on the primary market. This
instrument, as revised in this way, has brought two advantages over the SMP route of
providing support to the sovereigns. First, banks can, unlike the ECB, lend to governments
and purchase sovereign debt in primary markets, and therefore provide more effective relief
than through the ECB’s SMP purchases. Second, since the banks purchase the government
debt, the problem of effectively senior officially held debt subordinating private creditors,
would not arise.
Reduction of the reserve ratio was instead seen as a measure to free new liquidity. This was
subject to a strong haircut, helping banks to raise about € 50bn.
Since credit claims
correspond to certain types of loans to households and firms, their eligibility as collateral
enables Euro area banks more readily to access Eurosystem refinancing using assets directly
related to their lending activity. Moreover, this support in raising alternative credit assessment
sources reflect our view that the assessment of credit rating agencies have a pro-cyclical and
short-sighted outlook. The continuous sequence of GIIPS’ private and public debt
downgrading seems to support this opinion.
Although the established of new massive liquidity arrangements for banks, from spring 2012,
across the Euro area countries there were signs of increasing fragmentation in the funding
conditions for households and firms. Basically, the ability and opportunity of banks to
~ 53 ~
refinance and rebuild their balance sheets with the ECB non standard operation was not
followed to the credit provision to household and firms. Two were the possible reasons of this
stand-still.
First, bank funding costs were pushed up by continued tensions in sovereign debt markets,
causing pressure on the quality of bank balance sheets, mostly to the Core Tier 1 capital.
Second, the reduced availability of high-quality collateral was weakening capability of credit
institutes to raise liquidity. For this reasons, ECB announced
v.
the commitment, stated by the President of the ECB, of infinite support for the Euro
area existence;
vi.
the introduction of the Outright Monetary Transactions (OMTs) from September
2012, in place of the previous SMP.
4.4.
The ‘stealth’ bailout of the Euro area.
The innovation in the Eurosystem non standard monetary policy has been as stronger as
innovative. On 26 June 2012, Draghi, President of the ECB pronounced these words:
“When people talk about the fragility of the euro and the increasing fragility of the euro,
and perhaps the crisis of the euro, very often non-euro area member states or leaders,
underestimate the amount of political capital that is being invested in the euro […] we
think the Euro is irreversible [...] Within our mandate, the ECB is ready to do whatever
it takes to preserve the euro. And believe me, it will be enough. There are some shortterm challenges, to say the least. The short-term challenges in our view relate mostly to
the financial fragmentation that has taken place in the euro area. Investors retreated
within their national boundaries. The interbank market is not functioning. It is only
functioning very little within each country by the way, but it is certainly not functioning
across countries. And I think the key strategy point here is that if we want to get out of
this crisis, we have to repair this financial fragmentation”.
About a month later, on 6 September 2012, ECB governing council decided on a scheme to
intervene in secondary sovereign bond markets subject to strict and effective conditionality,
the so-called OMT. In practice, the measure has been introduced to enable the ECB to address
severe distortions in government bond markets. A substantial innovation with respect to the
SMP. This definitely sent a strong signal of the irreversibility of the Euro, as ‘no ex ante
quantitative limits’ has been set on the size of outright monetary transactions. This
~ 54 ~
announcement addressed the risk of adverse equilibriums that had started to exert upward
pressure on yields in sovereign bonds, obstructing market access of banks in a severe way.
A necessary condition for outright monetary transactions with respect to a specific sovereign
bond market is ‘strict and effective conditionality’ to an European Financial Stability Facility/
European Stability Mechanism programme. ECB has further guaranteed that would suspend
the OMT in case of failure on the side of the government to comply with conditionality. This
was necessary, as a similar intervention includes the possibility of primary market purchases
by the EFSF/ESM. Such a scheme, when operative, will involve the financial means of the
Euro area governments, as they are the stakeholders of these facilities. This implies that an
approval by parliaments will come ahead of decisions of the other entities involved. This
means that even the ECB would wait for the Euro area governments to be ready to put their
money first before deciding whether central bank money would be used in the sovereign bond
markets.
In fact, the conditionality of the OMT relates different agents. First, the sovereigns
themselves, whose bonds may be the object of interventions. Second, the Euro area
governments collectively, which fund the EFSF/ESM facilities and at last the ECB. It would
eventually protect the IMF, depending on its involvement on the stabilization/restructuring
programmes. The possible block of the OMTs is a guarantee to the governments that see
similar schemes a possible source of moral hazard. If a strict build up, as the one designed,
theoretically prevents tail risk, it is always true that it would even prevent a possible
implementation of the scheme. As this essay was drafted, the OMT scheme has never been in
use from its foundation. Strict conditionality here in fact implies strict austerity plans. And
with a declining economy, with record unemployment, governments seeks to avoid to commit
against their own electorate.
4.5.
Does the ECB only acts as price stabilizer?
Central bank communication has two different objectives. First, it targets to contribute to the
accountability of the central bank (see De Haan et al. (2004) for a focus on this point).
Second, it helps the governing councils in managing expectations. The latter point is the one
of our interest. As it is commonly accepted, the emphasis on the communication is markedly
increased for the last two decades, as a consequence of the greater independence from the
political process and the related need for accountability. This helped shedding the shrouds of
mystery that always accompanied the central banks. This openness is now a characteristic, a
key instrument in the toolbox of the central bankers. ECB operates in this world. Several
economic decisions hinge on those overnight interest rates. Expectations are important as it is
~ 55 ~
widely accepted that central bank’s ability to affect the economy depends upon the degree to
which it can influence market expectations regarding the future path of those yields.
According to De Haan et al. (id.), it is the only market interest rate effectively controlled by
the central bank.
In our opinion, interest rates are not the primary means by which ECB has acted to ease the
tensions across financial markets. We affirm that from 2008 to 2012, ECB monetary policy
has been partially ineffective, as governing council decisions has been severely influenced by
outside communications. Before the crisis, ECB communication scheme was always centered
in its unique objective, price stability. Governing council communications were not
characterized by a full information disclosure, like in other central banks (e.g. New Zealand,
Norway, Sweden) happens. Indeed, according to Checchetti and Schoenholz (2008), were
based on the use of code words. We deem that, by indirectly anchoring non standard policy to
a standard objective, ECB has never effectively used its power to communicate positive
expectations to the market. As Checchetti and Schoenholz (id.) affirmed, codes are an
imperfect signal for every kind of policy announcement. In fact, these typically relates only to
short term prospects and not for critical long-run market expectations.
Figure 22. ECB main Overnight interest rates, 1999-2013 (percent)
7
6
5
EONIA
Euribor (12M)
4
3
2
1
0
Note: last accessed 10 May 2013
Source: ECB Data Warehouse, authors’ own evaluation
On figure 22 it can be noted that the overnight interest rates path moves into the corridor of
the official rates, as announced by the governing council of the ECB (see figure 25).
~ 56 ~
In every statement, publication and speech, the ECB or its executives justifies market
interventions as a requisite for the correct transmission of the monetary policy, whose unique
target is, as well known, price stability. This has been true since the start of the crisis in 2007.
In ECB (2011), former ECB President, Trichet, declared that the ECB’s non-standard
measures first purpose was focused on the ECB’s primary objective – the maintenance of
price stability. Later in time, the new ECB President, Mario Draghi, at his first press
conference and Q&A session following the November 3, 2011 meeting of the Governing
Council of the ECB, confirmed this impression.
We agree that the non standard measures were implemented in a way to help the functioning
of the standard monetary policy. The measures implemented clearly has helped in this way.
What we complain about is the fact that in a exceptional environment like the economic
situation created since August 2007, standard monetary policy was not enough to allow public
to build up affordable expectations about the future.
