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The initials LTRO, barely ever discussed prior to last December, now form the most revered acronym in the financial markets. Before the first of the ECB’s two Longer Term Refinancing Operations in December, global equity markets lived in fear of widespread bankruptcies in the eurozone financial sector. Since LTRO I was completed on December 21, equities have not only become far less volatile, but have also risen by 11 per cent.
With LTRO II completed last week, over â?¬1tn of liquidity has been injected into the eurozone’s financial system. Private banks were permitted to bid for any amount of liquidity they wanted, the collateral required was defined in the most liberal possible way, and the loans will not fall due for three years. Any bank that might need funds before 2015 should have participated to the hilt, thus eliminating bankruptcy risk fora long time time to come.
What can there possibly be not to like about this? A few things. Some observers point to the danger of a zombie banking system, kept alive artificially as a wing of the central bank. And, in a much-publicised “private” letter to Mario Draghi in February, Jens Weidmann, Bundesbank president, expressed concerns that the latest two LTROs will expose the ECB to potential losses which will undermine its capital base.
Of course, this can only happen in dire circumstances, under which banks borrowing from the ECB or the national central banks go bust, and the collateral held by central banks proves insufficient to cover the associated debts. Even in the case of Greece, this has not yet happened, because the ECB has been fully protected from losses on Greek government bonds up to now. But it is fairly easy to imagine that it could happen, especially if there were a generalised collapse in the euro, involving sovereign defaults in several of the indebted economies at the same time.
It is now widely recognised that a central bank cannot become insolvent in the same way that a private company can. Even if it incurs losses on its assets which more than completely eliminate its equity, it can never find itself in a position where it is unable to settle its debts, at least in its own domestic currency. Most of the liabilities of a central bank come in one of two forms: banknotes, and commercial banks’ deposits at the central bank. It is impossible for the private sector to force the central bank to exchange these assets for any other asset (like gold, for instance), and in any event the central bank can create more of each of them at will. Hence it can never become illiquid.
Admittedly, a central bank can encounter a negative equity (ie insolvent) position by taking write-downs on its assets, and it cannot eliminate this simply by creating central bank money. This is because printing money increases its liabilities as well as its assets, thus leaving net capital unchanged. But over time it would expect the interest earned on its assets (eg government bonds) to be much higher than that paid on its liabilities (eg banknotes), so an increase in the size of the balance sheet would normally be expected to generate extra profits for the central bank. It could take some time, but these profits, which are called seigniorage, will in the long run compensate for any losses made by the ECB on its LTROs.
So why worry? One reason is that the ECB’s future seigniorage revenue should be seen as an asset of the governments of the member states. Therefore if it is used up in LTRO losses, the long-term income of the member states from the ECB will be reduced, and in effect their net government debt will be increased.
Seigniorage revenue is an asset of the governments, like future tax revenues. A decision to put the future seigniorage revenue at risk is in fact exactly equivalent to putting at risk future tax revenues by making inter-government loans which might incur subsequent defaults. Jens Weidmann is correct to point this out, though Mrs Merkel seems to be much more favourably disposed to these heavily disguised, quasi fiscal transfers than he is.
The second reason to be concerned is the potential risk to inflation. There is a long run safety limit to seigniorage, which is determined by the amount of central bank money which the private sector will be willing to hold if inflation remains at its 2 per cent target. Recent estimates by Willem Buiter at Citigroup and Huw Pill at Goldman Sachs both suggest that the net present value of this asset is over â?¬2tn, many times bigger than the official capital reserves of the ECB of only â?¬80bn.
These calculations have led many economists to conclude that the ECB could lose more than E2tn on its LTRO and other lending operations before it risks creating inflation through excessive creation of central bank money. Since this would imply a much greater loss than anything that appears likely at present, the LTRO operations have been widely deemed to be “non inflationary”.
This conclusion is not axiomatically true. If the central bank brings forward its future seigniorage revenue by creating a lot of money now, it seems clear that it could cause inflation to rise in the short term while still remaining well within its long-term E2tn limit for central bank money creation. This is analogous to a situation in which the government creates inflation by running a large budget deficit in the short term, while remaining solvent in the long term.
