Greg Ip

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Central-bank lending to government serves a valuable, though risky, purpose

Nov 5th 2011 | from the print edition

[Greg Ip] IT CANNOT be pleasant to start a new job with a continent’s fate resting on your shoulders. On November 1st, Mario Draghi’s first day as president of the European Central Bank (ECB), peripheral-government bond yields shot up and stockmarkets sank on fears that Greeks might reject a rescue plan agreed days earlier. On November 3rd, as The Economist went to press, Mr Draghi was presiding over his first policy meeting. Much is riding on what the ECB decides then and in coming weeks because it alone currently has the means to stem the intensifying crisis. It has bought Greek, Portuguese and Irish debt; since early August, it has also purchased Spanish and Italian bonds. But its purchases have been intermittent and begrudging. Without a firm commitment to buy as much as needed to prevent yields on Italian and Spanish bonds rising so high that both countries become insolvent, investors have less incentive to return. The ECB’s reluctance to make such a commitment is understandable: its legal mandate and doctrinal persuasion bar it from directly supporting governments. Yet throughout history central banks have been lenders of last resort to their governments. In 1694 the English monarchy was broke and in need of a loan so that it could wage war with France. A group of financiers agreed to lend the crown £1.2m in return for a partial monopoly on the issue of currency. Thus was born the Bank of England. Central banks routinely serve as their government’s agent: they accept payments, disburse outlays, auction and redeem their bonds. Most buy and sell government bonds to carry out monetary policy. At times they have done so to finance government, especially in wartime. The Bank of England suspended the convertibility of its notes to gold from 1797 to 1821 to enable it to better finance Britain’s wars with France. In the 1930s the Bank of Japan was compelled to buy the government’s bonds, and from 1942 to 1951 the Federal Reserve agreed, at the Treasury’s request, to hold Treasury yields to 2.5% or below. The risks are obvious: bond purchases expand the money supply, potentially leading to inflation. Virtually all hyperinflations begin with such monetisation of budget deficits, including Germany’s in 1920-24, which explains the Bundesbank’s, and now the ECB’s, reluctance to lend to governments. The mere possibility of inflation can force governments with weak central banks to pay punitive interest rates.

But as Chris Sims of Princeton University, who shared this year’s Nobel prize for economics, notes in a recent presentation, there is another side to the story. Bonds of a country with its own central bank are simply a promise to repay one government obligation (ie, debt) with another (ie, currency). The owner of such a bond is confident he can always sell or redeem it, and thus does not demand a higher yield to compensate for counterparty risk. A country that gives up its monetary sovereignty by dollarising or adopting the euro may gain greater credibility on inflation but may have to pay more to compensate investors for counterparty risk. This may seem like a good idea when counterparty risk is low, but that can change abruptly and dramatically. Mr Sims, in a 2002 paper, says the option of using inflation to repay debt is a valuable fiscal-shock absorber that over time may be less expensive than the risk, or fact, of default. This can be seen starkly by comparing Britain with Spain (see chart). Based on debts, deficits and inflation, Britain should be the riskier credit. But British bonds yield around 2.3% whereas Spain’s yield around 5.5%. One reason is that Britain can still devalue to boost growth; Spain can’t. Another is that it has a lender of last resort; Spain doesn’t. Paul De Grauwe of the University of Leuven says that if Britain couldn’t roll over its debt at acceptable interest rates, it could ultimately force the Bank of England to buy it. “This means that investors cannot precipitate a liquidity crisis in the UK that could force the UK government into default.”

No central bank wants to be put in that position, of course, and institutional arrangements have sprung up to prevent it. The most common is to require that bonds be purchased only at market prices. The Federal Reserve is prohibited from buying bonds directly from the government, except to roll over a maturing issue in its portfolio. It can buy bonds on the secondary market, which is how it enforced the yield ceiling during the second world war, but its accord with the Treasury in 1951 ended that obligation. The Bank of Japan can buy bonds on the secondary market, but not directly from the government unless the Japanese Parliament votes to require it. The Chilean central bank may not buy government securities while Israel, Argentina, Canada and South Korea impose limits on how much the central bank may purchase.

The European Union’s Maastricht treaty is in keeping with these arrangements: it prohibits the ECB from buying bonds directly from member governments, but not from buying them on the secondary market. The ECB claims it buys only to ensure its monetary policy is transmitted to interest rates. How could the ECB be enticed into becoming lender of last resort? Mr Sims says the ECB needs to be reassured its own balance-sheet has sound fiscal backing. That is because it may deplete its capital by selling assets at a loss or paying interest on reserves to prevent bond purchases from fuelling inflation. He suggests empowering the European Financial Stability Facility, Europe’s bail-out fund, both to issue euro-denominated bonds (backed by a euro-zone-wide tax) which the ECB could buy during open-market operations, and to recapitalise the ECB if needed.

But the ECB may not have time to await such arrangements. Brad DeLong of the University of California, Berkeley, notes that central banks have taken liberties with their mandates when financial stability was at stake. The Bank of England lent aggressively during the financial crisis of 1825-26, for example, despite lacking the legal authority. Sir Robert Peel, First Lord of the Treasury, later said: “If it be necessary to assume a grave responsibility, I dare say men will be willing to assume such a responsibility.” Whether Mr Draghi does so may determine the euro’s fate.

The original article is linked here.


Written by gregip

November 3, 2011 at 9:20 am

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