In our opinion, private agents have never lend special credence to the official economic
pronouncements, as the ECB was not believed as completely credible as effective forecaster
of the economy during the crisis. In fact, as Wyplosz (2011) cited, there were serious ‘rumors’
that the former ECB President, Jean-Claude Trichet, does not even wanted to consider the
possibility of a Greek default, as it could hurt some European banks.
Figure 23. Balance Sheet size of selected central banks, 2007-2013 (2007=100)
Note: Estimated as value of total assets.
Source: Carpenter et al. (2013)
~ 57 ~
So the former President of the ECB was not even considering what the market was widely
expecting as for a resolution of the Greek crisis. By reporting ECB (2013), a first partial steer
to this policy, literally came from the new President of the ECB speech cited at point v.
above. President Draghi justified the successfully 3Y LTROs by almost explicitly admitting
another target for the ECB policy, financial stability. In fact, the core objective of price
stability cannot be successfully reached without the stabilization of the fragmented financial
markets in the Euro area. It is true that the ECB has to date always considered its nonstandard measures primarily as a complement to its interest rate instrument, not as a substitute,
as is the case for the bulk of unconventional policies of other major central banks. However,
in the lines of the speech, President Draghi admitted the possibility to turn to a relative grade
of “independence” of financial stability facilities. A simple graph, like the one in figure 22
taken by Carpenter et al. (2013), gives a measure of the importance of central banks
interventions from 2008 onwards.
4.6.
ECB as a Lender of last resort
Figure 23 support our thesis that the European Central Bank acts as a lender of last resort.
(LoLR). Our previous statement is based on the interpretation that the longer-term refinancing
operations (LTROs) of December 2011 and February 2012 were as much about acting,
indirectly, as LoLR for the Spanish and Italian sovereigns. ECB in fact has acted by
facilitating the purchase of their debt by domestic banks in the primary issue markets and by
dealing with a liquidity crunch for Euro area banks in that particular stage of the crisis. We
cannot agree with the version of the ECB that the SMP was only motivated by the desire to
restore orderly sovereign debt markets, as these are necessary for the proper functioning of the
monetary transmission mechanism, based on interest rates.
The European Central Bank is the unique institution that can provide unconditional Euro
liquidity in any amount and without notice. We can state that, as a result of the failure of the
European political authorities to provide adequate liquidity and solvency support, the
Eurosystem has been forced to act not only as LoLR for sovereigns and banks. Moreover, has
gone even well beyond. Providing financial support to insolvent banks and sovereigns, in
order to prevent disorderly defaults of sovereigns and of systemically important banks and to
create a window for orderly sovereign debt restructuring and for orderly bank debt
restructuring and recapitalization, it has demonstrated that the “too big to fail” criterion is
among his possibilities.
~ 58 ~
Table 3. Non-standard monetary policy measures implemented by central banks from 2008.
Note: Operations implemented by the ECB are the ones underlined in green in the spectrum considered.
Source: ECB(2013), authors own elaboration
This is the reason why we argue that, with the introduction of the LTRO, first, and President
Draghi speech after, ECB took under considerations all the possible options in order to save
the Euro area.
4.6.1. Need for a lender of last resort?
One of the function a lender of last resort is to provide liquidity to solvent but illiquid
counterparties. The idea of the LoLR was originated at the beginning of the 19th century by
Henry Thornton (1802), which suggested the basic elements a sound central bank should
practice with respect to distress lending25. This concept has then been expanded by Walter
Bagehot. We can define his approach as the “classical” one. This requires that liquidity is
provided against good collateral and at a penalty rate (Bagehot (1873)). Although this
description of the LoLR function continues to influence central bank policy maker today,
current practices have also been shaped, i.e. the Bagehot approach is too restrictive. On this
section, likewise on the previous and subsequent, we shall use the term LoLR in the sense of a
lender to illiquid but most likely solvent counterparties, on whatever terms.
25
See Freixas et al. (1999) and Freixas and Parigi (2008) for a review of the literature and the role of the LoLR.
~ 59 ~
Illiquidity is almost always the product of fear of insolvency. Nevertheless, in practice it may
be very difficult to determine whether an illiquid entity is indeed most likely solvent,
provided that the illiquidity is remedied by providing the illiquid counterparty with liquidity
on terms that are appropriate for a solvent borrower. This is one of the reasons that has led for
a long to accept that, because of liquidity and maturity mismatch among their assets and
liabilities, banks need a lender of last resort26. Notice however that sovereigns are in a similar
position to banks (de Grauwe (2011b)). Like banks, a sovereign does not have full control
over its central bank, is prone to face liquidity and maturity mismatch between its assets and
liabilities. This is what we also know as ‘sudden stop’. In most of the countries, the treasury is
the beneficial owner of the central bank operations; this is the reason why the term “fiscal
dominance” was coined. This helps to tackle problems when a sovereign funds himself with a
domestic currency. Nevertheless, it is not a solution when a foreign currency funding block
materializes. It is broadly known that main assets of a treasury are intangible, e.g. the net
present value of future taxes. When a sovereign would face trouble in rolling over maturing
debt or funding new deficits, there would be problems, for example, in turning a current
political commitment to cut future public spending. At least because of credibility and
commitment problems. This is the key point of the discussion. When pessimism rules on the
markets and on conditions of that sovereign, confidence vanishes and trust is weak. In this
circumstances the government may be unable to translate promises of future public spending
cuts or of future tax increases into a actual ability to fund itself on the markets. This is harsh
even during normal times, when the size of the intangible assets of the sovereign is illiquid
and of long-maturity. Alas, even a firm attempt to reduce the intangible (future) liabilities of
the government need not translate into any significant increase in its ability to borrow today.
In addition, many sovereigns have nontrivial financial deficits and/or a sizeable stock of
sovereign debt, part of which matures and requires re-financing each period. Then most
governments therefore have regular, recurrent funding needs. This summary clearly shows
that, like banks, sovereigns therefore suffer from maturity and liquidity mismatch among their
assets and liabilities.
4.6.2. The means of a modern lender of last resort
Even in the case that a sovereign is solvent27, if the ‘self-fulfilling fear equilibrium belief’
will spread on the market, this state could be switched into a fundamentally unwarranted
payments default, should the market instead adopt the belief that the government is not
26
27
See Goodhart and Issing (2002) for a complete view of the debate and functions of the LoLR.
Provided it can get funded at yields that reflect the market’s belief that the sovereign is solvent.
~ 60 ~
solvent. A lender of last resort capable of issuing an unquestionably liquid instrument, e.g. an
expansion in the base money in any amount, may well be necessary to ease a ‘debt run’
equilibrium that always threatens the sovereign. This role would be equivalent to prevent
solvent but illiquid banks from succumbing to a bank run (see Goodhart and Illing (2002)).
Hitherto, this suggestion has been underlined several times since 2010 in the case of the Euro
area, where a single central bank copes with 17 sovereigns. Note also that this is equal to the
case of the US, where a single sovereign faces the Central Bank (see also Buiter and Rabhari
(2012b), de Grauwe (2011b), Gros et al. (2012). Among this ‘sovereign side’ financing, is
essential to underline the payments made to the treasury by the central bank, i.e. the share of
the Treasury in the seignorage profits raised by the central bank. The net present value (NPV)
of these future ‘taxes’ paid by the central bank to the treasury is, anyway, also an intangible
and illiquid asset of the Treasury. This unveils the core of the discussion we want to pose. As
for the treasury, the main assets are represented by the future value of its incomes, then the
central bank main profits are represented by the net present value of the seignorage. With this
term we mean the profits derived by the Central Bank from its monopoly of the issuance of
legal tender in a country/area. Printing fiat money is a highly profitable activity – and that is
the reason why it has been strictly regulated and monopolized by the state. In fact, as to
simplify, assume that seignorage is to the difference between the face value of a coin and its
costs of production and mintage. Then, the difference between the face value of a tender note
and its marginal printing cost are almost equal to its face value, as marginal printing costs are
effectively zero. This is the reason why NPV of future seignorage is so important for a
sovereign. According to Buiter (2007), we can state that the asset in a central bank balance
sheet are (1) the NPV of future interest saved by having borrowed through the issuance of
base money rather than through the issuance of non-monetary debt instruments, (2) the NPV
of the payments made by the Central Bank to the Treasury, which we encountered as an asset
of the Treasury, (3) the NPV of the helicopter money drops made by the Central Bank and (4)
the NPV of the implicit, quasi-fiscal subsidies made by the central bank on its financial assets.
