Governments, Banks, and Monetary Policy in the Crisis

1. MPI Gemeinschaftsgüter Martin Hellwig Governments, Banks, and Monetary Policy in the Crisis Berlin, DIW, September 2013

2. 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

3. 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

4. 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

5. 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

6. 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?

7. 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?

8. 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?

9. 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?

10. 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?

11. 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

12. 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)?

13. 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“?

14. 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?

15. 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

16. 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....

17. 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

18. 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...

19. 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

20. 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...?

21. 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

22. 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?

23. 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

24. „..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

25. 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?

26. 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

27. 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?

28. 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

29. What do we want? • Overcome the crisis • Establish a sustainable regime What 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

30. 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

31. 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?

32. 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“

33. 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

34. 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