The ECB's new role, as foreshadowed in the Modest Proposal: Q&A with a reader

14/03/2011 by

In this post I continue my Q&A with Manos Makrakis on our Modest Proposal 2.0. Tomorrow I continue with some important points raised by Jan Toporowski. 

(MM’s points in green)

…your proposal at least on point one, suggests a solution that… seems to have a bigger political weight and lesser of a technical one as I think you seem to imply.

Well spotted! The resolution of the euro Crisis can be nothing but political. And yes, you are completely right, what our Modest Proposal is suggesting is a radical change from the past. A politically major move for the EU to make. So, why do we call it ‘modest’? Because it requires changes to existing institutions that, compared to their gigantic political impact, are quite… modest.

This means that your proposal would most likely need an amount of effort and political will that would come close to the one necessary to support the construction of a federation which, I totally agree with you, does not appear to be likely to happen anytime soon.

Possibly. It will take oodles of hard work, of political commitment and an escalation of the Crisis that will force the surplus countries to jump off the fence, on which they seem so determined to continue sitting. Having said that, the order of magnitude of the difficulties involved is far, far lower than that federation would throw at us.

So if then the ECB acts as an intermediary, servicing debt on behalf of member states in the eurozone, and is clearly prohibited from mixing monetary policy operations with operations in this new role to avoid causing a potentially catastrophic global monetary crisis or to the very least Euro crisis, here’s a question. Who/what is the guarantor of this debt then?

The ECB itself!

What is the collateral?

No collateral. In ECB we trust! And why do we trust in the ECB? Because the ECB has a huge reputation to defend. (Come to think of it, whenever investors buy public bonds, there is no collateral either. What collateral did investors receive when they purchased €300 billion of Greek bonds?  Indeed, what collateral does the US Treasury offer for its Bills? Nothing. Zero. Zilch. Are investors impeded? Not in the slightest.)

You clearly do not want to have the ECB in that role because the ECB can only really create fiat currency and you want to clearly separate the two as I think we agree.

As argued just above, I have no qualms with the ECB playing that role. The fact that it creates fiat money does not stop it from borrowing on its own account – especially when investors know that these borrowings are being serviced by the eurozone’s member-states.

So, since you do not have a federal government yet, I gather it will have to be the collective creditworthiness of the economies of the member states it services. Its credit rating would be such as to represent a weighted average credit rating of each state’s participation in the scheme.

Not so. The ECB is more than the weighted average of its parts. This is an empirical hypothesis that I cannot prove theoretically (only observation can verify or falsify it) but I stand convinced that, given the dearth of safe investments around the world, and in view of the surplus of savings desperately seeking a safe home, ECB-issued bonds will secure quadriple-A ratings in no time. Look at the eurobonds issued currently by the toxic EFSF. Everyone knows that it is a structured vehicle in whose DNA lurks the genome of contagion. And yet the EFSF secures loans for interest rates insignificantly different from those of Germany’s bunds!

And in the event that a state failed to pay up its debts, then the funds would have to be raised collectively by the remaining state members (remember the ECB cannot print money to service this debt).

I think that this point is well made and needs to be elaborated further. As Lorenzo Smaghi (ECB executive board member) has recently suggested (see this report by the Financial Times – thanks to Jan Toporowski for pointing this out to me), it is perfectly possible, under a new structure like that suggested in the Modest Proposal, for central control of member-state budgets. That way, the EU could guarantee that no member-state ever defaults, especially vis-a-vis its debts to the ECB. Such a mechanism is, I think, the answer to your concern and an important pillar to the new architecture that we are proposing.

Also one more question that is a result of the implications of having the central bank service up to 60% of the GDP of member states government debt. Today the ECB provides liquidity to member-state banks by accepting government bonds as collateral. If you have it issue in its name part of this debt, wouldn’t that also imply that banks would not be able to use the same to borrow from the ECB? If yes how would you replenish this lost liquidity and what might be the consequences on inflation?

There is a misunderstanding here: The ECB will not be issuing new debt on the member-states’ behalf. It will be issuing its own e-bonds to finance the tranche transfer. So, the banks’ existing bond holdings (of a value up to the Maastricht-compliant debt limit of the member-state) would be registered with the ECB’s new division. This is no more than a technical shift. If, following that transfer, a bond-holding bank wants to borrow from the ECB, nothing will change from the present arrangements. Whereas now the bank sends its bonds to the ECB as collateral, under our scheme the bank asks the ECB to take it from the registry of one ECB department (the one holding on to the tranche transferred bonds) to another (the one holding the collateral against which the bank draws liquidity). Having said that, most existing bonds of fiscally-stricken states, like Greece, have already been deposited as collateral with the ECB. Our proposal in fact lessens your concerns about the future for a simple reason: Banks will now want to buy the ECB-issued e-bonds since they will be infinitely more desirable collateral in the eyes of the… ECB.

Regarding the bail out of US banks, MM wrote: Clearly no federal entity bailed out any state banks. Here’s a comprehensive list from FDIC of the banks that failed since 2002 (the majority are after 2008 as you may imagine). They bailed out the big offenders (banks or not) that clearly posed a systemic risk to the US and global financial system after the consequences of letting Lehman collapse. Definitely not state banks.

Yes, but this is not the point. The Federal Reserve System guaranteed the savings and bonds of all US banks, regardless of whether they were actually saved or not. So, the State of Nevada did not have to borrow from the money markets to guarantee its territory’s banks, as Ireland had to do, at its detriment. The Federal safety net for the banks was of the essence in the mergers that took place after 2008 throughout the US banking system and which ensured that no savings accounts were lost. Without these guarantees that do not appear on the list you shared with us, hundreds of smaller state-based banks would have gone under. If Europe had such a system in place, Ireland would have been well out of the woods, as we speak.

The European debt crisis is not of the same nature everywhere. In Ireland it was a result of the problems of the banking sector, in Greece the crisis was clearly a result of unmanageable government debt that did not originate in the banking system.

Perfectly true. But, once the Crisis reared its ugly head, and because we are all connected by the same currency, it spread from one realm (banks in the EU) to sovereign debt (beginning with Greece) before zooming back to the former (inflating banking losses throughout the continent) and then again back to the latter (bringing Ireland down) etc. etc. In the end, it really does not matter where it began and how. Once under way, we have two crises, banking crisis and public debt crisis, that are feeding off each other throughout the eurozone. For this reason, only a pan-European solution will do, one that goes well beyond tinkering with loan agreements...

I am with you in terms of punishing, regulating and allowing for more credit rating companies to operate enhancing competition. Though having the ECB (or any other government run organization) setting up an agency of its own that would provide credit ratings on its own bonds I think you start with a good amount of conflict of interest that you’d have to address. I personally would have serious concerns about its ratings.

True. Conflicts of interest should be taken seriously. But, are they absent from the existing agencies? Moody’s and the rest have turned conflict of interest into an Olympic sport. My suggestion is that  the ECB, the EU etc. ought to set up their own credit rating agency by which to rate the bonds of our banks, our municipalities, our corporations, our member-states even.  As for the ECB e-bonds, of course it would be absurd to have the ECB rate them. So, in this case, my solution is simple: Do not rate them. Leave it to Japanese, American, Chinese agencies and investors to do that. Even Moody’s.

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