A consideration: even when a central bank cannot engage in ‘helicopter money operations’,
which is realistic as, in most real-world economies, point (3) is nil, it can provide implicit
transfers to private counterparties through subsidized lending rates, what we have listed on
point (4) on the previous list. This is what the ECB has implemented in the Euro area.
Consider the two 3-year Long-Term Refinancing Operations carried out in December 2011
and February 2012. These loans were made at an interest rate linked to the official monetary
policy rate, the Main Refinancing (MRO) rate. As from figure 25, this stands currently at 0.50
percent and is expected remain stable by the end of the year and over the life of the LTRO.
~ 61 ~
When these measures were introduced, it stood at 1.00 percent. This means that, over the 3
years of the LTRO, the bank’s cost of borrowing could almost stand at 60 basis points.
Nonetheless, this cost will decrease whenever the main refinancing rate will be reduce in the
future. In addition, collateral requirements for the loans were weakened dramatically.
Figure 25. Key ECB interest rates (percent)
7
6
5
4
Deposit facility
Marginal facility
3
MRO
2
1
01/01/2013
01/01/2012
01/01/2011
01/01/2010
01/01/2009
01/01/2008
01/01/2007
01/01/2006
01/01/2005
01/01/2004
01/01/2003
01/01/2002
01/01/2001
01/01/2000
01/01/1999
0
Note: Marginal facility is the upper bound, whereas the deposit is the floor rate. MRO is set between the
two other rates controlled by the central bank.
Source: ECB, authors’ own evaluation
There can be little doubt that these LTROs involved a significant subsidy from the ECB to the
borrowing banks, in our view at least 3.00 percent per year (if not more). With just over €1
trillion worth of LTROs undertaken, the annual subsidy would be €30bn. Assuming a 4.00
percent discount rate for the NPV calculations over three years the NPV of the subsidy would
be around €80bn. As the refinancing via LTRO was mainly used to buy sovereign debt, we
can state that ECB acted (indirectly) as lender of last resort over last three years.
In principle, the domestic central bank is not the only possible lender of last resort for
sovereigns. Sovereigns could also rely on some form of self-insurance, e.g. by amassing a
large stock of liquid financial assets, or an external institution, such as the International
Monetary Fund, could play the role of lender of last resort. Both of these alternative sources
of emergency liquidity are likely to be useful (and are in fact used) in the Euro area, but are
simply not large enough to replace the central bank as the primary lender of last resort for
domestic currency liquidity for euro area sovereigns and banks. The insufficient size of the
~ 62 ~
facilities available to these other potential lenders of last resort it is a consequence of
unwillingness/political inability of the political leadership in the Euro area and in the wider
global community to create facilities of sufficient size.
Table 4. Gross refinancing requirements
of selected countries, 2013-2014 (€ bn)
Austria
Belgium
Cyprus
Finland
Greece
Ireland
Italy
Spain
Portugal
France
Germany
Netherlands
GR+IR+PO
CY+GR+IR+PO+SP+IT
Total
2013
24.9
43.4
2.5
7.9
25.1
19.5
211.1
156
19.2
225.9
224.9
56.6
66.3
451.7
1016.9
2014
31.5
31.3
0.9
7.7
23.7
20.7
162.5
95.2
18
158.3
178.9
46
63.3
328.6
774.6
2013-2014
56.4
74.7
3.4
15.6
48.8
40.2
373.6
251.2
37.2
384.2
403.8
102.6
129.6
780.3
1791.5
Note: Refinancing requirements are estimated as maturing general govern_
ment bonds and bills plus estimates for the general government deficit.
Source: Buiter and Rabhari (2012b).
Country/Group 2012 2013 2014 2012 - 2014 Q2
A truly credible LOLR, at a minimum, should be able to cover the plausible liquidity needs of
the agents that are potentially vulnerable to a funding strike by private investors. In the Euro
zone, one way to make the latter requirement operational is to estimate the total financing
requirements of euro area sovereigns over, say, the next two years. As Table 4, taken from
Buiter and Rabhari (2012b) shows, the gross financing requirements of the Euro zone
periphery (GIIPS plus Cyprus) plus the EA ‘soft core’28 (Austria, Belgium, France,
Netherlands), estimated as maturing general government bonds and bills plus estimates for the
general government deficit, exceed €700bn in 2013 alone. For the Euro area as a whole, gross
financing requirements for the general governments are above to €1 trn for 2012. If we
assume that the lender of last resort should be able to cover at least two years’ worth of
funding for all Euro zone sovereigns, its minimum funding capacity shall not fall over
EUR2trn. This is the simplest reason why the ECB should be considered as a true LoLR.
28
With ‘hard core’ we mean the group composed by Germany, Finland, Luxembourg and the Netherlands, even
if this last registered a general government deficit on the last year.
~ 63 ~
4.7.
Fiscal dominance in the Euro zone
The undertaking of a LoLR role is the consequence of the political disorder that reigned over
Euro zone members. Because of institutional and policy failures in the Euro area, the ECB,
has been forced to assume on its balance sheet material sovereign credit risk, on top of the
growing counterparty and credit risk. It has been the inability of the Euro area political
leadership to create legitimate fiscally backed institutions for dealing with sovereign
illiquidity and insolvency and also bank insolvency in our opinion, to force the ECB to
embark this quasi-fiscal role. Also a large part of economists (Buiter et al. (2011), De Grauwe
(2011a,b), Sinn (2011a, b, 2012), Sinn and Wollmershäuser (2011), Whelan (2011),
Whittaker (2011), Wyplosz (2012)) has recognized that ECB has engaged in similar
interventions.
We affirm that instead of just providing liquidity as lender of last resort and market maker of
last resort, the ECB has assumed significant credit risk vis-à-vis the Euro zone periphery
sovereigns (through the SMP) and vis-à-vis many of its counterparty banks throughout the
whole Euro area through its collateralized lending facilities. At least since the eruption of the
sovereign debt crisis in Greece from the early 2010, there has been a quiet battle between the
ECB, which represents the monetary authority, and the fiscal authorities of the fiscally strong
core Euro area member states. The named conflict concerns how any net resource transfer
from the core Euro area members taxpayers to the sovereigns in the periphery (which are
fiscally weaker), is going to be split between explicit fiscal contributions from the a) core
members’ ministries of finance and b) implicit quasi-fiscal contributions from the ECB. This
issue has been described as a “game of chicken” between ECB and national governments (see
Buiter (2012) and De Witte (2012)). The prolonged disagreement between the Eurosystem
and the core countries’ fiscal authorities suggests that both parties to the dispute were aware
that this was not just a lender of last resort role. In fact the dispute was about who should take
the exposure to the Euro area periphery sovereigns, i.e. the Eurosystem − on its Balance sheet
− or the sovereigns, through the various multilateral and supranational facilities, i.e. EFSF and
ESM. Since there is a material risk that one or more of the sovereigns will turn out to be
insolvent as well as illiquid, so that what started as a loan will reveals to be a direct transfer.
