ECB's €489 Billion Correctly Recognizes the Liability Side of Banking is Not the Place for Market Discipline

December 25th, 2011
in Op Ed

by Warren Mosler, Mosler

Euro-DebtWhen it comes to CB (central bank) liquidity operations, as previously discussed, it’s about price- interest rates- and not quantities of funds. In other words, the LTRO (Long Term Refinancing Operation) is an ECB (European Central Bank) tool that assists in setting the term structure of euro interest rates. It helps the ECB set the term cost of funds for its banking system, with that cost being passed through to the economy on a risk adjusted basis, with the banking system continuing to price risk.

Follow up:

So what does locking in their funds via LTRO do for most banks? Not much. Helps keep interest rate risk off the table, but they’ve always had other ways of doing that. It takes away some liquidity risk, but not much, as the banks haven’t been euro liquidity constrained. And banks still have the same constraints due to capital and associated risks.

To its credit, the ECB has been pretty good on the liquidity front all along. I’d give it an A grade for liquidity vs. the Fed where I’d give a D grade for liquidity. Back in 2008 the ECB was quick to provide unlimited euro liquidity to its member banks, while the Fed dragged its feet for months before expanding its programs sufficiently to ensure its member banks dollar liquidity. And the FDIC (Federal Deposit Insurance Corporation) did the unthinkable, closing WAMU (Washington Mutual) for liquidity rather than for capital and asset reasons.

But while liquidity is a necessary condition for banking and the economy under current institutional arrangements, and while aggregate demand would further retreat if the CB failed to support bank liquidity, liquidity provision per se doesn’t add to aggregate demand.

What’s needed to restore output and employment is an increase in net spending, either public or private. And that choice is more political than economic.

Public sector spending can be increased by simply budgeting and spending. Private sector spending can be supported by cutting taxes to enhance income and/or somehow providing for the expansion of private sector debt.

Unfortunately current euro zone institutional structure is working against both of these channels to increased aggregate demand, as previously discussed.

And even in the US, where both channels are, operationally, wide open, it looked for a while like FICA taxes were going to be allowed to rise at year end and that would have worked against aggregate demand, when the ‘right’ answer is to suspend it (FICA) entirely. The question is still on the table though – the “fix” was only for two months. The question will be faced all over again starting in a week or so.

The initial rate on the 3 year LTRO was reported to be ‘fixed’ at 1%, but turns out it adjusts with the policy rate and will be an average of the policy rate over the three year term.

So it doesn’t fix rates for the banks, it just ensures funding at the policy rate. Which makes sense, as the bank’s cost of funds is the policy instrument of the ECB.

Also interesting is how, in the case of bank defaults, the member nations guarantee the bank deposits. But those member nations get their funding from bond sales. And with the weaker ones that means bond sales to the ECB. So in that sense, the ECB is backing bank deposits. This means when it provides liquidity and takes collateral, should the bank subsequently realize losses, causing the ECB to realize losses on the funds provided to the bank for liquidity, the member nation would then sell bonds to the ECB to get the funds to pay for the loans it got from the ECB.

Again, it all comes down to the ECB writing the check. And it all works from a solvency point of view when the ECB writes the check. However, the ECB writing the check introduces a serious moral hazard issue. The attempt to mitigate moral hazard leads to the (over) emphasis on austerity.


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About the Author

Warren Mosler is co-founder and Distinguished Research Associate of The Center for Full Employment And Price Stability at the University of Missouri in Kansas City. CFEPS has supported economic research projects and graduate students at UMKC, the London School of Economics, the New School in NYC, Harvard University, and the University of Newcastle, Australia. He is Associate Fellow, University of Newcastle, Australia.

Warren is the founder and principal AVM, L.P., a broker/dealer that provides advanced financial services to large institutional accounts. He is also founder and principal of Illinois Income Investors (III), specializing in fixed income investment strategies for 29 years. He is presently located in the U.S. Virgin Islands where he heads Valance Co, Inc., the corporation that owns the shares of III Offshore Advisors and III Advisors, the companies that manage AVM and III.

Warren has a degree in economics from the University of Connecticut. He has 38 years of experience in a variety of fixed income markets, including derivatives. He writes at his blog and widely in the press and blogosphere. Warren is considered to be the founder of Modern Monetary Theory (MMT). You can read a longer bio here.

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