The Lender of Last Resort

What Paul Krugman is saying about Ireland and the Eurozone is not wrong. But he keeps missing the most important point. And it's bugging me.

Sure, the scale (H/T anne via Mark Thoma) of Ireland's bank guarantees is much bigger than the US's TARP, as a percentage of GDP, and that matters.

And sure, the Eurozone is less of an Optimal Currency Area than the US, and that matters too.

But the lender of last resort matters more. The US has an effective lender of last resort. The Fed has the political authority to print as many US dollars as are needed. The only effective limits are the risks of inflation and moral hazard. The Eurozone does not have an effective lender of last resort. The individual Eurozone countries do not have their own central banks. The ECB lacks the political authority to print as many Euros as are needed.

Suppose you abolished the US Federal government. So you needed all 50 State governments to agree before the Fed could act as lender of last resort to one of those State governments. And suppose some of those US State governments had as much debt as Greece, or were bailing out their banks like Ireland. Think all 50 State governments would agree on anything? I don't. (And they all at least speak the same language, and really do all think of themselves as part of the same nation). Think it would matter? I do.

If Ireland had its own central bank, and saw the risk of deflation and recession, and interest rates on 10 year government bonds at 9%, what would it do? It would start buying a lot of government bonds. It would push interest rates down, and push expected nominal GDP growth up. That would get rid of a lot of the problem right there. All of the problem? Maybe not. But it would give Ireland's fiscal austerity a fighting chance to work. It's a lot easier getting your debt/GDP ratio under control when nominal interest rates are only a percentage point or two above the growth rate of nominal GDP.

Comments

[K]

But he does point out that they don't have a fiscal union.  And not having an omnipotent ECB is highly correlated with that.  And the effect of both is in many ways similar, i.e. the lack of socialization of losses.

[Nick Rowe]

K: True, he does. But the fiscal union matters more than just transfer payments between booming and slumping regions (which is the standard Optimal Currency Area stuff). It's political/fiscal backing for the central bank, and its power to print unlimited quantities of money.

[K]

I agree.  I'm just saying that because two are intertwined and the effects are in some ways similar, the effect of considering the crippled ECB is largely quantitatively, rather than qualitatively, different from considering the lack of fiscal union alone.  They need massive wealth transfers from debtors to creditors.  They can do that by purely fiscal means or by cutting rates, doing QE on greek bonds, whatever.  Fiscal is more important in the long run (Ireland isn't helped much by borrowing at 3%) but the monetary impact would work in the same direction.

[K]

Oops. From creditors to debtors, obviously...

[Andy Harless]

"The individual Eurozone countries do not have their own central banks."

Technically, this is not true, although you could argue that they are abusing the definition of a central bank. The Central Bank of Ireland exists. It may not have the authority to do anything of consequence, however.

[JKH]

Nick,

You've almost become an MMT'er as well - the importance of monetary sovereignty is a lot of what they emphasize.

[Mike Sproul]

Nick:

The first thing to appreciate about bank runs is that they result from insolvency, not illiquidity. If some bank has $100 of deposits, and its assets consist of just 99 paper dollars, then that bank is going to face a run. If the central bank lent that bank $1 it wouldn't change anything. the bank would be just as insolvent and would still face a run. A LENDER of last resort won't help. That bank needs a GIVER of last resort to just give them $1.

Of course, a gift of $1 only takes the loss that properly belongs with that bank's depositors and transfers it to taxpayers, who had nothing to do with the bank's insolvency.

[Nick Rowe]

Andy: yep.

JKH: On this point, I find myself in strong agreement with the MMTers. I'm not 100% sure the analysis leading up to this conclusion is the same, but it's at least got a lot in common. Winterspeak actually had a cryptic comment at the end of one of his posts a year or so back. Something about the Eurozone not having a lender of last resort, IIRC. Haven't been able to find it since. He didn't explain why, but I think he's basically right.

[jsalvati]

Rowe: are you a believer in "optimal currency areas"? It seems to me that the concept doesn't make much sense if you think about monetary policy in terms of monetary equilibrium instead of interest rates. How can there be too much money in one area and not enough in another? Is the banking system totally crazy? If it is, then you sort of already have two currency areas and you can already implement semi-independent monetary policy.