Implicit quasi-fiscal burden sharing occurs through any losses of the ECB on its outright
holdings of periphery members sovereign debt. As we are talking about core Euro area
taxpayers’ money, it is important to know whether the exposure and the transfer is made
through a facility like the EFSF and the ESM or through the ECB. To a first approximation,
this is only a negligible book-keeping issue. The profit and loss-sharing proportions of the
EFSF and the ESM are the same as those of the Eurosystem. But with limited – asymmetric –
~ 64 ~
information and bounded rationality, this framing matters. A quasi-fiscal transfer from the
core Euro area taxpayer to the original creditors or to the periphery taxpayer through the ECB
is opaque and non-transparent, as it would not show up in the budget or balance sheet of the
current year.
~ 65 ~
~ 66 ~
5. Targeting the villain: the quest for fiscal discipline
We point on a problem which is complementary and substitutive at the same time. The quest
for fiscal discipline in fact can clearly be seen from two different points of view. First, as a
straightforward conduct, as a consequence of the rules adopted twenty years ago in the Treaty
for the Functioning of the European Union, in order to adhere to the European Monetary
Union. Second, as a conditional and additional instrument, as to access to the support
advanced by the so called “troika” or by an eventual LoLR. This second, clearly, is a
consequence of the misunderstanding of the former definition. The reason why is in our
interest the latter definition, is that it involves the grade of intervention of a lender of last
resort into a crisis in the Euro Area. As noted above, true LoLR support is granted to illiquid,
but solvent institutions only, against good collateral29. In principle this happens without
further conditions attached to accessing the support. This is straightforward when dealing
with banks and other financial institutions. When sovereigns are involved however, the
distinction between illiquidity and insolvency becomes particularly tricky. If we consider that
also ex-post enforcement actions aimed at sovereigns are particularly difficult30, additional
safeguards to ensure that the presence of a lender of last resort does not weaken incentives for
fiscal discipline seem merited. Among these could be statutory fiscal rules, such as those that
are part of the amended Stability and Growth Pact, and the succeeding Fiscal Compact.
Regular debt sustainability analyses should be carried out and a positive verdict should be a
precondition for obtaining LoLR support. These are mostly meant to reduce the likelihood
that Euro area sovereigns would run into solvency problems. Fiscal and structural reform
programme conditionality are also likely to be required for LoLR access. But all of these
together are unlikely to be sufficient.
5.1.
Austerity budgets and counterfactuals
In the real world experiment, we have tested that contractionary fiscal policies when the
economy is in recession make the recession deeper and longer lasting and fail to reduce public
indebtedness. This has been proved theoretically, as Corsetti et al. (2012) have shown. This
means that the current strategy adopted by the to date “salvage float” (the EU-IMF-ECB
troika), is not a ‘first best’ solution. Nevertheless, it is also clear that is one of the few
29
Or against collateral that would be good in normal times.
This is a relevant problem, which is also aggravated by the inability of most sovereigns to offer adequate
collateral for any financial support they receive. The operations implemented by the ECB (acceptance of below
investment grade collateral) shows that it is of primary importance, as to fund troubled counterparts Eurosystem
has even accepted collateral that would never be accepted in normal times.
30
~ 67 ~
possible in order to restore confidence. The policy implication is less obvious, however.
Fiscal policies cannot remains contractionary, but should they be made expansionary? Clearly
the crisis and quasi-crisis countries, which have either lost market access or struggle to keep
access, cannot further deepen their current, large deficits.
For the regime to be effective in the long term, sovereigns would likely have to be allowed to
fail, as in the Euro area, an increase of the sovereign spending is no more possible as from an
economical as a political point of view. After all, governments with much lower debts would
have the fiscal space needed to end austerity and pursue expansionary policies. However, the
debt overhang of the Euro area periphery makes this alternative impossible to date. Debt
overhang, in fact, whether public or private, impedes investment and growth (Reinhart and
Rogoff 2011). From 2011, when originally troubles were only in Ireland and Spain, problems
have transmitted to all Euro zone. Signs of fiscal distress is seen in France, Austria and
Netherland. All countries that, when analyzed in 2011, were classified as “core”, so stable
countries. Neither Germany is exempted from this list, as its growth slowed down markedly in
the last two years.
The question is: how then can debts be lowered fast enough? We have seen that three
solutions are possible: the first one would be a burst of inflation. That cure, however, is worse
than the disease. The second would be an internal devaluation. However this one would add
depression to recessive pressures, leading to similar consequences to the previous solution.
The third, and only viable solution in our opinion, is debt restructuring. Many economists (for
the sake of comprehension, see Wyplosz (2011, 2012), or Gros and Mayer (2011)) called for a
restructuring of the sovereign debt in the Euro area for a long time. Not only the small and not
systemically important sovereigns should be allowed to fail, and not only after months or
years of procrastination and useless squabbling. There is simply no other way out than debt
restructuring. For that, in order to assure the counterparties in a so severe event and to
supervise it in a rational manner, it is possible that an official mechanism attributed of the
sovereign debt restructuring may be necessary. This task can be attributed to the ESM, which
by construction contains the outlines of such a mechanism. Notice that a partial task is already
attributed to the ESM, through the requirement that all sovereign debt in the Euro zone issued
from January 1, 2013, have collective action clauses (CACs) that authorize a qualified
majority of the debt holders to accept a debt restructuring offer from the troubled sovereign.
Otherwise, an alternative solution would be to include an option for a restructuring into the
OMT programme when it will be requested to the ECB by some sovereigns. The only crucial
point, is to make such a process reasonably orderly. This is the reason why we believe that a
statutory dimension will have to be given to any effective restructuring mechanism operative
~ 68 ~
for the Euro area. In our opinion it would be a solution since a vast body of literature (see
Borzenstein and Panizza (2008), and Reinhart and Rogoff (2009)) shows that defaulting
countries quickly recover market access after having fulfilled all the programs accorded with
the bailing-out institutions. Sovereign restructuring sounds radical and sometimes brutal. This
however must be seen from a wide point of view, which will consider that restructuring i) is
the consequence of an unprecedented situation, and ii) is something that will never repeat
again. Buti and Pench (2012) concluded that countries with very high and/or rapidly rising
debts may be well-advised to pursue a fast adjustment, in spite of an unfavourable economic
environment, if the alternative of a sovereign-debt crisis is sufficiently plausible. In practice
they argue, the only mean to fulfill a similar objective is a debt restructuring. At the actual
economic condition, in some of the Euro zone countries, we cannot disagree.
Nevertheless, the conditional “charges” imposed on possible draconian programmes would
not leave the causes of such events as unquestioned. Some would regard:
i) Getting rid of Article 123. This would permit the ECB, at its discretion, to act as lender of
last resort to Euro area sovereigns through sovereign debt purchases in primary and secondary
markets, by lending to the sovereigns directly, allowing for concrete support in a rescue plan
and by engaging in collateralized lending to the banking license-enhanced ESM, thus
strengthening the banking integration.
ii) At the same time, restricting the ability of the Eurosystem to purchase sovereign debt in
primary, and secondary, markets to purchases that benefit from a full joint and several
guarantee from all Euro area governments, i.e. an arrangement with member governments on
who will bear the costs. This would stand as a pledge of no bailout by the Eurosystem, thus
reducing the credit risk on the ECB/Eurosystem balance sheet.
iii) Any countries benefiting from (ii) should be subject to tough conditionality that involve a
material surrender of national fiscal and wider economic policy sovereignty for the duration
of the programme.
An optimal solution would then be given not by an ambitious (and unrealistic) fiscal union,
but rather by the Euro area banking union, characterized with a minimal, and capped, fiscal
component. A similar scheme seem, at a first sight, to be redundant with respect to a fiscal
union, which would directly tackle sovereigns. This framework indeed would be much more
important and necessary. In order to solve definitely the debt crisis in the Euro area, it is
essential to de-couple national sovereigns from the banks in their jurisdictions. This need has
growth further after the Cypriot banking system bailout in the early 2013. We will focus on
the argument on section 6.5.3.
