As we wrote in the article "Back to the true origins of the crisis," it will always be tempting for political and business leaders to ask a central bank to pay for their mismanagement, their inconsistency or incompetence.
More than 4 years after the official start, now where everyone wonders how we will emerge from this ongoing crisis, let’s come back for a moment on the true origins.
Indeed this type of institution is the lender of last resort (to save the banks liquidity crisis) and the buyer of last resort (to save the states into a solvency crisis and / or liquidity or to influence the price of certain financial assets).
As we also wrote, central banks in general and the ECB in particular will become the international financial system trashcans and somehow real bad banks since we will benefit from their dual specificity:
1/ they are the only financial players with some of their liabilities (debts) not payable, by creating money, the central bank issued debt on its own that is non-refundable in any case as the currency issued is accepted as a means of exchange, payment, transaction and reserve. We cannot for a moment imagine that it is any other way because the economic agents that we are all, have no other choice.
2/ In addition, they are also the only players indifferent to the mark-to-market (valuations) of the assets they hold in the case of market value loss, there is no need to recapitalize them as normal banks; we just have to write a provision for liabilities in the balance sheet as we know so well how to do it in finance.
So this is the last stage of the financial crisis, the institutionalized monetization
In the euro zone, there will be a forced but massive monetization from the ECB despite the hostility of the Bundesbank, the Bundestag and the German Federal Government. It is true that these institutions have little choice because soon it will be understood that the so-called structural solutions to resolve the sovereign debt crisis are politically and socially just not possible and highly unlikely
- whether the exit of weak countries from the Euro zone (economic and social costs unbearable for these countries)
- whether the exit of Germany from the Euro zone (with substantial macroeconomic cost, a loss of competitiveness and significant financial cost considering the commitments of German banks in the peripheral countries of the Euro zone)
- whether the restructuring of the Euro zone with the establishment of a fiscally virtuous northern zone and a southern zone trying to catch up with its competitive handicaps (politically difficult since it would separate the six Euro zone’s creators : Germany and the Benelux countries on the one hand and France and Italy on the other)
- whether the establishment of a true political union with fiscal federalism and therefore systematic budget transfers from the richer to poorer. This solution cannot be admissible in Germany and its satellites, more generally, this scenario is difficult to anticipate given the abandonment of national sovereignty that it entails.
The ECB will be forced to monetize and thus create money ex nihilo to buy more toxic assets
Mory Doré
The ECB has so far set up a soft monetization with sterilization of liquidity (that means the creation of money generated by the purchase of peripheral debt securities was removed by other means). Since August 2011, the ECB has established a more aggressive monetization with the purchases of Italian and Spanish debt. It is true that given the outstanding amount, the sterilization of these massive purchases would have severely disrupted the functioning of the money market which was already seriously disrupted with the confidence crisis between banks.
It will be recalled that the ECB has purchased 75 billion Euros of government securities (Greece, Portugal and to a lesser extent Irish) between May 2010 and July 2011. With direct purchases of Italian debt and Spanish debt, the pace has accelerated considerably and, at the end of October 2011, the purchased securities outstanding amounted to 175 billion Euros. From a rate of 5 billion Euros of monetization (who is sterilized) per month between May 2010 and July 2011, the ECB increased to a monthly average of 30 billion between August 2011 and today, without fully sterilizing the monetary mass
We are certainly far from the amounts accumulated by the Fed and the BOE through their quantitative easing programs since early 2009
- the outstanding US Treasuries rose on the FED balance sheet from 480 billion USD in September 2008 (Lehman) to nearly 1.6 trillion USD in June 2011 (official date of the end of quantitative easing 2)
- the outstanding UK Gilts held by the Bank of England increased from 45 billion GBP to GBP 215 billion in June 2011. With the prospect of raising the stock to around GBP 300 billion by Q1 2012 as it was announced in early October 2011 an additional quantitative easing program by 75 billion GBP.
But the fact remains that the ECB is on monetization and that is mostly irreversible. So you say, let’s go merrily and monetize without asking any questions. except that we draw attention to two issues
First issue
Imagine that we put in place extensive programs to monetize, so purchasing unlimited amount of Italian, Spanish and why not French debt through a new EFSF profile, transformed as wanted France and other countries with banks sourcing liquidity with the central bank.
Mory Doré
As a bank, this new EFSF could then lend up to an infinite number of times its capital, especially if the government securities purchased still do not consume capital from a regulatory perspective. Remember that when a bank lends 100 to a company, it uses (as defined by banking regulations) 8 of capital; when it lends to another bank, it consumes 8 times 20%, or 1.6 and when it lends to an OECD country, it consumes 8 times 0%, then 0 (it is well known that a country from the OECD is less risky ..). Finally all that was in the old world and regulation with Bale 2 and Bale 3 changes and operates under the pressure of crises, it will change again after a long delay and inertia. But unlike a traditional bank, the EFSF would have two types of borrowers: first, more or less weak countries postponing their solvency problems on the other hand, poorly capitalized banks. In other words, the EFSF balance sheet reputation will deteriorate irreversibly, and therefore the rating of this institution.
Moreover, the collateral provided by the EFSF to refinance with the ECB would be less and less attractive in terms of quality
- as made up of guarantees provided by more and more fragile and more insolvent countries
- as made up also of more and more toxic assets represented by the debt of the least creditworthy states and the less well-capitalized banks.
From a macroeconomic point of view, we will then see the creation of money by the ECB to buy directly or indirectly by the new EFSF, toxic debts. Considering that these debts are purchased with the liquidity created in the secondary market to private investors, they will then use this cash to buy safe assets (safe public, assets from emerging countries, commodities). The risk is that all this will lead to new asset bubbles and repeated financial crises with high volatility, assets value disruption, negative wealth effects and economic and social crisis.
Second issue
There is certainly no technical limit, as we have seen, regarding the increase in the size of the central bank balance sheet but there is a financial limit. Indeed, the uncontrolled money creation in the central bank liabilities and the accumulation of financial assets of poor quality in the balance sheet will cause a sharp devaluation of the currency. It has many names: loss of the money purchasing power, hyperinflation, currency rejection, storage of physical assets among which gold, stone and land
We will come back to this issue of the tomorrow true safe assets in a future paper