I think the concept of "optimal currency areas" should bother people who think about people monetary equilibrium.

[Nick Rowe]

Mike: I disagree. I think there's something to be said for the Diamond/Dybvig model of bank runs. Plus, if monetary policy affects real income and prices, which it does, that can affect the banks' solvency, plus the government's solvency.

jsalvati: that's an interesting argument. I'm going to think about that one.

[rjs]

what is this, if not a lender of last resort?

And now for some real money: ECB is considering a capital increase
http://www.eurointelligence.com//index.php?id=581&tx_ttnews[tt_news]=2982&tx_ttnews[backPid]=901&cHash=60972c097b

ECB Boosts Capital Base by $6.6 Billion to Protect It From Losses on Bonds - The European Central Bank will almost double its capital base to help protect it from losses as the institution buys bonds of governments from Portugal to Ireland to fight the sovereign-debt crisis.
http://www.bloomberg.com/news/2010-12-16/ecb-boosts-capital-base-by-6-6-billion-to-protect-it-from-losses-on-bonds.html

European Central Bank arms itself for Spanish crisis - The European Central Bank (ECB) is to double its capital base to cope with "credit risk" stemming from the eurozone debt crisis, paving the way for direct action to shore up the Spanish debt markets if necessary. The ECB said it would raise its subscribed capital by €5bn (£4.2bn) to €10.76bn, the first increase since the launch of the monetary union.
http://www.telegraph.co.uk/finance/economics/8207710/European-Central-Bank-arms-itself-for-Spanish-crisis.html

how is that different from the Fed?

[K]

In some ways its even better than the Fed. Assuming both CBs set rate policy for the union as a whole, I think the ECB is more helpful to troubled regions than the Fed.  What has the Fed done for Arizona?  The ECB has bought (repoed) tons of Greek and Irish bonds.  To my knowledge the Fed hasn't bought a single state or muni bond.

[K]

Here it is, straight from the horses mouth (Note the author in the top right hand corner of the letter): "In addition, the Federal Reserve generally has little or no authority to lend directly to a state or municipal government".

[Nick Rowe]

rjs: is E10.76 billion big? George Soros' hedge fund had more than double that last year, according to Wiki. And he probably takes bigger risks. And are they really buying, or re-poing? And is it enough? Again, think of the thought-experiment where Ireland had its own central bank. Would it allow 9% interest rates and falling nominal GDP?

K: Arizona doesn't bail out Arizona banks, AFAIK.

[rjs]

ok, nick, i see that compared to $600B that amount isnt significant; i just recalled they were buying bonds of the PIIGS and my thought when i first read about it was "just like the the Fed"...

[David Pearson]

"Lender of last resort" to whom? If its European banks you are referring to, then certainly, the ECB is carrying out that function. After all, they are in the process of absorbing a good chunk of the PIIGS sovereign debt held by European financial institutions. As a result, the European banking system remains liquid and functioning -- in fact, I believe European private credit is actually growing. What about "lender of last resort" to sovereign governments? I'm not sure this is the traditional role of a central bank, but in any case, again, ECB debt purchases have allowed auctions of sovereign debt to go without incident. As result, dodgy sovereigns have had no problem rolling over maturing debt, and sovereign debt markets remain liquid and orderly.

Or is it that the ECB is allowing the sovereign risk premium to rise to "too high" levels? But this is an issue of solvency, not liquidity. The implication here is that the Central Bank should finance the deficit spending of sovereign states when that financing becomes too expensive in private markets. Alternatively, one could argue that by raising nominal demand expectations, the need for future deficit financing actually falls, and so should the risk premium. Whether one agrees with these concepts or not, are they associated with the liquidity-providing function of a central bank?

[K]

Nick: Ireland didn't *have* to bail out banks either. That's when they missed their chance at a far less painful devaluation by spreading out the pain over the international creditors - where it belongs. Yes, the ECB told them to do it because *they* didn't want the losses. So what? The ECB, like the Fed, took the (really bad) collateral, and I don't believe there is anything Europe could have legally done to Ireland for not bailing out the ECB. 