~ 69 ~
5.2.
Has austerity gone too far?
About the fiscal discipline implemented in the Euro area after the explosion of the debt crisis
in Greece, Cottarelli (2012) warned that countries that commit to short-term deficit reduction
in a way to shift to long-term sustainability, thus a steady growth, may find obstacles to this
objective, as growth will slows more than expected. He even warn that unless a country is
forced to implement austerity measures, it should not do it as effect on the economy are not
clearly predictable.
A Voxeu.eu debate surged later in time, named with the section’s title, is helpful in
understanding why debt crisis in the Euro area protracted to long, causing so severe damages
in some cases. Corsetti (2012) about this debate, traced conclusion similar to that of Cotarelli.
He also pointed that theory and evidence on the effect of fiscal policy at times of financial
crisis is scant. Nevertheless, a possible negative impact of budget austerity reforms to be
adopted at the bulk of a crisis, had been evidenced even at the outset of the present crisis, as
Corsetti (2012) made present. In a global environment dominated by financial difficulties of
banks and with struggling financial markets, which only to date seems able to recover from
the paralyzing shocks recorded from 2007, there may be unexpected externalities that would
negatively influence fiscal policy. This, as a consequence, would affect the economy in ways
that are not sufficiently understood. Even the IMF (for a bulking see IMF(2012)), an
institution famous for its harsh advocacy of procyclical austerity, in mid-2012 openly asked to
Euro zone nations that they can “pace down” with similar measures, as uncertainty about
fiscal austerity was growing. Citizens rightly feel that this sort of sacrifices do not deliver the
promised results.
In fact, we are not proposing that monetary policy must be detached from the fiscal
component. The fact that two organism (the central bank and the government) are the
different arms of the same institution (the sovereign) is widely accepted for decades, after a
plenty of works have been drafted31. We question about austerity. In the last three year a
number of works about fiscal consolidation has been presented. Most of them were directly
published from the European Commission32. All of these were elegant theoretical models
standing, nonetheless, on impractical assumptions about the current crisis in the Euro area
countries. Most of this weight was given to the fiscal conditions in its periphery. This have led
policymakers to the conclusions that a fiscal consolidations, focused on the reduction of the
31
32
For a straightforward proof, see Calvo (1988)
For a non exhaustive example, see Buti et al. (2009)
~ 70 ~
public-debt ratio relative to its pre-consolidation levels was to be reached33. This was right,
theoretically. Positive results are scarce, however. In this sense we can say that fiscal
consolidation can is ‘self-defeating’.
On April 2012, before French and Netherlands general elections, the response of a part of the
European economic establishment has been to stay the course of this fiscal consolidation. In
the words of the Bundesbank President, Jens Weidmann34, possible policy targets were only
excessive deficits and boost competitiveness. These sentiments are comprehensible, but in our
opinion these are basically wrong. Germany is rightly concerned about past and future fiscal
profligacy by several countries undermining the Euro. But the problems of Spain and Ireland,
for example, stem not from public borrowing but rather high private debts due to the
aftermath of the construction bubble. Forcing Spain down to a deficit of 3% of GDP by 2013,
when the 2011 level was 9.5% and in 2012 was 10.6 is possible only if one accepts to
dismantle the Spanish public sector, contribute to destroy Spanish government credibility by
its electorate and create perilous social distress. Nevertheless, fiscal consolidation is working,
as primary budgets are quickly decreasing in all the peripheral countries. However, we noted
is that austerity is also harming countries that were known as ‘fiscally responsible’ in the past.
Then we have deepen the analysis on empirical data.
In Figure 26 we have assembled an informal indicator about the austerity policies efforts in
the Euro zone for the period 2009-2012, by inspiring to an idea of Wyplosz (2012b). This
actually shows the relationship between the proxy for the austerity budget stabilization efforts
and the real improvement on the deficit/GDP. On the horizontal axis, we have the Forecasted
budget ratio, measured as the general government forecasted primary balance for the year to
come – over the GDP. On the vertical one instead we have considered the effective change in
the general government primary balance/GDP. The 45 degree line is the threshold where the
austerity efforts are matched by real improvement in the primary deficit to GDP ratio, i.e.
effective primary deficits equals the forecasted ones. It has been estimated with a simple OLS
estimation. Points corresponds to the cumulated difference between the real improvements
and the austerity efforts for the period. Clearly, a positive indicator means a successful effort
in restraining the budget, while a negative implies the converse. Nonetheless, we kept in mind
also the average GDP growth. The red squares correspond to those countries where real GDP
overall growth over the period was less than 2%; as it is clear, the outcome of such efforts has
been worse than the expected result, as all the point are under the line. The diamonds
33
In particular, it showed that while gradual consolidations are in general more likely to succeed than coldshower ones, the superiority of a gradual strategy tens to evaporate for high levels of debt and is also less
pronounced for consolidation episodes following a financial crisis.
34
Taken from “Leaders in Austerity Backlash”, Financial Times, 24 April 2012.
~ 71 ~
conversely, represents countries that grew faster than 2%; in these, we can affirm that the
outcome was as good as the effort. However, for these countries, only Germany is showing an
increasing trend in the change, whereas other has seen a deterioration of the accounts in the
last two years.
What we found is that it is a not a good idea to tighten fiscal policy where growth is weak or,
worse, where the economy is receding. There are indeed reasons for believing that recessions
impose costs even after they theoretically end. This after-end results are also known as
“hysteresis effects” (see deLong (2012)). The surge in the unemployment rate in peripheral
countries seemed to confirm this possibility. As a consequence, the possibility of incurring
negative outcomes as a consequence of fiscal consolidation and, most of all, the fear of an
insurgence in the credit risk bared by core countries and the ECB, has led policymakers to
remodel the intervention plans for the future salvage plans.
Figure 26. Effects in Budget consolidation efforts, 2010-2012.
Note: The sample includes all Euro area member countries except Ireland, for which data about the
primary balance were not available.
Source: AMECO, ECB Statistical Data Warehouse, authors’ own evaluation
5.3.
Cyprus
Cyprus banking system bailout in March 2013 had been the occasion for the European
institutions (namely EU and ECB) to give a steer to the ‘salvage approach’ to be adopted in
case members countries in difficulties would need to be rescued. The facts are now well
~ 72 ~
known to the public. Nevertheless, these were not so clear at the time facts were occurring in
the small island. The sequence that led to this ‘half-salvage’ was clear for a long time:
negotiations on a possible bailout by the EU or ECB in fact had been seen as inevitable as
early as mid-2012. Greece’s partial debt restructuring hit Cypriot banks hard, raising doubts
about the solvency of the Cypriot government in case of a bank bailout to be put in place.
Nevertheless, discussions were frozen until the Cypriot general election last month. This
delay constrained possibilities for an intervention similar to the one seen before in Ireland,
Greece and Portugal. Cyprus has earned no sympathy by harboring Russian and Russianlinked financial activities, widely presumed to be connected with money laundering. What is
also known is that before the explosion of the crisis, and the call of the Cypriot government
for a support in the bailout of the banking system, probably not all the lacks of this system
were clear, almost in its whole extent. It was only clear that the resolution of these banks and
the funding of this expensive process, was beyond the capacity of the Cypriot government.
Driven by German domestic politics, the idea to impose losses on large Cypriot deposits
became an indispensable component of the package for European negotiators.
