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Is the ECB too cautious or too reckless?

By Paul Taylor
June 30, 2009

The European Central Bank has long been criticised for being too cautious in its response to the financial crisis. Didn’t the inflation hawks of Frankfurt raise rates in July last year just as the credit crunch was about to reach its climax? Despite their massive injections of liquidity into the money markets, Jean-Claude Trichet and his colleagues were pilloried as timorous clones of the Bundesbank for cutting rates too slowly and refusing to follow the Fed and the Bank of England into Quantitative Easing by buying government and corporate debt.

But after last week’s helicopter dump of a record 442 billion euros in liquidity in one-year lending on demand to banks at its 1.0 percent refi rate against a broad range of collateral, the bank suddenly stands accused by some critics of being more reckless than the Anglo-Saxon central banks.

Anatole Kaletsky, writing in The Times, argues that the ECB is now printing money faster than the Fed by spraying cheap cash at the banks against poor-quality collateral, taking much greater credit risk than the U.S. central bank.

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.

Furthermore, he contends, the ECB’s action amounts to an indirect purchase of government debt.

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.

Willem Buiter, a former member of the Bank of England’s Monetary Policy Committee, accuses the ECB on his Maverecon blog of usurping the role of governments and recapitalising European banks by stealth, without any return for the taxpayer, by giving them effectively a massive interest rate subsidy.

Buiter contends that the banks will have lumbered the European System of Central Banks with shedloads of dodgy collateral and will be able to make substantial profits by lending on the money in mortgages or … by buying government debt.

The risk-adjusted rate of return to the Eurosystem on its lending to the banks can hardly be more than 0.70%, given the poor quality of the collateral offered and the dreadful state of the balance sheets of many Euro Area banks.  In that case there is a subsidy from the ECB to the banks of just over 0.25 percent, say € 1 bn.  While this is a small number, on the gargantuan scale on which bank losses and bailouts are measured these days, it is clearly inappropriate for the central bank to engage in quasi-fiscal operations of this nature.  Subsidies should be voted by the appropriate parliaments, not distributed by unelected technocrats.

The total increase in profits to the Euro Area banks from this operation is a multiple of the subsidy, and can be measured by the difference between the safe lending rate of the banks and the rate charged by the ECB.  Depending on which use of funds you consider, this could amount to 1.5% of the €442 bn (if the money is invested in 3-year government instruments and nothing too nasty happens to short rates over the next 3 years) or 2.5% (minus a discount for default risk) one-year housing loans, that is, around €6bn or €10bn. While most of that is not a subsidy, it is a gift from the Eurosystem to the banks.  If the ECB wants to play Santa Claus, I know of more deserving recipients of their largesse than the banks.

What do you think? Has the ECB gone from Scrooge to Santa Claus in one giant leap? Or has it provided a prudent monetary stimulus that will be easier to withdraw than the Fed’s or the Bank of England’s QE?

 

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