The Eurosystem might have a fatal flaw. But it’s not this

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Willem Buiter has just published his book, Central Banks as Fiscal Players, online. @jvtklooster alerted us to this, along with one of its most controversial arguments. The controversy in question is that the Eurosystem, that is the European Central Bank and the central banks of the 19 member states, has a fatal flaw: the national central banks can go bankrupt. Here’s an excerpt: The 19 national central banks (NCBs) hold significant amounts of assets for their own risk rather than on a risk-sharing basis and for some of these NCBs a significant share of these assets is subject to material credit risk. Because NCBs have no control over their issuance of central bank money – this is a collective decision taken by the Governing Council of the European Central Bank (ECB) – a central bank can go bankrupt – become insolvent. Effectively, all euro-denominated assets and liabilities of an NCB (and all euro-denominated Eurozone sovereign debt instruments) are foreign-currency-denominated financial instruments, both from the perspective of the issuers (including sovereigns) and from the perspective of the holders, including the NCBs. But is he right? In a sense, he is. Besides in exceptional circumstances (more on which later), the terms on which the Eurosystem lends central bank money is decided back in Frankfurt by the governing council. Every national central bank governor sits on the council, but the real power lies with the six insiders that also sit on the ECB’s executive board. It is they who design the policy responses — and, unlike other members, in each and every meeting hold the right vote on them. It is not just the cost of borrowing that the council determines, but also the collateral that can be accepted in exchange for central bank loans. The exceptional circumstance here is so-called Emergency Liquidity Assistance, or ELA. ELA can be granted at the discretion (and risk) of the national central bank to lenders that have collateral so poor that would be deemed unacceptable for the purposes of the ECB’s regular auctions. However, even the amount of ELA offered can be vetoed by a two-thirds majority of the governing council. All of which means, while Buiter might be overstating the case to say national central banks “have no control” over the issuance of central bank money, they have far less authority than other monetary authorities.It is indeed a flaw in the system. It is also one that has influenced the way the eurozone’s central bankers design their policies. It has meant, for instance, that the €2.6tn (and counting) quantitative easing programme is set up in a way that says more about the Eurosystem’s political economy than it does the architecture of the eurozone’s financial markets. Government bond purchases are not made on the basis of the outstanding amounts of debt in each member state’s market; Instead they are divvied up based on the amount of capital each member state contributes to the ECB. Those capital shares largely reflect the size of a member state’s economy and its population, meaning that more German bonds are bought than Italian ones despite the sovereign debt market being relatively smaller in the eurozone’s largest and most populous state. As Buiter points out, risks are often not shared, with national central banks responsible for the bulk of any losses incurred on their holdings of their own government’s debt.But, if a central bank incurs losses and falls into the red, does this matter? As @jvtklooster points out, a central bank is not a regular business.
Still, opinions differ and former ECB president Jean-Claude Trichet was one insider who shared Buiter’s view that negative capital was a dangerous thing. Indeed the ECB under his stewardship was forever admonishing the Czech National Bank for the losses on its balance sheet. Trichet’s view was that negative capital puts pressure on a central bank’s independence to set monetary policy as they see fit, void of political pressure. The reason being that in times when central banks are in the black, they usually hand their profits over to the government. And when lawmakers notice the funds are missing, they try to interfere with central banks’ policy deliberations in a bid to recoup the funds.  We think this is far fetched. Losses are not ideal for anyone, including the central bank. But you need to look at the circumstances in which they develop and ask what is the alternative? Central banks such as the Czechs’ and Israel’s that find themselves in the position of being in the red are usually there because of costs incurred on the interventions they make in foreign exchange markets to counter volatile movements in their currencies. Note that this is about managing the pace of appreciations and depreciations and is, therefore, different from a currency peg. The Czech response to the ECB, which we entirely agree with, was to argue that the central bank’s credibility owed more to its ability to guard against wild fluctuations in the value of its currency than the health of its balance sheet.We would add that negative capital positions often prove short-lived. While the Eurosystem central banks are limited in what they can do to control the supply and cost of central bank money, they do get a share of the profits that come from seigniorage — that is, the business of printing banknotes.As Buiter has written, this industry is “wildly profitable” and he himself expects the Eurosystem to reap gains of between €2tn and €6.9tn. Gains that will be divided between the national central banks according to the capital key. You cannot dismiss a lack of control the national central banks have; in many respects Buiter is right to label them “glorified currency boards”. It is one among many dysfunctional elements of the eurozone. Over time one of those elements might well prove fatal, but we doubt it will be the bankruptcy of a national central bank that pulls the whole system down. 

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