5.3.1. The ‘half salvage’
One of the largest banks in Cyprus, namely Laiki, had been later discovered to be completely
insolvent. As Bank of Cyprus, the largest national bank, was deeply insolvent too, EU and
ECB realized that these institutions were but too big for the government of Cyprus to save. At
the time, bank assets amounted to some 900% of Cyprus GDP. This find out was very clear as
executives in European governing institutions were at least motivate to avoid the tragic
‘double drowning’ fate that shadowed over Ireland for two years on, that is the government,
while trying to rescue banks, found itself needing a rescue. Cyprus was not able to solve the
crisis alone, given an already high debt/GDP ratio, which was already increased at a high pace
in the previous years (see figure 7), and an oversized banking system. A recapitalization of the
banks through sovereign debt would produce unsustainable sovereign debt levels and,
ultimately, the default of the sovereign itself.
Was not surprising, then, that Cyprus government in Nicosia was obliged to find about €6bn
without increasing the country’s indebtedness. Astonishing, indeed, was the mentioned
approach, as the ungrateful duty or raising such a sum was delivered to President Nicos
Anastasiades on Friday 15 March, by an ECB executive board member. In simple words, its
task was to raise €5.8 billion, that would then added to the €10 billion offered by the ESM,
the European Stability Mechanism. What happened that day unveiled to be a tough snatch
between Euro zone periphery Governments and core ones, as it is undeniable that ECB first
~ 73 ~
and EU then, received strong pressures from some chancellors in order to impose direct losses
to Cypriot citizens. Troika experts had certainly discussed different possible options in order
to solve solvency problems in Cyprus:
-
Give Cyprus the possibility of a complete bailout, with an estimated cost of €18bn
(then raised to €23bn);
-
Restructure the outstanding Cypriot debt which stand, to the date, at €8.2bn, of which
€4.4bn are governed by Cypriot law and €3.8bn consist in Eurobonds, governed by
English law35;
-
Haircut excess deposits, that is deposits in excess of the €100,000 minimum covered
by the local deposit insurance scheme, which represent about half of the total deposit
base in the Cypriot banking system;
-
Haircut the uninsured deposits and the insured as well.
Nonetheless, to the surprise of many, Cypriot president Nicos Anastasiades, at a first glance
suggested the most drastic choices, adding a hit to small depositors as well. Like everywhere
in the EU, bank deposits in Cyprus are guaranteed up to €100,000. The deposit insurance
system is the best scheme against bank runs. Given such guarantee, depositors have arranged
their wealth accordingly. Nevertheless, opting for a similar 'solidarity levy', had put a in
serious vulnerability the credibility of the bank deposit guarantee system throughout Europe,
particularly on other peripheral countries. Taxing stocks, or ‘confiscate’ private deposits as it
is the case, it is a great way of raising money but it has some adverse incentive effects. First, it
dismantle property rights, a sensible argument for taxpayers. Second, it casts dark shadows on
possible bank runs counter mechanism.
5.3.2. Repercussions on the depositors
The European Union, at a first glance approved the ‘dramatic’ option. Insured depositors
would have suffered a 6.75% loss on their deposits; amounts in excess of that level would be
subject to a solidarity contribution of 9.9%. Out of the fact that a similar levy is manifestly
unfair, this means that holders of Cypriot sovereign bonds would appear to be untouched. To
give an example of such a situation, as Buchheit and Gulati (2013) evidenced, the bond
matured on 3 June 2013 in the amount of €1.4 billion − even if previously bought deeply
under the par – would then have been paid out at the par in Euro in about ten weeks from the
35
As indicated in “Zypern Rettung – Ein modell für Europa”, Frankfurter Allgemeine Zeitung, 31 March 2013,
Link available on the web sources.
~ 74 ~
‘bailout’. Each depositor in a Cypriot bank, would had made a solidarity contribution toward
that payment to bondholders if a similar scheme would have been effective.
As to avoid a bank run, the decision to tax deposits had been preceded by a freezing of bank
deposits. What is important is the public reaction in Cyprus we have seen after the
government decision of leaving banks closed for a week or more – something that does not
bode well for obtaining the local legislative approval necessary for the plan to go through this
plan. Fortunately, Cypriot policymakers have subsequently changed this proposal.
Nevertheless, only conceiving it has been dramatic, as it caused large tensions across other
large peripheral countries. At the end of march, in fact, a different proposal that spared small
depositors up to €100.000. In fact, since 2009, deposit insurance has been harmonized
through the EU − plus Switzerland, Norway and Iceland− by an European Union directive36.
This last proposal wiped out both the junior and senior bondholders of Laiki, while imposing
huge losses on its large-deposit holders, has since then replaced the ‘bloody’ scheme chosen
at the first moment.
This experience of such a dramatic policy is remindful of many old experiences with capital
controls happened during the past decades. The most recent case is given by the Icelandic
banking crisis. The Icelandic authorities (the government and its central bank) and the IMF
too, as Danielsson and Amasson (2011) have evidenced, have considered the controls as
necessary because many foreigners, mostly Dutch and Britons, and wealthy Icelander, from
2008 had lost faith in the small economy and only wanted to take their money out. Their exit
from the Icelandic banking system would have had ruinous costs. Authorities was in the need
to adopt such desperate measures. Nevertheless, this is does not the exactly method to be
followed in order to build confidence. Anybody with money or deposits in the troubled
country in fact will seek to ‘abandon the sinking ship’ as quickly as they can, almost until
things look better. This is the reason why Icelandic authorities then have always presented
such instruments as a temporary measure, to be in place only for some months. Half a decade
later, capital controls are still in place. Probably, getting more and more restrictive. As last
and least recent case, we remind to the measures implemented in Italy during the sixties and
seventies, when massive controls on deposits were adopted in order to block the outflow of
capital from the country (see Frattianni e Spinelli (2001)). In these past decades, exporting
capital outside Italy was considered as a penal crime like a fiscal fraud or a theft. Would had
been adopted in Cyprus the dramatic solution explained before, deep risks of dismantling the
deposit system would then have been in place throughout the Euro area.
36
~ 75 ~
5.4.
Risks after Cyprus bailout
5.4.1. Bank runs and deposits insurances
Deposit insurance has been set in the years as an instrument that would prevents contagion.
That is, if depositors at failed or failing banks are forced to take losses, then there may be runs
on solvent banks as well, as panic spreads over the public. The idea is that each depositor
believes that all other depositors will run and as a consequence an otherwise solvent bank will
fail, then it is optimal for each depositor to run as well, as in a seminal work Diamond and
Dybvig (1983) had demonstrated. As a result of a run, the bank fails. Observing depositors
lose their money at a failed bank is the sort of event that might coordinate the beliefs of
depositors of solvent banks in such a fashion. Deposits insurances, coupled with prudential
regulation, have helped in getting rid quasi-completely − Northern Rock runs in 2007 is the
exception − this sort of events. But the argument misses an important point. There are other
ways to prevent self-fulfilling bank runs. Runs on solvent banks can be prevented or their
effects mitigated by having a central bank system, such as the ECB and the Eurosystem, that
controls over the whole banking system in the Euro area. Such a scheme would also be
consider as a credible lender of last resort for Euro zone. As a consequence, there would no
need for transfers from either taxpayers or other credit institutions to any of the creditors of a
failed bank. The discussion on the role of the deposit insurance agency in bank failure
resolution is also intimately linked to the design and structure of the deposit insurance scheme
(see Hardy (2013)). Theory, indeed, does not provide an unambiguous answer to the question
of who should resolve failing banks. In countries with explicit deposit insurance schemes,
deposit insurers might be more likely to carefully monitor banks and intervene rapidly into
failing banks as they have to carry the costs in terms of higher pay-out to indemnified
depositors.