The ECB, like the Fed, bailed out banks by lending at the discount window against some less-than-stellar collateral. The fact that the ECB is requiring some additional capital and had to be bailed out by both Greece and Ireland is evidence of the fact that they took worse collateral. I.e. they helped more. But neither institution is free to take losses via crappy lending. Additional capital is a fiscal, not monetary, constraint. 

The big difference between European and US banking is that deposit insurance in Europe is at the state rather than union level. The FDIC had sufficient capital to bail out Arizona bank depositors, and if not, the US government, via the treasury, would have stepped in. Ireland, on the other hand, would have had to bail out AIB depositors themselves. But here again, deposit insurance, and its implicit or explicit government backing is a fiscal rather than monetary matter. 

[White Rabbit]

Nick: Krugman wrote several articles in 2010 about the dangers of Ireland (and other eurozone countries) not printing their own currency. Being indebted in a currency you do not print is dangerous because it presents a risk of a death trap debt spiral - and Krugman has been amongst the first economists to point out this problem in the scope of the eurozone.

I suspect he left out a detailed analysis of this aspect from this particular article you linked to because he mentioned it so many times already.

So I don't think there's any fundamental disagreement there - you seem to have summed up the main eurozone points Krugman has written about since late 2009.

[White Rabbit]

I searched Krugman's blog and in fact he has been warning about Spain, Ireland & co as early as January 2009:

http://krugman.blogs.nytimes.com/2009/01/19/the-pain-in-spain/

Quote:

"In Spain’s case (and Italy’s, and Ireland’s, and Greece’s) the euro may well be making things worse.

And Britain’s plunging pound, unpopular though it is, may turn out to have been a very good thing. "

That sums it up pretty well - almost a year before the Dubai/Greece/Ireland dominos fell. Pretty amazing.

(And yes, Britain's plunging pound is enabled through the 'lender of last resort' implementing a 'soft default' by devaluing the currency. Krugman wrote a few articles about that as well, later on - but this is the earliest Krugman reference I could find to Ireland.)

[D. I. Harris]

I agree with White Rabbit: Krugman made the point so many times that for his regular readers, it's tedious.

Though I think this article by Krugman says it more explicitly: http://www.nytimes.com/2010/02/15/opinion/15krugman.html?em
Important part:
"And there’s not much that Spain’s government can do to make things better. The nation’s core economic problem is that costs and prices have gotten out of line with those in the rest of Europe. If Spain still had its old currency, the peseta, it could remedy that problem quickly through devaluation — by, say, reducing the value of a peseta by 20 percent against other European currencies. But Spain no longer has its own money, which means that it can regain competitiveness only through a slow, grinding process of deflation."

By April, Krugman had already made this point so many times that he uses it as a footnote:

http://www.nytimes.com/2010/04/30/opinion/30krugman.html
Important part:
"Greece could alleviate some of its problems by leaving the euro, and devaluing. But it’s hard to see how Greece could do that without triggering a catastrophic run on its banking system. Indeed, worried depositors have already begun pulling cash out of Greek banks. There are no good answers here — actually, no nonterrible answers."

[K]

White Rabbit and D I Harris: Nick wasn't making the point that the euro is bad for weak members. Everybody knows Krugman's been making that point for eons. The point is *why* it's bad. Nick says the biggest problem is an insufficiently powerful ECB.

[D. I. Harris]

K,

Yes, we all know that. But Krugman says the why is exactly what Nick's talking about.

Here's what Nick says:

"The Fed has the political authority to print as many US dollars as are needed. The only effective limits are the risks of inflation and moral hazard. The Eurozone does not have an effective lender of last resort. The individual Eurozone countries do not have their own central banks. The ECB lacks the political authority to print as many Euros as are needed."

So, essentially, the Fed can print money; the ECB can't.

That's Nick's critique of Krugman.

But Krugman makes that point in the articles I pointed to above.

The reason why Spain could devalue with its old currency? Because it could print money. Now it can't.

Krugman makes the exact same point Nick does.

[D. I. Harris]

OK, just in case you still don't believe me, I've found where Krugman says what's almost identical to what Nick says he misses:

"European Central Bank could engage in much more expansionary policy, among other things buying lots of government debt, and accepting — indeed welcoming — the resulting inflation; this would make adjustment in Greece and other troubled euro-zone nations much easier."

