4 Lectures on the

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4 Lectures on the uropean crisis

• Lecture 3 Monetary Policies

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The philosophy of the EZ economic policy

• Independent CB with 2 inflation has its only
  target (monetary policy ineffectual in the long
  run)
• Prohibition to use budget policy (fiscal
  expansions compete with the private sector for
  scarce resources)
• Full employment is a national issue (total deny
  that it is an international issue)
• Issing

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Monetary policy the ECB and Eurosystem

• The European System of Central Banks (ESCB)
  comprises
• the European Central Bank (ECB) and the national
  central banks (NCBs) of all 28 EU Member States.
• The Eurosystem as the central banking system of
  the euro area comprises
• the ECB and the national central banks (NCBs) of
  the 17 EU Member States whose common currency is
  the euro.
• The ECB has two main bodies which take all the
  decisions the Governing Council,  the Executive
  Board, 
• The Governing Council of the ECB is the main
  decision-making body of the Eurosystem. It
  comprises all the members of the Executive Board
  of the ECB, and the governors/presidents of all
  the national central banks (NCBs) of the euro
  area, i.e., those EU Member States that have
  adopted the euro.
• The Executive Board comprises the President of
  the ECB, the Vice-President of the ECB, and four
  other members (selected by the Heads of State on
  recommendation from the EU Council).

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Monetary policy objectives and pillars

• Two main characteristics of the ECB independence
  with 2 inflation target no bail-out clause
• Two pillars of the ECB monetary policy (?
  determination of the interest rate)
• M3 ? quantitative theory of money (less
  important)
• A variety of economic and financial indicators
  (including indicators of the real activity,
  current and expected inflation, exchange rate,
  financial markets indicators, agents
  expectations, labour market indicators)

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Monetary policy objectives and pillars

• It is not clear which monetary rule the ECB
  adopts
• Monetary targeting from MsV PYn we get
• And the rule is
• (whenever money is growing above target, the CB
  increases i)

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Monetary policy monetary rules

• Taylor rule
• Inflation targeting
• (the CB changes the interest rate when expected
  inflation is different from target inflation ?
  the idea is that this stabilises output too)
• Good criticism of IT Fontana Palacio-Vera
  http//www.levyinstitute.org/pubs/wp_430.pdf
• Forward guidance
• (the CB tries to guide markets expectation about
  the CB long term interest rate policy)
• ECB not clear rule (but see again to next graph)

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Taylor rule? (studies suggest the ECB might have
followed the TR giving a higher weight to a
compared to the Fed). Difficulty for the ECB to
have a one fits all monetary policy
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Two aspects of the crisis banking crisis and
sovereign crisis

• The crisis has not a fiscal origin (with the
  possible exception of Greece).
• Once the housing bubbles exploded the crisis
  became a banking crisis
• Once banks were bailed out the crisis became a
  sovereign crisis
• The fiscal crisis magnifies the banking crisis
  (given that banks own a lot of sovereign bonds).
• ? doom loop between banking and sovereign crises.
• (particularly German banks were also plenty of
  American toxic assets and they were bailed out by
  the government).
• The EZ crisis is also a balance of payment
  crisis.
• Can you have a BoP crisis in a CU? Yes, of course.

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The EZ crisis as a BoP crisis

• Any region, in a CU or not, can sustain a current
  account deficit as long as it receives loans or
  subsidies from other regions.
• The EZ went through the typical pattern of a BoP
  crisis (the This time is different story)
• In the typical story, however, the crisis is
  followed by the abandonment of pegged exchange
  rates, default in the foreign obligations, IMF
  intervention, austerity etc.
• In the EZ we had a little of these things, but no
  a Euro break up.
• However, the EMU monetary arrangements prevented
  the BoP crisis to explode as in a typical BoP
  crisis.
• When the sudden stop of capital flows took place,
  a payment system called TARGET2 permitted the
  repatriation of capitals, while the Eurosystem
  monetary instruments permitted peripheral
  countries to refill the lost reserves.