Nevertheless, also deposit insurers might face perverse incentives. The first of these perverse
cases raises if the deposit insurance agency is run by the banking industry itself, which might
face a conflict of interest in dealing with failing banks. Second, deposit insurers might have
incentives to postpone realization of bank losses to avoid that bank failure “happens on their
watch”. This case has strong links with problems that affects bank supervisors. As third and
last observation, we remember that if the deposit insurer is ahead of other non-deposit
creditors and, specifically, with uninsured depositors in the creditor preference during
bankruptcy, the guarantor will face incentives to intervene too late, as Kaufman and Seelig
(2002) evidenced. In this case, in fact, incentives to inactivity are sent by the depositors. It has
proven that this sort of incentives are effective in practice. This goes on hand with the
~ 76 ~
incentive-compatible structure of deposit insurance. On one hand, this can be enhanced by a
proper alignment of interests. Funding and administration of the deposit insurance scheme by
the banking industry can increase the incentives of the deposit insurer to minimize insurance
losses. On the other hand, the possibilities of the deposit insurer to minimize insurance losses
can be further enhanced by aligning interests such as by giving supervisory power to the
deposit insurer. This can be taken even further by giving the deposit insurer the authority and
responsibility to intervene into problem banks and resolve failing banks. Theory in fact
suggests that a deposit insurance scheme can only maintain market discipline and minimize
moral hazard risks if banks problems are efficiently and timely intervened and resolved.
5.4.2. Which future for insurance schemes?
Cyprus government decisions’ have not been the first to put into doubt insurance deposits
schemes. When the Icelandic bank Icesave collapsed, a strong pressure came to the Icelandic
government, which was the responsible for the deposit insurance scheme. Nevertheless, as
from EFTA Court (2013), the relevant court then ruled that the Icelandic government was not
legally obligated to repay insured depositors. The court in fact accepted Iceland’s argument
that the EU directive was never meant to deal with the collapse of an entire banking system. It
noted that the provision of a scheme that was both financed solely by credit institutions and
that was able to guarantee coverage in the case of a systemic collapse would itself undermine
the stability of the financial system, as noticed on paragraph 158 of the sentence. Then, we
can draw some conclusions from Cyprus and Iceland experience: deposit insurance is a valid
insurance only for small crises, e.g. financial distress regarding some non-systemic financial
institutions. Sufficiently large bank failures or system collapses are a different matter as, in
such cases, small depositors are only safe if the sovereign or deposit insurer, if private entity,
has both the ability and willingness to compensate them by raising the necessary funds. As
noticed before, in 2011, assets of commercial banks in Cyprus with Cypriot parents were
about five times Cyprus’s GDP. To end-2012 this ratio rocket to seven, making the job even
harder than before. From Buiter and Siebert (2008), we know that in Iceland, the assets of the
three large Icelandic banks were about 11 times as large as Icelandic GDP prior to their
collapse. Looking at this facts, it seems clear that these deposits were not insured for the case
of systemic failure. It is well known that when a business fails, its creditors must take their
losses. This directly applies to banks: if the creditors of banks do not take losses when
institutes fails, then banks would take on too much risk, raising a huge problem of moral
hazard and thus increasing the total credit risk in the banking system. This consequently
raises two reasons for which it may be desirable to protect small depositors. We could call the
~ 77 ~
first one as the ‘widows and orphans’ argument: this argues that small and financially
unsophisticated investors should be protected as they would not be able to do it by itself, as
not in the means to implement an adequate insurance scheme. The second argument instead
regards directly the efficiency of the banking system: it is in fact inefficient, for a large
numbers of small-deposit holders, to devote resources toward assessing the health of complex
financial institutions. This system functioned well during the North-Atlantic financial crisis.
There exists a couple of common principles when dealing with bank resolution. The first one,
and probably the most important, is the respect for creditor ranking. As it is commonly known
in all business, equity holders are the first subjects to be hit from a creditor. Stockholders
normally are responsible before debt holders. In this second category, then we differentiate
between junior debt holders, which are the first hit after equity holders, and senior creditors,
which are hit only on a second time step, and before the uninsured depositors – those with
deposits over €100.000 in the European framework. Insured deposits money should be
considered only as a ‘last resort’ if creditors are not already satisfied. Such a creditor ranking
is based not only on legal rules, but also on the idea that claims should be priced according to
their risk and expected repayment in case of failure. Although these arguments are appealing
and consolidated on the practice, some might assert that €100,000 of guaranteed coverage is
excessively large. Nonetheless, reducing this coverage would devastate the standard of living
of a large part of individuals across the Europe, by cutting their savings and their decisions
about permanent income and inter-temporal consumption. This is the reason why the ‘former’
Cyprus rescue package under discussion, with its tax on insured bank deposits, has triggered
fiery and controversial reactions. Reducing the covered deposit insurance is not the point of
the discussion. The core of such a discussion is that imposing losses on depositors is to be
done in order to reduce the risk of over-indebtedness sovereigns only by guaranteeing
repayment of current sovereign-bond holders.
First, by imposing such a 'solidarity dues' on insured bank depositors, in order guarantee
repayments to sovereign-bond holders, we see the will to protect the bond holders category,
which is certainly composed by more sophisticated investors, above holders of small deposits,
thus mostly less financially sophisticated individuals. This goes against the definition of
financial investment, that is the will to have responsibility in bearing a risk by investing
money on a financial activities. It would be a devastating precedent, as it could give the base
for successive lawsuits on similar events. Second, and last, we argue that imposing a tax on
depositors of all banks, independent of the financial situation of each bank, further
undermines market discipline. Even if this constitutes to be an easier option to implement − as
it would require less administrative effort – it sends the negative message that investors do not
~ 78 ~
have to price investments accordingly to the risk of an institution/activity, as later, in case of
such an event, the haircut would be the same across banks.
5.4.3. The urgent need for a banking union in the Euro zone
The Cypriot economy is in crisis, for many reasons. But the insolvency of the banking system
is at the core of the current crisis, and attention should therefore be the focus on the resolution
instruments. The literature on resolving bank crises has pointed to several important lessons
(see Kaufman and Seelig (2002) for a broad view on the argument). One argument is that
losses should be recognized early on, allocated and then managed. We can recognize some
arguments in this literature. The flow solution, i.e. re-establishing solvency of the banking
system through retained earnings or future government earnings, seems attractive as it avoids
immediate pain. Nonetheless, it implies an high risk, mostly for the government. Another
argument stands that financing recapitalization out of future taxes and expected privatization
gains is also counterproductive as it ties banks and governments together yet again. Unless
banks are properly recapitalized, they will not be able to support the private sector and the
economy in its attempt to grow out of the crisis, which in turn undermines government
finances. This effect is much more severe when resolution involves foreign-owned banks in a
third country (see Eisenbeis and Kaufmann (2005)).
Finally, it is clear that, by tying banks and governments together, expectations that more
adjustments and possible write-downs might be ahead will be created. In doing this, there is a
tendency in such circumstances to under-estimate present losses and overestimate future
revenues, as the Greek case has clearly shown. As so often before, 'bailout' agreements has
caused more trouble than solved problems. Rather than disentangling banking and sovereigndebt crisis, charging failed banks to governments has tied them again together. The only
consequence has been a shift in bank insolvency issues to sovereign-debt insolvency, as it is
happened in Ireland.
There is little disagreement that banks need special insolvency rules compared to nonfinancial
corporations. Their role in transforming maturity, i.e. transforming short-term deposits into
medium-to long-term loans, makes banks more sensitive to short-term liquidity shortages that
ultimately could result in bank runs. Specifically, an interruption of the access to their savings
in the failed bank can cause depositors to panic and run on other, fundamentally sound, banks.
Furthermore, the information value of an ongoing credit relationship, which serves as the
basis for debtor discipline and access to credit, decreases substantially in the case of failing
banks. Many observers posed the question of such a situation within the presence of a
supranational banking control, the so called ‘banking union’. There have been working a
~ 79 ~
unique banking supervision and resolution mechanism in the Euro area, a similar uncertainty
about the measures to adopt to bailout Cypriot banking system would probably have been
avoided. In our opinion, consider the banking union with a true lender of last resort that
support the troubled institutions, would be the best solution. This is a key lesson we have to
take from the ongoing crisis, as in the last years many mistakes has been drawn.