Source: http://www.nytimes.com/2010/05/07/opinion/07krugman.html

[K]

Yes. He says "they could". There's nothing stopping them. Just like the Fed. They just dont want to. But no structural impediment. So, like Nick says, he and Nick have different perspectives on this.

[RSJ]

K,

No structural impediment? Unlike the Fed, the ECB does not have any riskless assets it can purchase in order to conduct monetary policy, neither does it have access to virtually unlimited capital.

The ECB needs to worry about default risk and about its capital position.

IIRC, it just increased the capital subscriptions for this reason.

In general the member states are not obligated to supply the ECB with additional capital when it suffers losses, and therefore the ECB cannot expand its balance sheet as much as the Fed.

[Min]

" The ECB lacks the political authority to print as many Euros as are needed.

"Suppose you abolished the US Federal government. So you needed all 50 State governments to agree before the Fed could act as lender of last resort to one of those State governments."

Could you please explain that more? It sounds like an explicit restriction, one which, given the history of the importance of the lender of last resort, sounds like one that would not be accepted. Europe has a central bank, while national banks are shadows of their former selves, and are unable to act as lenders of last resort. Why would the architects of the Euro omit or restrict an important function of its central bank? (Not that it did not happen, but exactly what did happen?)

Thanks. :)

[Nick Rowe]

Min: "Why would the architects of the Euro omit or restrict an important function of its central bank?"

My answer is appallingly simple, and perhaps naive. I think they just forgot. I don't think they thought about it. "That sort of thing can't happen here. We're Europe! Europe is not Argentina"

But then, Argentina forgot too. They thought the hard peg to the US Dollar was all you needed.

I vaguely remember saying, before Argentina got into trouble, that I couldn't see how they could handle the Lender of Last Resort function. But I couldn't *prove* it would lead to trouble. I couldn't really even convince myself. With hindsight it's more obvious.

Stuff happens.

[Min]

RSJ: "In general the member states are not obligated to supply the ECB with additional capital when it suffers losses, and therefore the ECB cannot expand its balance sheet as much as the Fed."

Who creates Euros? If the individual states can do so, why don't they?

@Nick: Thanks. :)

[K]

They can't create euros. But they can exchange Euros or bonds for equity of the ECB.

[James]

I think Iceland had it right all along. Let the banks fail, have the government take them over, and tell all the creditors to go to hell!

[George J. Georganas]

"Would Ireland's central bank allow a 9% real interest rate and falling nominal GDP ?"
Well, the 9% real interest rate is, for about half its value, the result of a falling price level that, also, leads to a falling nominal GDP. I cannot see much benefit in printing money to correct falling nominal GDP at the expense of falling real GDP and higher real rates for a number of years to rebuild credibility. This is what all countries who went through a credit crisis have had to go through. Individual borrowers go through this process all the time. Why would Ireland or the European Union be able to change this elemental fact of life? If they had managed that trick, they would have to tackle perpetual motion next. In fact, they may get there in a few years with their nuclear fusion research at CERN. But not with credit crises, not in this world.

[vjk]

K:

"They can't create euros. "

I thought the same, but, apparently, Ireland can:

"ECB Allows Ireland To Counterfeit 51 Billion Euros" (www.businessinsider.com/ecb-allows-ireland-to-counterfeit-51-billion-euros-2011-1

How is it possible if true ?

[Nick Rowe]

vjk: Yep, that one surprised me too. I'm really not sure on the legalities of what they have done.

But, the important point is this: are the Euros created by the Central Bank of Ireland redeemable? And who is obliged to redeem them, if they are?

[vjk]

Nick:

My naive assumption is that if it is called "euro" it is as redeemable as any other euro, otherwise it should be called something else, "ireuro" perhaps ?

I am puzzled a lot, my otherwise elegant and sensible mental picture of the world is falling down and apart around me ;)

Is MMT dream world coming to life ? Funnily, if true, the reality exceeds even their expectations as I belive Mosler stated not once on his site that due to euro commitment individual member states cannot bootstrap themselves back to life through Fed-esque spending.

Perhaps, California or Illinois can print some $$$ too, who knows ?