How the ECB’s fig leaf has completely withered away
News Article Date: Monday 29th of June 2009
Now that the global recession appears to have passed its low point, panicmongers in the media and financial markets are shifting their attention from deflation to inflation — and especially to the debasement of the dollar by the money-printing operations of the US Federal Reserve. Whether printing money necessarily always leads to inflation is a long-running theoretical debate which the economics profession shows no sign of resolving, there is a factual question related to this argument that is much more important and straightforward, yet completely misunderstood. Leaving aside the question of whether it is a good or a bad idea to print money, which of the world’s leading central banks is printing money faster: the Fed or the European Central Bank?
Last Wednesday, the European Central Bank injected €442 billion (£377 billion) of new cash into the euro money markets. This was the biggest long-term lending operation in the history of central banking and was equivalent to half the Fed’s entire monetary expansion in the past 18 months. Yet most people still believe that the Fed (along with the Bank of England) is engaged in a “reckless” experiment with inflationary quantitative easing (QE), while the ECB is steadfastly honouring the deflationist traditions of the Bundesbank’s “steady hand”.
The ECB Council debated for months about QE, the modern equivalent of “printing money”, since it involves the central bank creating money out of thin air by signing computer-generated promissory notes and then distributing these around the commercial banking system by using them to buy up government bonds. In the end, the ECB decided to print only €80 billion to buy on private sector bank bonds, in contrast to the $1 trillion (£606 billion) of bond purchases undertaken by the Fed. And even this trifling monetary expansion was ferociously attacked by Angela Merkel for threatening Europe’s inflation outlook and jeopardising the credit of the ECB.
However, if we look at the facts, the transatlantic difference is less clear. In fact, the ECB is printing money even faster than the Fed is.
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It is also supporting fiscal policy more explicitly through debt monetisation and taking much bigger risks with its credibility and solvency. The first point is illustrated in the chart. Since mid-2007, central banks have expanded their total liabilities (the broadest definition of what it means to print money in the modern world) by $1.2 trillion in the US and by $1.5 trilllion in euroland. Given that GDP is 12 per cent bigger in the US than in the eurozone, this means that the ECB’s printing presses have actually been running 50 per cent faster than the Fed’s. Someone should point this out to Mrs Merkel: since the ECB presses were presumably made in Germany, it would give her something else to boast about.
Meanwhile, we can move on to a second surprising comparison between the European and US central banks: their willingness to monetise government debts.
Having established that the scale of the money-printing operation has actually been bigger in Europe than in America, the next step is to compare the methods used by the Fed and the ECB to achieve these expansions. On this point, consensus opinion is even clearer: the ECB is almost universally seen as more “prudent” in the way it has expanded its balance sheet. The Fed has been buying government and agency bonds outright, thereby exposing itself to the risk of capital losses from rising interest rates, which in turn could potentially constrain its future monetary decisions. Even worse, the Fed’s willingness to buy Treasury bonds, at a time when the US Government’s deficits are exploding, means that it has taken the first step down the primrose path of debt monetisation that leads ultimately to Zimbabwe and Weimar. The ECB, by contrast, has not weakened its balance sheet with long-maturity bonds and dubious corporate assets and, most importantly, it has refused to buy government bonds or engage in debt monetisation.
This is the conventional wisdom, but again consider the facts. It is certainly true that the ECB has expanded its balance sheet almost entirely by lending money to the euro-area banks, while the Fed’s new lending has mostly been to the US Government and agencies. But does this really mean that the Fed has taken greater risks than the ECB or done more to facilitate profligate public borrowing? The answer to the question is a clear “no”. The ECB’s loans to eurozone banks at the latest count stood at $1.5 trillion — before accounting for last week’s €442 billion bonanza. Are these loans really as safe, or even safer, than the Fed’s $1.7 trillion of US Treasury and agency bonds? According to ECB apologists, its loans to the banks are completely safe because they are secured by collateral that can be sold if the borrowers default. But this reassuring claim disregards the massive reduction in the quality of collateral that the ECB has been accepting since the start of the credit crunch.
Unlike the Fed and the Bank of England, which only accept AAA public bonds as collateral for their lending operations, the ECB now lends against low-rated mortgage bonds, commercial loan books and other dubious assets that the markets would treat as “toxic” were it not for the ECB’s willingness to turn them into instant cash. The ECB has been praised for the boldness with which it has set aside the traditional rules of central banking in the crisis — and this is perfectly justifiable, but the ECB’s apologists cannot have it both ways. Those who praise the ECB for its “imaginative” response to the crisis must also acknowledge that it has accepted much greater credit risks than the Fed. Which brings us to the question of financing public debts.
The Fed has “monetised” roughly $1 trillion of US Government debt since 2007, if we combine its Treasury and agency bond buying. Meanwhile, the ECB has lent $1.5 trillion to the euro-area banks. But what have the euroland banks done with this new money? They have lent most of it straight to their governments. Indeed, the governments in Ireland, Greece, Portugal, Spain and Austria would long-since have gone bust had it not been for the willingness of the commercial banks in these struggling economies to buy unlimited quantities of government bonds with money borrowed from the ECB. And these bond purchases have, in turn, been used as collateral for more ECB borrowings, which could be used to buy more government bonds.
In effect, therefore, the ECB has been lending money by the shed-load to governments, with commercial banks acting merely as a fig leaf for what would otherwise be seen as a blatant monetisation of the most insolvent European countries’ public debt. In normal circumstances, this fig leaf might at least have theoretically protected the virginal purity of the ECB by interposing the commercial banks’ own balance sheets between the government borrowers and the ECB.
In normal circumstances, if the Greek Government defaulted, damaging the collateral deposited by Greek banks at the ECB, the losses would fall on the Greek banks, rather than the ECB, since commercial banks remain the beneficial owners of the collateral they deposit. But in today’s conditions, this Maginot Line between the credit problems of European governments and the ECB’s balance sheet is a joke, since the Greek, Irish and Spanish banks queuing up for ECB funding are near-insolvent and would certainly be insolvent were it not for the limitless supply of money they are getting, in exchange for dubious collateral, from the ECB itself. In short, the commercial bank intermediaries interposed between the ECB printing presses and European governments’ borrowings should not even be described as a fig leaf — more like the climactic G-string in the world’s most expensive strip show.
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