In October 2008 the ECB discovered that there is more to central banking than price stability. This discovery occurred when it was forced to massively increase liquidity to save the banking system. The ECB did not hesitate to serve as lender of last resort to the banking system, despite fears of moral hazard, inflation, and the fiscal implications of its lending.
Things were very different when the sovereign debt crisis erupted in 2010. This time the ECB was gripped by hesitation. A stop-and-go policy ensued in which it provided liquidity in the government bond markets at some moments and withdrew it at others. When the crisis hit Spain and Italy in July 2011, the ECB was compelled again to provide liquidity in the government bond markets.
This behaviour raises the question: Is there a role for the ECB as a lender of last resort in the government bond market?
Fragility of a monetary union
It is useful to start by describing the weakness of government bond markets in a monetary union.
- Eurozone governments issue debt in a “foreign” currency, ie one which they do not control by fiat.
- Thus governments cannot guarantee to the bondholders that they will always have the necessary liquidity to pay off the bond at maturity.
This contrasts with “stand-alone” countries that issue sovereign bonds in their own currencies. This feature allows these countries to guarantee that the cash will always be available to pay out the bondholders. This is why a stand-alone country can provide an implicit guarantee—the central bank is a lender of last resort in the government bond market.
The absence of such a guarantee makes the sovereign bond markets in a monetary union prone to liquidity crises and contagion—very much like banking systems were before central banks backstopped them as lenders of last resort.
How the existence of a lender of last resort prevents bank runs
In banking systems without such backstopping, one bank’s solvency problems can quickly lead deposit holders of other banks to withdraw their deposits (in other words, a bank run). This sets in motion a liquidity crisis for the banking system as a whole. The next step comes as banks try to sell off their assets—thus pushing down their prices. This asset-price collapse can go on until the point when the banks owe more than they own. This is how the liquidity crisis triggered by a bank run can degenerate into a solvency crisis—thus justifying the fears that led depositors to run in the first place.
It was exactly this sort of instability that was solved by requiring the central bank to play the role of a lender of last resort. The point is that when people know that they will in any event get their money back, they do not panic and withdraw funds. The really neat thing about this solution is that is it rarely has to be used. The very existence of a lender of last resort prevents the cascading loss of confidence.
The government bond markets in a monetary union have the same structure as the banking system.
Buyer of last resort for government bonds
When solvency problems arise in one country (say, Greece), bondholders may sell other nations’ bonds as they fear the worst. This loss of confidence can trigger a liquidity crisis in these other markets because there is no buyer of last resort. Without such a backstop, fears can grow until the liquidity problem degenerates into a solvency problem. In the case of bonds, the cycle starts as the loss of confidence increases the interest rates governments must pay to rollover bonds. But the higher interest harms governments’ solvency. Since there is always an interest rate high enough to make any country insolvent, the cycle of fear and rising interest rates may lead to a self-fulfilling default.1
The single most important argument for appointing the ECB as a lender of last resort in the government bond markets is to prevent countries from being pushed into this sort of bad equilibrium—a self-fulfilling debt crisis. In a way it can be said that the self-fulfilling nature of expectations creates a coordination failure, ie the fear of insufficient liquidity pushes countries into a situation in which there will be insufficient liquidity for both the government and the banking sector. The central bank can solve this coordination failure by providing lending of last resort.
Backstopping banks without backstopping government debt may be expensive
Failure to play the lender of last resort role for government bond carries the risk of forcing the ECB to actualise their lender of last resort promise to banks in the countries hit by a sovereign debt crisis. And this sort of lending is almost certainly more expensive than backstopping the government debt. The reason is that typically the liabilities of the banking sector of a country are many times larger than the liabilities of the national government. This is shown in Figure 1. We observe that the bank liabilities in the Eurozone represent about 250% of GDP. This compares to a debt-to-GDP ratio in the Eurozone of approximately 80% in the same year.
Figure 1. Bank liabilities as a percent of GDP
Source: IMF, Global financial stability report, 2008
While the argument for mandating the ECB to be a lender of last resort in the government bond markets is a strong one, the opposition to giving the ECB this mandate is equally intense. Let me review the main arguments that have been formulated against giving a lender of last resort role to the ECB.
Risk of inflation
A popular argument against an active role of the ECB as a lender of last resort in the sovereign bond market is that this would lead to inflation. By buying government bonds, it is said, the ECB increases the money stock thereby leading to a risk of inflation. Does an increase in the money stock not always lead to more inflation, as Milton Friedman taught us?
A key distinction is the difference between the money base and the money stock. When the central bank buys government bonds (or other assets) it increases the money base (currency in circulation and banks’ deposits at the central bank). This does not mean that the money stock increases. In fact during periods of financial crises, the monetary base and money supply tend to become disconnected.