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TARGET2. What is it? (courtesy of Eladio Febrero)

• Acronym Trans European Automated Real- time
  Gross settlement Express Transfer System.
• TARGET2 has to be used for all payments involving
  the Eurosystem. Operated by the Eurosystem.
• TARGET2 mainly settles operations of monetary
  policy and money market operations.
• In essence, TARGET2 makes possible the transfer
  of bank deposits and reserves between countries
  within the Euro Zone.

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TARGET2. Implications for MP implementation

• Credits make deposits, and then, banks borrow
  reserves from the central bank. The central bank
  lends all demanded reserves, but it fixes the
  interest rate at which it lends them.

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TARGET2. How does it work?

• When a bank deposit is transferred from Spain to
  Germany, it has to be done with central bank
  money.
• At the end of the day, the Banco de España
  acquires a liability against the Eurosystem (T2
  liability) whilst it reduces the Reserve account
  held by the Spanish bank. Simultaneously, the
  Buba increasese the reserve account of the German
  bank when it acquires a claim against the
  Eurosystem.

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TARGET2. Implications for MP implementation

• After the deposit transfer, the Spanish bank does
  not comply with the reserve requeriment (10
  deposits). However, the German bank has excess
  reserves, amounting to 9 monetary units.

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TARGET2. Implications for MP implementation

• The German bank will not lend in the interbank
  money market its excess reserves at a rate below
  the MLF.
• The Spanish bank will not borrow in the interbank
  market at an interest above the MCF.
• Under normal circumstances, banks agree on an
  intermediate interest rate, which is in the
  middle of both facilities.

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TARGET2. Implications for MP implementation

• TARGET2 claims and liabilities (almost) cancel
  each other out when the German bank lends its
  excess reserves to the Spanish bank.
• The Spanish bank complies with the reserve
  requirement.
• The interest rate that prevails at the interbank
  market is that of MRO.

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TARGET2. Implications for MP implementation

• What happens when the German bank does not wish
  to roll over its lending to the Spanish bank?
• (Hyp the maturity of the loan granted by SPB is
  longer than that of the loan granted by GPB to
  SPB)
• TARGET2 imbalances return, and
• The Spanish bank does not fulfil the reserve
  requirement.

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TARGET2. Implications for MP implementation

• The Spanish bank needs 10 monetary units as the
  reserve corresponding to its 100 m.u. of
  deposits.
• The demand for reserves is rather inelastic. A
  deficit of reserves in Spain would lead to a
  rocketing interest rate there.
• If the interbank market has dried up, only the
  Eurosystem can provide required reserves.

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TARGET2. Implications for MP implementation

• The Banco de España, part of the Eurosystem,
  lends reserves to the Spanish banking system. It
  has no other option if
• NCBs have to contribute to the smooth working of
  the payment system.
• The interest rate has to be the same in the whole
  Euro Zone.
• All banks must have the same access to CB
  funding.
• N.B. MROs are implemented by National Central
  Banks.
• What happens with the excess reserve in Germany?
• The German bank can pay back prior liabilities to
  the Buba.
• It may try to lend them at an interest rate below
  the MRO official rate, but this means that the
  Eurosystem loses control of the interest rate.

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TARGET2. Some evidence.

• There is a large correlation between GIPS T2
  liabilities and Germanys T2 claims. When we add
  Italy to GIPS, the degree of correlation is a
  little lower. This indicates financial capital
  flights from the EZ periphery towards Germany.

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TARGET2. A stealth bailout?

• Hans Werner Sinn, president of the highly
  influential CES Ifo, Munich based Economic
  Research Institute, has pressed the alarm buttons
  in the mass media, arguing that TARGET2
  imbalances are a stealth bailout of the Euro Zone
  (EZ) periphery by the ECB.
• Sinn interprets the current crisis in the EZ as a
  typical balance of payments crisis in a pegged
  exchange rate system.
• According to Sinn, peripheral countries (PIIGS)
  are experiencing a BoP crisis (capital outflow)
  and, therefore, they should adopt the usual
  measures of economic policy to solve this
  problem fiscal austerity cum- devaluation, with
  temporary interest rate hikes.
• In his view, T2 liabilities are Eurosystem loans
  to the EZ periphery, providing them with some
  relief in a protracted balance-of-payments
  crisis.

