How the ECB could be forced to print money

By Felix Salmon
December 6, 2011

The European Central Bank has been notoriously reluctant to print money during this crisis. But what if it had to?

Aaron Tornell and Frank Westermann have a wonky post up at VoxEU about the flows between various national central banks within the Eurozone, which includes this key chart:

Assets of the Bundesbank

TornellFig2.gif

The line to concentrate on, here, is the solid one in blue. It shows a key part of the Bundesbank’s assets — its loans to other institutions — falling perilously low to zero, even as its loans to other European central banks — the maroon dotted line — continue to rise inexorably. (These loans from one national central bank to another are known as the TARGET system.)

Up until now, the Bundesbank has managed to fund the latter by means of selling off the former: when it’s asked to lend money to PIIGS central banks, it just sells off some other loans and advances the cash to the Irish or Portuguese central bank instead.

But it can’t do that any more, because the Bundesbank is down to its last €21 billion in private loans. And when that hits zero, the only things left to sell are the Bundesbank’s gold and reserves. Which, it’s pretty safe to say, the Bundesbank is not going to sell.

There’s good news and bad news here. The bad news first:

Before long, the Bundesbank’s stock of domestic assets is going to hit zero, and it is highly unlikely that it will agree to sell its gold or borrow more in private capital markets. At that point, the Bundesbank will not be able to lend more funds to the Eurozone TARGET mechanism… If a critical mass of agents were to engage in capital flight away from fiscally weak countries, the TARGET system would be overwhelmed. In principle, a speculative attack could occur within a day, and the ECB would have to assume all of the marketable securities from countries that suffer the speculative attack. Since the ECB has a relatively small capital base, it would not be able to purchase a large amount of assets from countries that suffer the attack.

This is a bank run, basically, with the banks suffering the run being the central banks of euro-periphery nations. Bank runs are always about liquidity, and so long as there’s a firehose of liquidity somewhere able to give anybody who wants it all the cash they want, bank runs are non-issues. But the point here is that the network of European central banks is running out of cash, and that the Bundesbank — which has been the main provider of liquidity to date — has now pretty much run out of it.

Here’s how Izabella Kaminska reads this:

If the ECB doesn’t act to discourage the borrowing (or for that matter fails to somehow top up the Bundesbank’s assets), it could become a victim of a speculative attack not dissimilar to that experienced by the Bank of England during the ERM crisis of 1992.

There are, after all, many similarities in both situations. Most notable is the fact that both central banks seem to have under-estimated the amount of quality assets (or foreign exchange in the case of the BoE) they needed to hold to defend their monetary policy effectively.

I, on the other hand, am (uncharacteristically) a little more optimistic here. Faced with the imminent collapse of a national central bank, it seems to me that the ECB would have no choice but to print as much money as was necessary to meet that country’s demand for liquidity. The problem in 1992 was that the pound was overvalued, and that the market was demanding Deutschmarks, which the Bank of England couldn’t print. In this case, the market would be demanding euros, which the ECB can print.

Basically, there’s a constant flow of money out of the European periphery and towards the center. Up until now, that flow has been matched by an equal and opposite flow of central bank lending from the Bundesbank to the PIIGS central banks. And when the Bundesbank runs out of money to lend those central banks? The ECB will have no choice but to step in and print all the money necessary to stop those banks from going bust. And that, I think, is how we’re going to see the ECB finally take on the lender-of-last-resort role it has been so reluctant to adopt until now.

Update: Karl Whelan takes issue with Tornell and Westermann’s assumptions.

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