An example of this is shown in Figure 2. One observes that prior to the banking crisis of October 2008 both aggregates were very much connected. From October 2008 on, however, the disconnect became quite spectacular. In order to save the banking system, the ECB massively piled up assets on its balance sheets, the counterpart of which was a very large increase in the money base. This had no effect on the money stock (M3). In fact the latter declined until the end of 2009.
Figure 2. Money base and M3 in Eurozone (2007=100)
Source: ECB, Statistical Data Warehouse
This happened because banks hoarded the liquidity provided by the ECB; they did not use it to extend credit to the non-banking sector. A similar phenomenon has been observed in the US and the UK.
Another way to understand this phenomenon is to note that when a financial crisis erupts, agents want to hold cash for safety reasons. If the central bank decides not to supply the cash, it turns the financial crisis into an economic recession and possibly a depression, as agents scramble for cash. When instead the central bank exerts its function of lender of last resort and supplies more money base, it stops this deflationary process. That does not allow us to conclude that the central bank is likely to create inflation.
What Milton Friedman would have said?
All this was very well understood by Milton Friedman, the father of monetarism who cannot be suspected of favouring inflationary policies. In his classic book co-authored with Anna Schwartz, A Monetary History of the US, he argued that the Great Depression was so intense because the Federal Reserve failed to perform its role of lender of last resort, and did not increase the US money base sufficiently (see Friedman and Schwartz 1961).
In fact, on page 333, Friedman and Schwartz produce a figure that is very similar to Figure 2, showing how during the period 1929-33 the US money stock declined, while the money base (“high powered money”) increased. Friedman and Schwartz argued forcefully that the money base should have increased much more and that the way to achieve this was by buying government securities. Much to the chagrin of Friedman and Schwartz, the Federal Reserve failed to do so. Those who today fear the inflationary risks of lender of last resort operations should do well to read Friedman and Schwartz (1961).
A second criticism is that lender of last resort operations in the government bond markets can have fiscal consequences. The reason is that if governments fail to service their debts, the ECB will make losses. Thus by intervening in the government bond markets, the ECB is committing future taxpayers. The ECB should avoid operations that mix monetary and fiscal policies (see Goodfriend 2011).
All this sounds reasonable. Yet it fails to recognise that all open market operations (including foreign exchange market operations) carry the risk of losses and thus have fiscal implications. When a central bank buys private paper in the context of its open market operation, there is a risk involved, because the issuer of the paper can default. This will then lead to losses for the central bank.2 These losses are in no way different from the losses the central bank can incur when buying government bonds. Thus, the argument really implies that a central bank should abstain from any open market operation. But then it stops being a central bank.
There is another dimension to the problem that follows from the fragility of the government bond markets in a monetary union.
- Financial markets can in a self-fulfilling way drive countries into a bad equilibrium, where default becomes inevitable;
- The use of the lender of last resort can prevent countries from being pushed into such a bad equilibrium; and
- If the intervention by the central banks is successful there will be no losses, and no fiscal consequences.
What about moral hazard?
Like with all insurance mechanisms there is a risk of moral hazard. By providing lender of last resort insurance, the ECB gives an incentive to governments to issue too much debt. This is indeed a serious risk. But this risk of moral hazard is no different from the risk of moral hazard in the banking system. It would be a terrible mistake if the central bank were to abandon its role of lender of last resort in the banking sector because there is a risk of moral hazard. In the same way it is wrong for the ECB to abandon its role of lender of last resort in the government bond market because there is a risk of moral hazard.
The way to deal with moral hazard is to impose rules that will constrain governments in issuing debt—very much like moral hazard in the banking sector is tackled by imposing limits on risk-taking by banks.
Separate the regulation of moral hazard and lender of last resort functions
In general it is better to separate liquidity provision from moral hazard concerns. Liquidity provision should be performed by a central bank; the governance of moral hazard by another institution, the supervisor. This has been the approach taken in the strategy towards the banking sector—the central bank assumes the responsibility of lender of last resort, thereby guaranteeing unlimited liquidity provision in times of crisis, irrespective of what this does to moral hazard; the supervisory authority takes over the responsibility of regulating and supervising the banks.
This should also be the design of the governance within the Eurozone. The ECB assumes the responsibility of lender of last resort in the sovereign bond markets. A different and independent authority takes over the responsibility of regulating and supervising the creation of debt by national governments.
What about insolvent states?
Ideally, the lender of last resort function should only be used when banks (or governments) experience liquidity problems. It should not be used when they are insolvent. This is the doctrine as formulated by Bagehot (1873).3 It is also very strongly felt by economists in Northern Europe (see Plenum der Ökonomen 2011). The central bank should not bailout banks or governments that are insolvent.
