Mario Draghi became president of the European Central Bank on 1st November, 2011, at a critical moment for the euro. Banks – particularly banks in the Club Med countries (i.e., Italy, Spain, Greece) – were having difficulty rolling over their inter-bank lines. As the lines matured with little prospect of renewal, the banks were being forced to sell liquid assets. As these included bonds issued by Club Med countries, the price of the bonds fell and their yield increased. A surge in Italian and Spanish government bond yields was taken to constitute “the Eurozone sovereign debt crisis”. The media were full of talk of “a bazooka” of some sort to bring the crisis to an end. In October last year such talk usually focussed on the expansion of the European Financial Stability Facility, a back-up fund with resources provided by all Eurozone member states and able to extend credit to particularly hard-pressed governments. A widely-held view was that the EFSF might need to exceed 900b. euros, or even 2,500b. euros, if it were to have the fire-power to meet the crisis.
In the event, negotiations for the EFSF have not got far enough, while its credibility in financial markets has been undermined by the credit rating agencies’ downgrading of several member states. But Draghi has found a big, powerful bazooka and aimed it with precision. Between 4th November 2011 and 20th January 2012 the ECB’s lending to banks has jumped from 580.0b. euros to 831.7b. euros, or by over 43%. The new lending has taken the form mostly of three-year facilities at 1%, which – on the face of it – are extraordinarily privileged loan arrangements for the banks. Further large expansion of such lending is to be envisaged. The banks have stopped selling government bonds, the yields on Italian and Spanish bonds have fallen, and the sovereign debt crisis is over, at least for the time being. This weekly e-mail analyses the effect of the Draghi bazooka on Eurozone M3 growth, because of the importance of money to macroeconomic outcomes more generally.
The Draghi bazooka: the background up to Draghi’s appointment
Large-scale government borrowing from the central bank has potentially catastrophic macroeconomic consequences. The Maastricht Treaty of 1992 therefore proscribed direct government borrowing from the European Central Bank (and indeed from the central banks that together constitute the Eurosystem), because of fears that over-expansion of the central bank balance sheet (i.e., of the so- called “monetary base”) could cause an inflationary spiral. The Bundesbank, one of the key players in the original design of the Eurosystem and the single currency, remembered the damage that had been to Germany’s society by the Weimar hyperinflation of 1923.
The ECB’s balance sheet expanded rapidly in the aftermath of the banking crisis of autumn 2008. In the years leading up to the crisis ECB lending to banks was typically about 450b. euros. It soared in the three months from October 2008, with heavy usage of long-term refinancing facilities (i.e., facilities expected to last six months or longer) mostly responsible. (They doubled from 334.3b. euros in October 2008 to 613.6b. euros in January 2009.) During 2009 the facilities, which became known as “the non-standard measures” ran typically at about 700b. euros, with the monetary base similarly at a higher level than before. (The ECB’s measure of the monetary base climbed from 900b. euros in August 2008 to over 1,200b. in January 2009, and in summer 2009 the M1 money measure was expanding at an annual rate in the double digits.) Economists with a Bundesbank background – such as the ECB’s chief economist, Jurgen Stark – were anxious that the non-standard measures had created a significant medium-term inflation threat. In early 2010 the ECB announced that the non- standard measures were to be withdrawn. The banks would have to repay their long-term borrowings by the end of June. As the chart above shows, the value of these facilities crashed by about 300b. in the middle of 2010.
Various interpretations of the Eurozone sovereign debt crisis are possible. Plainly, governments that run large budget deficits, incur massive public debts and lie about the scale of their deficits and debt should not be surprised if they have no credibility in financial markets. The main cause of the surge in Greek government bond yields in early 2010 was that its government was financially irresponsible. Nevertheless, the timing of the yield surge was related to the ECB’s withdrawal of the non-standard measures. In order that they could pay back their borrowing from the ECB by end-June, banks had either to pull in loans or sell securities, and the obvious securities to sell were those of dubious quality, such as Greek government bonds. By implication, a relationship holds between changes in the generosity of the ECB’s credit lines to the banks and movements in Eurozone government bond yields. The ECB cannot lend directly to Eurozone governments on overdraft, but – by means of transactions with financial institutions that themselves hold Eurozone government securities – it can have a powerful impact on market conditions in Eurozone sovereign debt.
While Trichet remained president of the ECB, the standard line was that Europe’s governments were primarily responsible both for their own solvency and for bail-outs of fiscal delinquents. The European Commission and the International Monetary Fund also became involved, and the press talked of a troika of responsible parties (i.e., the ECB, the Commission and the IMF). The emphasis was on the formation of a new fund, the European Financial Stability Facility (or EFSF), which could lend to fiscal delinquents and impose the necessary external discipline on them, with the ECB’s knowledge and expertise, but without the ECB’s resources. By autumn 2011 it was clear that the establishment of the EFSF was proving problematic. The Eurozone sovereign debt crisis intensified, with sharp rises in the yields of Italian and Spanish government bonds, and suggestions that even France might be threatened by the decline in market confidence.