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TARGET2. A stealth bailout? Sinn is not wrong
(although he had a number of silly considerations
aimed to depict Germany as the euro-victim)

• In a fixed exchange rate system (FERS) a country
  can finance its current account deficit either by
  depleting the Official Reserves or by foreign
  loans. In case of sudden stops and once the OR
  are depleted, it must adjust the CA by domestic
  deflation and currency devaluation.
• In a currency union, as seen, a country can
  continue to finance a CA deficit by collecting T2
  liabilities with its banks reserves re-created by
  the Eurosystem.
• In a FERS international payments lead to a loss
  of reserves in a CU it is the same and the loss
  is counted as a T2 liability (and the gain of
  reserves as a T2 claim) while the lost reserves
  are re-created by the ECB.
• The Eurosystem has to lend reserves as the
  logical consequence of fixing an interest rate
  which has to be the same across the whole EZ.
  Moreover, unless it lended reserves, German
  investors could not repatriate their funds to
  Germany.
• Similarity with the currency/clearing union
  proposed by Keynes in the 1940s in which the IMF
  should automatically recycle the CA surpluses
  that surplus countries do not want to lend.

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TARGET2. A stealth bailout? And a risk for
Germany?

• TARGET2 loans are a potential source of risk for
  Germany in the case of a disorderly euro break
  up.
• Reserves gained in a CU are T2 claims, not
  dollars or gold. Reserves lost in a CU are T2
  liabilities, not dollars or gold.
• TARGET2 claims yield an interest rate to the
  holder, paid by the debtor to the Eurosystem
  (GIIPS). And TARGET2 claims are part of the net
  international investment position (financial
  wealth) of a nation, like gold reserves. In the
  event of a euro breakup, the Banco de España may
  renege on its international debts (T2
  liabilities) so that the Bundesbank will make a
  capital loss.
• Sinn suggests the ECB should stop lending to the
  EZ periphery and cancel T2 liabilities with
  marketable assetsm (gold etc).

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TARGET2. A critique.

• What are the true risks for Germany?
• In the event of a disintegration of the EZ, or if
  non-performing loans increase in debtor
  countries
• Germany will lose the interest rate on its T2
  claims (an ownership income paid by the rest of
  the world).
• Germany will lose part of its financial wealth
  (net international investment position NIIP) if
  debtor nations renege on their T2 liabilities
  (i.e it is as if Germany had dropped its gold
  bullion reserves into the ocean).
• According to Sinn, German tax payers should pay
  for the recapitalization of the Buba.

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TARGET2. A critique.

• Sinn is right when he claims that the German
  economy will experience a loss, because the
  income balance, in the current account balance,
  will fall, due to a fall in the interest on T2
  claims. And there will be a loss of financial
  wealth as well.
• But
• T2 claims change the composition of NIIP without
  making it to rise German private banks reduce
  their exposure to PIIGS banks whilst the Buba
  increases its exposure to the Eurosystem (only
  27). Dullien and Schieritz, 2012.
• A capital loss may happen if loans are not paid
  back in the EZ periphery. If the Eurosystem stops
  providing liquidity, the banking systems will
  collapse in the periphery and with them their
  whole economies. Sinns recommendations are a
  self- fulfilling prophecy.
• The value of the Bubas reserves (denominated
  in new Deutsche Mark, fiat money) is not backed
  by its assets and the Buba can monetize as
  much public spending as needed.
• The real risk is that Germanys new D-mark shall
  appreciate with regard to the already existing
  currencies. This is a threat for an exporting
  country.

