Greg Ip

Articles by The Economist’s U.S. Economics Editor

Is there a Greek moment in the Fed’s future?

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Up against the wall

May 10th 2010, 16:45 by G.I. | WASHINGTON

[Greg Ip] THE dilemma in which the European Central Bank found itself this year borders on tragic. As Charlemagne notes, it had, up to this point, had a very good crisis, showing itself as creative and forceful as the Federal Reserve in responding to the market mayhem while remaining a worthy custodian of the Germanic monetary discipline it had inherited.

Then it faced a Hobson’s choice of abandoning that discipline or risk seeing the entire euro experiment collapse.

Ironically, if the ECB had bought bonds a year ago as part of a quantitative easing operation as the Fed and Bank of England did, it could have credibly called it monetary policy since the aim would have been expansionary. In fact, it now plans to avoid any expansionary impact from its purchases of government and private bonds, presumably by shrinking private refinancing operations or issuing bills of its own.

This qualifies as fiscal policy because the clear intent is to enable member governments to borrow who otherwise could not. Greece is experiencing a solvency crisis, not a liquidity crisis. The ECB’s balance sheet is thus subsidising the credit risk of a member government.

I don’t think this spells death for the ECB’s credibility. That will ultimately rest on the course of inflation, and disinflationary forces now prevail in Europe. The ECB operations will arguably be helpful in offsetting those pressures. And if the rest of the package is successful, the ECB’s purchases will end up being minimal and costless. The ECB’s independence is another matter. It has now become fiscal agent of last resort, which could ultimately weaken budget discipline among member states.

Could the Fed one day face a similar dilemma? An American debt crisis is a remote eventuality, but these are unusual times so it’s worth asking what the Fed would do if faced with a request for help from a state or federal government on the verge of default. The Federal Reserve Act doesn’t permit the purchase of state or local government debt even under its 13(3) emergency exemption. But the Fed has been a master of legal gymnastics when it has to get money where it’s needed.

I think the Fed would say no to a state. None, as far as I know, has debts large enough or dispersed in such a way to bring down the financial system and the moral hazard would be huge. The Treasury is a more likely candidate though even it would, I think, ultimately say no.

Saying no to the Feds would be tougher; a federal default would be a systemic event of unprecedented magnitude. Not so long ago it was part of the Fed’s job to help the Treasury finance itself. From 1942 to 1951 it bought bonds as necessary to keep yields below prescribed levels. Into the 1960s and 1970s it timed its open market operations to help Treasury auctions go off smoothly (a practice dubbed “even keel”). Confronted with a debt crisis every bit as menacing as war, would a patriotic Fed say no? It could if it was clearly a choice between inflation and default; it might reason that monetising the debt only delayed the inevitable, and a refusal to cooperate would force the fiscal authorities to get their act together. The choice, however, is unlikely to be so clear-cut. As the ECB found out, you get backed into a corner, bit by bit.

The original blog post is here.

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Written by gregip

May 10, 2010 at 3:53 pm

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