Governments, Banks, and Monetary Policy in the Crisis

Berlin, DIW, September 2013

MPI GemeinschaftsgüterMartin Hellwig

My Own Position on OMT

Grudgingly in favour of OMT I consider the Fratzscher et al. statement in

favour of OMT to be too naively technocratic-Keynesian – too little political eocnomy

I also consider the fundamentalist opposition of some German economists to be somewhat hysterical and lacking in attention to the facts of the situation

I am strongly opposed to the idea that the dispute about OMT should be treated as a legal dispute

An Aside on the Legal Dispute 1

The Treaty prohibits direct funding of governments by the ECB

The Treaty also permits open-market operations – without restrictions

Are secondary market purchases of government debt allowed?

Answer 1: No because this would be a way of arbitraging the prohibition of direct funding

Answer 2: Yes because the Treaty only prohibits direct funding and allows opem-market operations

An Aside on the Legal Dispute 2

Both argument are legitimate legal arguments The Treaty is unclear Only a court can create clarity The ECJ is the court in charge The German Constitutional Court, which is not

in charge. has tried to make a distinction according to the objectives of the intervention: Illegal if intended to cirumvent the prohibition of direct funding – legal if intended to pursue monetary policy objectives

An Aside on the Legal Dispute 3

Proceedings in Karlsruhe have focused on the objectives of the ECB in OMT

Giving the Court (in KA or LUX) the right to assess objectives – beyond considerations of arbitrariness – endangers the independence of the ECB

.... Especially in view of the fact that the German Constitutional Court may decide that independence of the central bank with only the specification of price stability as an objective may violate Art. 20 GG

An Aside on the Legal Dispute 4

The Maastricht Judgment: Ceding sovereignty over monetary policy violates Art. 20 GG, the need for democratic legitimacy, except that with independence and a clear objective there is not much room for abuse.

Now we have seen that the objective of price stability leaves room for lots of decisions with vast distributive effects...

This is a problem within national boundaries as well as beyond: Was the Bundesbank law unconstitutional?

Distributive Effects of Monetary Policy

Open-Market operations have distirbutive effects The Treasury-Fed Accord Interest Rate Targets How about open market purchases of IBM shares?

So do low interest rates The Greenspan turnaround in 1990 Central bank lending since 2008 LTROs (... the greatest carry trade ever?) OMT?

Hamlet without the Prince

Assessments of OMT by public economists tend to focus on public budget constraint (distributive effects on governments)

Monetary macroeconomists tend to focus on inflation and the monetary base

What about the role of banks and other financial institutions as parts of the monetary system? The money supply? The transmission mechanism?

How do we assess „contractiveness“ of monetary policy?

Friedman&Schwartz: Consider monetary aggregates Base: + 15 % in 1929 – 33 M1: - 33 % in 1929 - 33

Contemporary critics of the ECB: Consider monetary base Base: doubling since 2008 M3: + 10 % since 2008 Prices: + 10 % since 2008 Bundesbank: Long and variable lags ... Who knows what is

to come? Exit?

Beyond the crisis: What role for central bank money in liquidity provision?

Friedman 1969: (Real) central bank money is costless; creation of a real return on this central bank money enhances efficiency

„Optimum quantity of money“ arguments suggest a replacement of interbank markets by central bank money as a source of liquidity may be efficient!

BUT: What collateral will private banks have? Toxic securities? Government debt? We get back to the problem of distributive effects and moral hazard..... What to aim for in exit?

From Theory to the Real World: Central Banking in the Crises

Trichet: No relation between conventional monetary policy/price stability orientation and unorthodox monetary policy/financial stability orientation on the crisis High rates in 2007/8, 2011

Relaxation of collateral standards Draghi: Lowering of interest rates, LTROs,

announcement of OMT

LTROs

Summer 2011: Prospect of Greek haircut suggests many European banks may become insolvent (Dexia did)

Funding broke away Stock markets went into decline Announcement of recapitalization exercise

generated more pressure on markets, significant deleveraging by banks (November)

LTRO indicated ECB readiness to ensure bank funding (whar about solvency problems)?

OMT

Summer of 2012: Banks in periphery countries, especially weak banks, lend to governments but not to firms

Recession is deepened by a lack of funding for nonfinancial firms

OMT as an attempt to address problems in the „transmission mechanism“?

Where do we come from ?

April/May 2010: Greece has a liquidity problem, no market access

October 2010: Deauville: Private Sector Involvement, not now, from 2013

November 2010: PSI only in cases of insolvency, not in cases of illiquidity

March 2011/July 2012: PSI now, but only 20% October 2011/March 2012: PSI now, over 50% June 2012: Spanish banks will be bailed out by

ESM – without haircuts for creditors?

The Multiplicity of Crises

Not a currency crisis! A combination of

A traditional sovereign debt crisis in Greece, Portugal, and perhaps Italy,

A traditional real-estate and banking crisis, in Ireland and Spain,

And a latent banking crisis in Germany and France where banks are poorly capitalized and the mess of 2008 has never been cleaned up

Sovereign Debt Crises and Banking Crises

Sovereigns that don‘t make ends meet. ... ask/coerce banks into funding them ... cause bank insolvency from haircuts – Argentina,

Greece Rescuing banks that are indebted in „foreign“

currency can overtax the power of the sovereign ... and cause sovereign a debt crisis (Iceland, Ireland) ... Which may cause the sovereign to lean on

healthier banks....