The Draghi bazooka: after Draghi’s appointment
So Mario Draghi became ECB president at a critical juncture in the Eurozone’s history. The Eurosceptic press (mostly in the English-speaking world) daily announced, with good reason, that the Eurozone’s break-up was imminent. As yields on Italian and Spanish government bonds climbed to around 7%, the value of the bonds declined. If these assets had been “marked to market”, their loss of value would have hit banks’ profits and capital, and further undermined their ability to expand their balance sheets. The Eurozone appeared to be caught in a vicious self-reinforcing downward spiral.
Between 1st November and mid-December last year much frantic negotiating about ECB strategy must have proceeded, almost entirely behind closed doors, between the various European authorities about how they should react to the crisis. It has to be assumed that the Bundesbank remained hostile to the re-introduction of the non-standard measures, although – I should say straightaway – I have no direct evidence that this was the case. At any rate, Draghi decided that the re-introduction of the very generous pre-2010 long-term refinancing facilities (for three years at 1%) could be justified by the gravity of the crisis. Last month 523 banks bid for their proportion of the extra facility, with the total bids coming to 489b. euros. Already the drawdown of the facilities has led to the leap in ECB lending to the banks from 580.0b. euros on 4th November to 831.7b. euros on 20th January, which was noted earlier. Rather impressively, the chart of these developments on the next page resembles a Grand Canyon. Evidently, although much of the 489b. euros has been drawn, another 100b. – 200b. euros remains available. Until now the peak level of ECB lending to the banks was in mid-2009, when it totalled 896.8b. euros, with the long-term element at 728.6b. euros.
Another tender for the ECB’s long-term refinancing facilities is due towards the end of next month. Market rumours are that it could be as large as – or perhaps even larger than – than in December. From the banks’ viewpoint, this is all a godsend. In late 2011 many banks in the Club Med countries were having to decide which assets to jettison as their inter-bank borrowings came up for renewal. That has now stopped. And what does that mean for the February long-term refinancing operation? The demands for inter-bank refinancing have now abated, which may seem to imply that the banks will want less cash than in December. However, everyone knows that the ECB must – at some figure or another – impose a limit on its lending to banks. Because the banks know that a limit will be introduced sooner or later, they are likely to bid for as much long-term central bank cash as possible at the next long-term refinancing operation. (The banks do not feel that any stigma attaches to using a central bank loan to finance their assets, if over 500 banks have already taken part in the exercise. Meanwhile, with an interest rate of 1%, this is very cheap money. Sure, the loans must be collateralized, but the rules on collateral are to be even easier in the February LTRO than in the December LTRO.)
Is it plausible to suggest that – at least in scenario planning – analysts must think in terms of 500b. – 1,000b. euro of loan applications at the February LTRO? By extension, that might take eventual figure for ECB lending to banks up to over 1,500b. euros in late 2012. If that happens, the Draghi bazooka will have a special, although very controversial place in the development of the single currency. With Italian and Spanish government bond yields dropping to more reasonable levels already, and the technocrats in charge of Italian public finances and a conservative government in Spain, there has to be a chance that the Eurozone will reach 2013 with much the same membership as at present (apart, presumably, from Greece).
But what will be the macroeconomic results of this approximate trebling of ECB lending to the banks in less than a year? What – to begin the discussion – will be the effects on the M3, broadly-defined measure of money?
Effects of the Draghi bazooka: why – in general terms – does it matter?
As I said at the start, the Maastricht Treaty forbids direct government borrowing on overdraft from the central bank. Why, more precisely, is massive government borrowing from the central bank so bad? The effect is to cause simultaneous expansion of both the central bank’s assets and liabilities. Since the central bank issues legal tender, the liabilities are cash in the hands of non-banks and so-called “cash reserves” if owned by commercial banks. Cash held by non-banks is plainly money. Further, according to a familiar textbook account, banks maintain relatively stable ratios of their cash reserves (which traditionally did not pay interest and were a non-earning asset) and their earning assets. (The inverse of this ratio is the so-called “money multiplier”.) The stability of the ratio between banks’ cash reserves and their other assets implies that, if their cash reserves rise by x %, then their total assets and liabilities, including their deposit liabilities, must rise by x % as well. Since deposits can be converted into cash and so also used to make payments, bank deposits are money. In short, massive government borrowing from the central bank is likely to be followed by rapid expansion of the quantity of money as a whole (i.e., notes in non-bank hands, plus bank deposits) and hence by inflation.
The last paragraph is standard monetary economics. However, two major caveats need to be entered. First, although rapid growth of the note issue and banks’ cash reserves (i.e., the so-called “monetary base”) may result in similarly rapid growth of the quantity of money, it is changes in the quantity of money that have powerful macroeconomic effects, not changes in the monetary base by themselves. Secondly, while it is true that the ratio between banks’ cash reserves and their deposit liabilities is stable in normal periods, during crises banks’ propensity to hold cash (relative to assets, etc.) may change. In the Great Depression of the early 1930s – and again in the last few years – banks’ cash reserves were much higher relative to their assets and liabilities than in the preceding periods of relative macroeconomic stability. It is not certain that an injection of extra cash reserves into the banking system will be followed by rapid growth in banks’ overall balance sheets.