In line with the propositions of Carmassi and Micossi (2013), and Buiter and Rabhari
(2012b), the Banking Union for the Euro area shall have different dimensions:
i.
a regulator for banks and other systemically important financial (‘too big to fail’)
institutions;
ii.
a resolution scheme, coupled with a bail-in regime, for banks and other systemically
important financial institutions;
iii.
a bank recapitalization facility (modeled on the existing US Fed TARP);
iv.
a facility for guaranteeing new unsecured term borrowing by banks;
v.
a deposit insurance regime and insurance fund.
This would be the minimum set-up to front similar possible severe events in the future. The
unsecured term borrowing guarantee facility is necessary if there will be significant unsecured
bank debt restructuring in the Euro area when a similar regime would be viable. In this case, it
is also likely that also senior unsecured bank debt holders too will find themselves
transformed into bank shareholders as part of the unavoidable deleveraging, restructuring,
recapitalization and consolidation of the Euro area banking sector, and not only subordinate
unsecured debt holders, like in normal times one expects to be. In choosing the rules and
modeling the structure for a banking union, the Eurosystem should get rid of possible tensions
about bailout of states in the area, thus reducing the subsequent LoLR intervention from the
ECB or to other institutions deemed responsible for the area, in order to lower the credit risk
quota in its balance sheet. In defining the roles of these new mechanism, indeed, it would be
desirable to ensure that the role of the Eurosystem in the lender of last resort processes for
sovereigns and for banks be limited to the provision of liquidity support. Moreover, all ECB
lender-of-last resort interventions, like all other decisions affecting the size and composition
of the balance sheet and off-balance sheet assets and liabilities of the Eurosystem, should be
at the sole discretion of the ECB, and sufficiently strong incentives must be provided for
sovereigns to adhere to fiscal discipline. We are not telling that all the powers have to be
centered on a unique institution. In fact it is a good thing to have banking regulation and
supervision detached from monetary policy. North Atlantic crisis it is a proof of the fact that a
~ 80 ~
stand-alone institution, both responsible for the LoLR functions that for banking regulation, it
is not efficient. Freixas and Parigi (2008) were in line with this proposition. Is their opinion
that the role of modern LoLR lies at the intersection of monetary policy, supervision and
regulation of the banking industry.
The Cypriot crisis has underlined again the urgent need for a wide approach to bank
resolution. This also means, that a detached banks supervision between Euro area members is
not sufficient. Gaps in banking supervision in Cyprus and about balance sheets of Cypriot
banks have been known for a long time. Even though the solvency gap has been known for a
long time (practitioners were dealing on about insolvency information almost since mid2012), leniency of supervisory organism on the national level, coupled with an uncertain
political situation, has made a bad situation worse. The only way for an intervention, a
recapitalization of Cypriot banks directly by the ESM, has been chosen. This confirmed our
suggestions that ECB, acting as LoLR even coupled with other supranational organism, thus
increasing the ‘firepower” in this type of non conventional operations. Nevertheless, this is a
tough task to be implemented.
As Wyplosz (2013) noted, the ECB could have stabilized the situation at little cost, as total
Cypriot bank assets represent less than 0.2% of Euro zone GDP. From table 2, we notice that
Central Bank of Cyprus share in the ECB balance sheet is 0,5%, that is a nil. Nevertheless, a
similar transfer would have involved the risk that European central bank could suffer severe
losses – especially if the Cypriot banks are badly resolved. This is not unlikely since the ECB
or the Eurosystem does not have control over Cypriot bank resolution mechanism. As in
Cyprus, and almost everywhere else, national authorities are deeply conflicted when it comes
to their banking systems, as special-interest groups become engaged when banks bankrupt and
governments has to decide who will bear the costs37. Risks for the ECB to bear too much
losses this time were effective.
37
Another clear picture of this intricate power is given by the fact that as in the first days was clear that the
‘deposits levy’ was designed at a supranational level. Then the news that it might not have been creditor
countries or the Troika who came up with this idea, but maybe the Cypriot government itself in order to avoid
imposing losses on large (and thus most likely) richer and more connected depositors wiped out. This is yet
another indication of how closely politics and finance can be interconnected, with strong though opaque
lobbying power of the oversized banking industry.
~ 81 ~
~ 82 ~
6.
Conclusions
As we have seen, Euro area problems are only partially about a lack of competitiveness of
some countries. All peripheral sovereigns from almost one year are slowly recovering from
the severe downturns that characterized their economic performance since 2008. The real
problem has been about the large increase in sovereign debt. Such a distress, added to the lack
of growth – to that date − inflated panic through capital markets. This surge in the lack of
confidence has then ignited by strong outflow of capitals from these countries, mostly to their
partners, as were felt safer. These, jointly with the political choices of some countries, have
been the causes of the large imbalances registered in the payment system, TARGET2. In our
opinion, the debate has only been a by-product of political prejudice.
In our opinion, ECB, by acting in the sovereign debt market, has done his job. Rather, in the
years the central bank has been excessively influenced by the theory that price stability should
be the unique objective of its activity. Nevertheless, also financial stability should be on the
list of a central bank. In a number of European countries, financial instability reached serious
levels because of nonfinancial corporations − deeply entangled with the banking sector – and
the behavior of households.
To solve an endemic problem of instability of financial systems, central banks are the only
institutions capable of stabilizing financial systems. A strengthening for the preventive arm is
required. In this way, a truly banking union, possibly joined with a stronger fiscal regime.
This would guarantee a sufficient supervision of the private sector and a stronger
macroeconomic stability. Eurosystem members in fact need a deeper coordination. Only in
this way the corrective arm, the ECB, would be effective in its role. Moreover, the stable
creation of a LoLR for sovereigns, should come with two other equally important objectives.
First, ECB should end the quasi-fiscal role it has played in the last five years. It is
unacceptable in a democracy that unelected technocrats are put in a position where they have
to rule on the allocation of multiple trillions of Euro without any legitimizing accountability.
Second, there is the need to create the right incentives for banks and sovereigns to behave
prudently, to avoid a repeat of the fiscal disorder and irresponsible bank investing and funding
of the decade before 2008. As we have told before, it has been the misbehavior of some that
caused the instability of many.
The complex network of institutions and procedures through which prevention and cure are
supposed to be managed, is constantly evolving. Nevertheless, this curtain remains
impenetrable and, perhaps, ineffective. In our opinion, this is caused by the continuous
adoption and juxtaposition of Treaties, pacts, arrangements and procedures. In place of a
~ 83 ~
simple framework, where a unique institution for the banking regulation is responsible for the
whole Euro area, confusion has been chosen. To give an idea of such a chaos, for the
Eurosystem and the EU, are responsible for financial stability: the European Central Bank
(ECB), the European Financial Stability Facility (EFSF, already suppressed to date), the
European Stability Mechanism (ESM), the European Financial Stabilization Mechanism
(EFSM), operating alongside the European System Risk Board (ESRB), the European
Banking Authority (EBA), and the European Securities and Markets Authority (ESMA).
These mechanisms are harmonized with the European Insurance and Occupational Pensions
Authority (EIOPA), the Directorate-General Economic and Financial Affairs and the
Directorate-General Internal Market. Supranational authorities are then coupled with the
national financial sector supervisors and regulators.
With such a disarray, it is not surprising that most of the job to prevent collapses of
systemically important financial institutions, disorderly sovereign defaults, or worse, the
disintegration of the Euro zone, has been done by the European Central Bank.
~ 84 ~
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