I am not saying that the ECB has already done this. It has not. But I am saying that it must be careful not to do this in the future. The LTROs were the right thing to do in the difficult circumstances of the time, but they are not a free lunch.
Gavyn Davies is a macroeconomist who is now chairman of Fulcrum Asset Management and co-founder of Prisma Capital Partners. He was the head of the global economics department at Goldman Sachs from 1987-2001, and was chairman of the BBC from 2001-2004. He has also served as an economic policy adviser in No 10 Downing Street, an external adviser to the British Treasury, and as a visiting professor at the London School of Economics. Gavyn Davies is an active investor and may have financial interests and holdings in any of the topics about which he writes. The views expressed are solely those of Mr Davies and in no way reflect the views of Prisma Capital Partners LP, Fulcrum Asset Management LLP, their respective affiliates or representatives. This material is not intended to provide, and should not be relied upon for, investment advice or recommendations. Readers are urged to seek professional advice before making any investments. To comment, please register for free with FT.com and read our policy on submitting comments. All posts are published in UK time. See the full list of FT blogs. FT.com latest global economy newsCreditor group to take part in Greek swapCommission to push quota for women directorsChina's Wen warns of slower growthHollande demands change to fiscal treatyIrish business to back Yes in treaty voteMost popular posts ECB liquidity is not a free lunch The metamorphosis of Ben Bernanke Boosting growth without raising budget deficits Thinking the unthinkable on a euro break-up The ECB and Target2 imbalances The most important graph of the year A global experiment in the fiscal/monetary mix Mario Draghi’s historic choice Eurozone’s reluctant take-over bid for Greece UK GDP figures too bad to be true Blogroll Abnormal Returns Baseline Scenario Brad DeLong: Grasping Reality with Both Hands Fed Paper Greg Mankiw’s blog Martin Wolf’s Exchange Naked Capitalism Paul Krugman: Conscience of a Liberal Peterson Institute for International Economics Roubini Global Economics Vox Categories Asia Banks Central Banks China Currencies Emerging markets Eurozone Germany Global economy IMF japan Macroeconomics Middle East Monetary policy Oil Recession Regulation Sovereign debt Sport UK US In the news.utcw-tag-link{background-color: !important;border-style:none !important;border-width:0px !important;}.utcw-tag-link:hover{background-color: !important;border-style:none !important;border-width:0px !important;}Angela Merkel Bank of England Ben Bernanke bond yields budget deficit Bundesbank central banks Commodities ECB Ed Balls EFSF europe European Central Bank Fed Federal Reserve FOMC GDP George Osborne Germany Greece Harry Truman IMF Inflation Italy jobs liquidity trap mortgages negative equity Nicolas Sarkozy oil Operation Twist QE QE2 QE3 Reinhart Rogoff Rudesbusch single currency sovereign debt spending Stability and Growth Pact Taylor Rule The Fed us US economy clientAds.fetch(AD_MPU); clientAds.render(AD_MPU); Archive « FebMarch 2012 M T W T F S S 1234 567891011 12131415161718 19202122232425 262728293031 function show_micro_ajax(response){document.getElementById('wp-calendar').innerHTML=response;} function microAjax(url,cF){this.bF=function(caller,object){return function(){return caller.apply(object,new Array(object));}}; this.sC=function(object){if(this.r.readyState==4){this.cF(this.r.responseText);}}; this.gR=function(){if(window.ActiveXObject) return new ActiveXObject('Microsoft.XMLHTTP');else if(window.XMLHttpRequest) return new XMLHttpRequest();else return false;}; if(arguments[2])this.pb=arguments[2];else this.pb="";this.cF=cF;this.url=url;this.r=this.gR();if(this.r){this.r.onreadystatechange=this.bF(this.sC,this);if(this.pb!=""){this.r.open("POST",url,true);this.r.setRequestHeader('Content-type','application/x-www-form-urlencoded');this.r.setRequestHeader('Connection','close');}else{this.r.open("GET",url,true);} this.r.send(this.pb);}} Elsewhere on ft.com Money Supply
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