These two caveats have been of great importance in the last few years. The Stark analysis in late 2009 – that the non-standard measures were risking high inflation two/three years later – has been discredited by the fall in inflation that is now under way. (If Stark has paid more attention to broad money, and less attention to the base and M1, he would not have been so badly wrong.) Meanwhile the coexistence of sharply rising cash reserves at the banks and more or less static bank balance sheets (in terms of size) has dented the plausibility of the claim that any expansion of the central bank balance sheet is inflationary. In intellectual terms, the Draghi bazooka has been relatively immune to criticism because standard elements in the Bundesbank theory of central banking have not been convincing in the Great Recession. The Draghi bazooka is the kind of trick that central banks in Mediterranean countries perform. Almost certainly, the Bundesbank is shocked and concerned. It is well-known that a ban on government overdraft borrowing from the central bank can be circumvented by large-scale central bank purchases of government securities in the secondary market (as in May 2010, at the behest of Trichet, Sarkozy and Straus-Kahn, against the opposition of Mrs. Merkel) and/or by central bank lending to banks which then purchase newly-issued government debt (which of course is the Draghi bazooka). However, the Bundesbank is probably dismayed that – by adopting both of these two expedients since May 2010 – the ECB has broken the spirit of the Maastricht Treaty on such an extensive scale.
The Draghi bazooka and the quantity of money
A loan from the central bank to a commercial bank does not in the first instance increase the quantity of money. The quantity of money consists of monetary assets exclusively in the hands of non-banks and nowadays is dominated by bank deposits. A loan from the central bank to a commercial bank is between two banking system agents (i.e., the central bank and the commercial bank concerned) and, to repeat, does not have a first-round effect on the quantity of money. However, the second- and third- round, and subsequent, effects on M3 of the kind of lending on which the ECB has now embarked could be radical.
First, the immediate justification for the Draghi bazooka is that the inter-bank market had again closed on a large number of Eurozone banks. Because inter-bank lines were not being rolled over as they came up for renewal, banks were putting pressure on their non-bank debtors (i.e., the households and companies borrowing from the banks) to repay their loans. A loan repayment destroys money, because an existing deposit is used to pay back the bank loan. Both the bank deposit (which is money) and the loan are cancelled, and disappear from the economy. So the Draghi bazooka has stopped extensive destruction of money that would otherwise have occurred. (The same argument holds if banks’ assets are reduced by the sale of securities rather than the repayment of loans. But there is the complication that the outcome depends on whether the sale is to another bank or to a non-bank. Only if the sale is to a non-bank, where the non-bank pays for the securities by running down its deposit, does the money destruction take place.)
Secondly, if the ECB’s total lending to banks exceeds 1,500b. euros in late 2012 (as I argued above is implied by recent announcements), a very large increase in banks’ cash reserves with the ECB is almost inevitable on the other side of the ECB balance sheet. Some banks may have been short of cash in the last two or three years, because they have been net borrowers from the inter-bank market. They have suffered continuous strain dealing with inter-bank loan repayments when they become due. Their plight may have made bank managements more cautious, even the managements of banks with a net credit position on other banks. But – because of the ECB’s evident willingness to help the system – it is plausible than by mid- or late 2012 – the inter-bank funding strains will be much eased. Indeed, some banks may have considerable excess cash in their balance sheets. (If the ECB could stop paying interest to the banks on their cash reserves, this effect would be reinforced.)
Thirdly, to the extent that banks respond to the excess cash in their balance sheets by lending more to non-bank customers, new money is created in the usual fashion. Banks credit loan proceeds to a new deposit held by a non-bank and mark the new loan facility on the assets side of the balance sheet. The extent to which the process of money creation restarts in mid- or late 2012 is to some extent conjecture, not least because Eurozone banks are in general less well-capitalized than their American or British counterparts. (Remember that bank balance-sheet expansion is subject to both cash and capital constraints.) Nevertheless, it deserves to be emphasized that in some Eurozone member states M3 has been growing satisfactorily for several quarters. The chart on the previous page – showing the dramatic contrast in money growth trends in Germany and Greece – demonstrates the point rather nicely. It is also interesting that German and French regulatory authorities have begun to ask that the Basle III capital rules not be applied too rigorously.
The Draghi bazooka could lead to 5%+ annualised growth of Eurozone M3 in mid- and late 2012
My conclusion is that the Draghi bazooka is such an aggressive example of monetary easing that Eurozone M3 growth will run at an annualised growth of 5% or more in mid- and late 2012. The data need to be watched all the time and I may be wrong. All the same, a 5% plus rate of money growth would be consistent with better asset prices and stronger demand. I remain sceptical about the viability of the European single currency in the long run, not least because the heavy dependence of some commercial banks on ECB support (i.e., to fund their assets) is artificial. But – because the ECB has “printed money” on a big scale (if in rather esoteric way) – the day of the Eurozone’s execution has been postponed once again.