Is the ECB Really Powerless? (Part III)

Michael Stephens | November 18, 2011

(Update added below)

In our last post on this topic, we found the head of the Bundesbank citing legal obstacles (Article 123 of the EU treaty) as the reason why the European Central Bank cannot step up as lender of last resort.  Can the ECB work around that Article 123 restriction?

In the last couple of days we’ve seen reports of a new, convoluted approach in which the ECB would lend to the IMF, which would in turn directly buy member-state debt.  Marshall Auerback noted another possible workaround, via a mechanism the ECB has already used (though not to the extent that would be necessary):  the ECB can get around the prohibition on buying member-country debt in the primary market by doing so through the secondary market.  (On the ECB buying bonds in the secondary market, Brad Plumer of the Washington Post has a nice quote from Richard Portes of the London Business School:  “If that’s illegal, then officials should already be in jail.  Because they’ve been doing it sporadically since May of 2010.”)

At Modeled Behavior, Karl Smith questions whether this would really work.  He points out that while the ECB has conducted limited buying of this sort in the secondary market, what would be required for the ECB to act as lender of last resort would be unlimited buying.  Smith then runs down the legal obstacles to unlimited ECB operations, citing two provisions that could stand in the way of this secondary market solution:

The first provision says that the ECB cannot target a price for Italian Debt on the secondary market.

The second provision says that ECB cannot guarantee that newly issued Italian debt will stand as collateral under repurchase agreements.

If the ECB were able to do either of the above things then it could provide guaranteed liquidity to the holders of Italian debt and cause the yield to collapse towards the overnight rate.

Smith ends by offering a couple of alternative routes, but in many ways, this may all be beside the point.  If you read between the lines in interviews given by people like Jens Weidmann, what comes through is not simply an expression of regret regarding the obstacles to a lender of last resort function, but something more like an endorsement of the value of these Article 123-type restrictions.  The barriers, in other words, seem to be more a matter of ideology and politics.

Update:  Ramanan adds some serious value to this discussion in comments (go take a look), including a link to a 2006 paper by Wynne Godley and Marc Lavoie in which they consider this very issue of working around the rules prohibiting the ECB from directly financing member-state Treasuries.  From the paper (emphasis mine):

… this would seem to be a very peculiar arrangement, which would prevent the Eurosystem from financing the fiscal deficits of euro governments. But very similar rules apply in the USA. As noted by a Vice-President of the Federal Reserve Bank of New York, Michael Akhtar…, ‘the Federal Reserve is prohibited by law from adding to its net position by direct purchases of securities from the Treasury that is, the Federal Reserve has no authority for direct lending to the Treasury. As a consequence, at most the Desk’s acquisition at Treasury auctions can equal maturing holdings’. But nobody has ever argued that it was impossible for the US Treasury to have its central bank finance part of its deficit through purchases of federal securities on the open market. In other words, the deficit is indirectly financed by the Fed, just as euro government deficits can be financed indirectly through the Eurosystem. This is currently most easily done through the repo market.


2 Responses to “Is the ECB Really Powerless? (Part III)”

RSS feed for comments on this post. TrackBack URL

  1. Comment by Ramanan — November 19, 2011 at 4:48 am   Reply

    Interesting discussion by Smith.

    I believe he has slightly misinterpreted the line “There shall thus be no pre-issuance advice”.

    I will try to prove this by an example. Suppose a bank is doing securitization of residential mortgages and is in the process of creating a capital structure. The bank cannot ask the Eurosystem which capital structure will be the best and whether tranche A will qualify as collateral. It has to ask the rating agencies. Only after the deal is closed, can the Eurosystem decide whether to include the deal in the list of eligible assets.

    So I do not see issues with the line “There shall thus be no pre-issuance advice” as far as government debt is concerned.

  2. Comment by Ramanan — November 19, 2011 at 4:50 am   Reply

    Godley and Lavoie had models for the Euro Area with sectors such governments, Eurosystem, households etc. in

    “A Simple Model Of Three Economies With Two Currencies”
    Cambridge Journal of Economics, 2006.

    In one of the models they had the Eurosystem setting the rate on government bonds of two Euro Area governments and they also talk of legal hurdles and conclude that their model is consistent with the “Article 21.1 of the Statute of the
    European System of Central Banks and of the European Central Bank”.

    Amazing what they touched on in 2005/06 is under discussion in public debates right now!

Leave a Reply