This is certainly correct. The problem with this doctrine, however, is that most often it is difficult to distinguish between liquidity and solvency crises. Most economists today would agree that Greece is insolvent. But what about Spain, Ireland, Portugal, Italy and Belgium? The best and the brightest economists do not agree on the question of whether these countries’ governments are just illiquid or whether they suffer from a deep solvency problem. How would markets know?
As argued earlier, when sovereign debt crises erupt in a monetary union, we very often see a mix of liquidity and solvency problems. Liquidity crises raise the interest rate on the debt issued by governments and therefore quickly degenerate into solvency problems. Solvency problems often lead to liquidity crises that intensify the solvency problem. It is therefore easy to say that the central bank should only provide liquidity to governments or banks that are illiquid but solvent. However in the real world, it is often very difficult to implement this doctrine.
EFSF and ESM: Poor surrogates
The ECB has made it clear that it does not want to pursue its role of lender of last resort in the government bond market. This has forced the Eurozone members to create a surrogate institution (the European Financial Stability Facility or EFSF and the future European Stability Mechanism or ESM).4 The problem with that institution is that it will never have the necessary credibility to stop the forces of contagion; it cannot guarantee that the cash will always be available to pay out sovereign bondholders.
- Even if the resources of that institution were to be doubled or tripled relative to its present level of €440 billion this would not be sufficient.
- Only a central bank that can create unlimited amounts of cash can provide such a guarantee.
In addition, the EFSF and the future ESM have a governance structure that makes them ill-suited for crisis management. Each country maintains a veto power. As a result, the decisions of the EFSF and the future ESM will continuously be called into question by local political concerns (“true Finns” in Finland, Geert Wilders in the Netherlands, and so on).
The EFSF and the future ESM can simply not substitute for the ECB. It is therefore particularly damaging that the ECB has announced it wants to transfer its lender of last resort function to that institution. This is the surest road to future crises.
The ECB has been unduly influenced by the theory that inflation should be the only concern of a central bank. It is becoming increasingly clear that financial stability should also be on the radar screen of a central bank. In fact, most central banks have been created to solve an endemic problem of instability of financial systems. With their unlimited firing power, central banks are the only institutions capable of stabilising the financial system in times of crisis.
In order for the ECB to be successful in stabilising the sovereign bond markets of the Eurozone, it will have to make it clear that it is fully committed to exert its function of lender of last resort. By creating confidence, such a commitment will ensure that the ECB does not have to intervene in the government bond markets most of the time, very much like the commitment to be a lender of last resort in the banking system ensures that the central bank only rarely has to provide lender of last resort support.
While the ECB’s lender of last resort support in the sovereign bond markets is a necessary feature of the governance of the Eurozone it is not sufficient. In order to prevent future crises in the Eurozone, significant steps towards further political unification will be necessary. Some steps in that direction were taken recently when the European Council decided to strengthen the control on national budgetary processes and on national macroeconomic policies. These decisions, however, are insufficient and more fundamental changes in the governance of the Eurozone are called for. These should be such that the central bank can trust that its lender of last resort responsibilities in the government bond markets will not lead to a never-ending dynamic of debt creation.
Bagehot, W (1873), Lombard Street, 14th ed., Henry S. King and Co.
Buiter, W (2008), “Can Central Banks Go Broke?”, CEPR Policy Insight No. 24.
Calvo, Guillermo (1988), “Servicing the Public Debt: The Role of Expectations”, American Economic Review, 78(4):647‐661.
De Grauwe, P (2011), "The Governance of a Fragile Eurozone”, Economic Policy, CEPS Working Documents.
Eichengreen, B, R Hausmann, U Panizza (2005), “The Pain of Original Sin”, in B Eichengreen and R Hausmann, Other people’s money: Debt denomination and financial instability in emerging market economies, Chicago University Press.
Friedman, M and A Schwartz (1961), A Monetary History of the United States 1967-1960, Princeton University Press.
Goodfriend, M (2011), “Central Banking in the Credit Turmoil: An Assessment of Federal Reserve Practice”, Journal of Monetary Economics.
Goodhart, Charles and Gerhard Illing (eds.) (2002), Financial Crises, Contagion, and the lender of last resort, a Reader, Oxford University Press.
Gros, D and T Mayer (2010), “Towards a European Monetary Fund”, CEPS Policy Brief.
Plenum der Ökonomen (2011), “Stellungnahme zur EU-Schuldenkrise”.
1 See Kopf(2011) and De Grauwe(2011) for more on this point. For formal theoretical models see Calvo(1988) and Gros(2011). This problem also exists with emerging countries that issue debt in a foreign currency. See Eichengreen, et al.(2005).
2 The same is true with foreign exchange market operations that can lead to large losses as has been shown by the recent Swiss experience.
3 See also Goodhart and Illing (2002)
4 Gros and Mayer(2010) were the first to propose the creation of a European Monetary Fund to substitute for the ECB.