A look in the mirror: Weimar

The myth of the reparations burden (Schuker 1988)

Lacking identification of elites with the state Lacking acceptance of impoverishment by war Fiscal irresponsibility: the civil service pay

„reform“ of 1928 Powerlessness of the Agent General under the

Dawes Plan Banking crisis 1931

French and German Banks

Poorly capitalized Excess capacity No cleanup in 2008/2009, rescue of everybody

(except WestLB) Significant exposure to..... toxic assets,

sovereign debt, cross-border bank debt, shipping loans...

Sales of Greek debt to .... Cypriot banks Borrowing from ECB on collateral using...

Problems today

Excessive Indebtedness: Greece, Spanish Cajas and Provinces, Banks

Interconnectedness: French banks – Greek banks, German banks – Spanish banks, Greek sovereign debt

Lack of viable institutions and liability (Maastricht, SGP, Bank Bailouts)

The Japanese temptation - „only a liquidity problem“

Mix of politics – banking – banking supervision

Why is there no progress?

Lack of workable national discourse Elimination of parliaments from discussion Conflicts of agendas, within governments, between

governments and opposition, between government, banks, the public, between the federal government and the Länder (Landesbanken)

Illusions and populisms, lack of analysis What are the problems? What are feasible stratgies?

What are the tradeoffs? Example: should Greece leave the euro? ... What does

that mean? .... A banking crisis, breakdown of the payments system, breakdown of...?

Why is there no progress?

Lack of a workable supranational discourse Conflicts of creditors and debtotrs, Clashes of personalities Conflict Commission – Member States Turf wars

Lack of legitimacy Elites versus public Legal Tricks - Banking Union as an example: Art 127 (6) „apply all EU law“ .... What does that mean for (not

directly applicable) directives

Where are we going?

Indebtedness of states, banks, private households is very high

Some cut of debt will be necessary Through resolution? Risk of further crisis; the

BRRD is a copout

Through monetization? Much easier: The ECB is weak because it is so strong!

.... With or without institutional reform?

An example

Treatment of sovereign debt in banking regulation

Sovereign carve-out in large exposure and equity regulation

„Sovereign debt is riskless“ „If it is not riskless, banking regulation is

unsuitable for reducing the risk“ „ESM will do the job“ „If not, we must have eurobonds“ ... or the ECB will bail us out

„..only a liquidity problem“

Interest rates are high because markets see a problem

„The problem is only serious because interest rates are so high. If markets believes that ....“

Sachsen LB 2007, Dexia, HRE 2008, Greece 2010: „only a problem of market access“

Dexia, HRE would be insolvent without state aid

Hausmann 2012: Greece does not have what it takes to be as rich as Greeks are

On the ECB

German Paradox: The ECB is independent but it must not do anything different from the Bundesbank, especially not anything we dislike

Legalisms: Prohibition of direct lending to governments versus license to do open market policy.

Price stability as an objective – viability of the monetary and financial system not?

On the ECB 2

However the central bank introduces money into the economy, it produces windfalls Banks Issuers of securities

LTROs Inflationary? Saving insolvent banks?

Costs of intervention? Not only inflation! Central bank versus interbank markets as

providers of liquidity

On the ECB 3

Moral hazard from ECB availability: The Greenspan put

Many politicians have learnt that inspite of Maastricht they can get access to the printing press if they borrow from banks and th ebanks get into difficulties

Banks are seen as a source of funds rather than a source of risks

Strength of the ECB is a weakness Conditionality? Banking union?

Banks and States

Spain: We want your help but we do not really need it and we definitely do not want you to meddle.

Recapitalizing banks by ESM? How much? With liability of the Spanish state? With

conditionality? What about liability of/for preferred stock in

Spanish cajas where courts say these contracts never were valid?

Problems arising from the symbiosis of local elites, banks and supervision

What do we want?

Overcome the crisis Establish a sustainable regimeWhat went wrong? Lack of fiscal discipline

Maastricht? SGP? New pact? Lack of Market discipline

PSI? Lack of effective supervision

Supervision as a tool for making banks cough up money

Fiscal discipline by imposition?

Lack of political legitimacy Illusions about enforcement (SGP, Agent

General) Differences in fiscal traditions

Financial Repression, monetary funding of government in G-I-S-P

Differences in traditions as to what is the role of the state Industrial policy, services publiques in France

Lack of market discipline

No exchange rate discipline (exchange rate as an indicator of current developments, brake on foreign borrowing)

No consciousness of risk on the side of creditors (zero risk weights as a basis for asking for bailouts)

Separate goods markets, inflation rates and real interest rates as a main driver of imbalances

What market discipline in a regime where the supervisor represents funding interests o f the state?

Effective Supervision through the SSM?

Supervision without resolution? Asset quality review? „In the case of directives, the ECB will apply

the national laws implementing the directives“

German attitude

Control of risks for ESM , ECB ... But also for own competence in banking

supervision? ... And the competence of Spanish authorities

in dealing with the cajas? The wonderful consistency of insisting that

ECB must check on the real estate valuations in the books of the cajas, but not on the ship valuations in the books of HSH Nordbank

What is missing?

Strategic thinking Comprehensive Assessment of situation

Risks and exposures Ability to pay

Assessment of Alternatives without Illusions On institution design On sustainability of rules and sanctions On liquidity versus solvency On the effects of what is being done