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Target 2 references

• http//www.ecb.int/pub/pdf/mobu/mb201305en.pdf
  (chapter on T2)
• http//www.bruegel.org/nc/blog/detail/article/731-
  sudden-stops-in-the euro-area
• http//www.uclm.es/dep/daef/DOCUMENTOS20DE20TRAB
  AJO/DT-2013/2013-220DT-DAEF.pdf
• http//www.deps.unisi.it/it/ricerca/pubblicazioni-
  deps/quaderni-deps/anno-2013/681the-implications-t
  arget2-european-balance
• http//www.cesifo-group.de/ifoHome/policy/Spezialt
  hemen/Policy-Issues-Archive/Target.html
• in particular
• http//www.cesifo-group.de/ifoHome/publications/do
  cbase/details.html?docId19088305
• Now, back to monetary policy

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ECB monetary policy instruments

• We focus upon
• OMO
• 1) MRO and LTRO
• 2) Structural operations ? outright purchases
• Standing facilities
• MLF and DF
• From 2008 the ECB (like the FED and BoE) widened
  its balance sheet.
• MRO, LTRO and Outright Purchases increased
  liquidity this was used by banks to frontload
  possible confidence crises (bank runs) and to
  offset sudden stops and capital flows reversals.
  Liquidity used to buy Gvt bonds ? diabolic doom
  loop between bank and sovereign crisis (avoided
  had the ECB directly/seriously sustained gvt
  bonds)
• Excess liquidity parked e.g in DF.

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Main monetary policy actions undertaken by the ECB

• Interest rate policy
• Fixed rate full allotment MRO and LTRO (2008)
• Covered bonds purchases (2008 and 2010)
• SMP (May 2010 and Summer 2011)
• 3y LTRO (beginning 2012)
• OMT (September 2012)
• Forward Guidance (June 2013)
• ?

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Criticism to ECB and references

• Main criticism is the missed intervention to
  sustain sovereign debt.
• Bad equilibrium, absence of a sovereign CB (De
  Grauwe Bindseil Wray/MMT)
• LTRO ? doom loop (Bindseil)
• Monetary policy implementation references
• ECB 2011 http//www.ecb.int/pub/pdf/other/monetary
  policy2011en.pdf?d51bad0288e53a9d35f77c3a3f6674df)
  .
• ECB 2012 http//www.ecb.europa.eu/pub/pdf/scpops/e
  cbocp135.pdf
• ECB http//www.ecb.int/pub/pdf/mobu/mb201305en.pd
  f (chapter on T2)
• http//www.bruegel.org/nc/blog/detail/article/731-
  sudden-stops-in-the euro-area
• DeGrauwe 2011 http//www.econ.kuleuven.be/ew/acade
  mic/intecon/Degrauwe/PDG-papers/Discussion_papers/
  Governance-fragile-eurozone_s.pdf

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In order not to be considered unfair, let me
report some opinions from an important German ECB
economist which is, de facto, very critical not
so much of the ECB (Draghi has done all he could)
but with the prohibitions the ECB meets in doing
what it should do

• Bindseil

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Banking UnionIn June 2012, euro area leaders
affirmed, ?it is imperative to break the vicious
circle between banks and sovereigns. (IMF
2013 20).

• Banking Union in the US
• Pillars of an European BU
• SSM, SRM, SRF (self-sustaining)
• SSM ? ECB ? evaluation exercise (130 large banks)
  Nov. 13 - Nov. 2014 Stress test. Problem ? lack
  of a SRM and a SRF
• Debate about the SRM and SRF.
• SRM (130 large banks), where to locate it?
• SRF ? single fund constituted by the banks
  themselves bail-in before any bail-out role of
  the ESM limited to systemic emergencies (power of
  veto). The system fully operational only in 2018.
  In the meantime countries must rely on bail-in,
  national funds or loans from the EMS to national
  governments (doom loop).

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Banking Union References

• http//www.economonitor.com/dolanecon/2013/03/22/b
  ailouts-bail-ins-haircuts-and-all-that-program-not
  es-for-the-cyprus-banking-drama/
• D. Gross http//www.voxeu.org/article/banking-unio
  n-if-ireland-were-nevada
• IMF http//www.imf.org/external/pubs/ft/sdn/2013/s
  dn1301.pdf
• Last news http//blogs.wsj.com/brussels/2013/11/15
  /how-europe-plans-to-deal-with-bank-stress-test-re
  sults/?modWSJBlogmodbrussels
• http//www.reuters.com/article/2013/11/15/us-eu-ba
  nk-backstops-idUSBRE9AE0T520131115