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Buba isn’t mad

18 February 2013 By Hugo Dixon

The Bundesbank isn’t mad. In a world where it is increasingly fashionable to call for central banks to print money, the German central bank is one of the last bastions of orthodoxy. Although its stance is extreme, it is a useful antidote to the theory that easy money is a cost-free cure to economic ills.

The Bundesbank is hostile to anything that smacks of monetary financing – printing money to finance governments’ deficits. It is worried that central bank independence is getting chipped away as recession drags on in much of the developed world; it thinks that the European Central Bank shouldn’t respond to the recent rise in the euro by loosening monetary policy further; it is always concerned about the potential for inflation; and it thinks that spraying cheap money around can allow governments to shirk their responsibilities.

To many people, these attitudes seem old-fashioned. Surely central banks should bend the rules to get the world economy out of its current rut? A few go even further and advocate “overt monetary financing”, as Adair Turner, chairman of the UK’s Financial Services Authority, did in a seminal speech earlier this month. Overt monetary financing involves governments deliberately running fiscal deficits and openly funding them by borrowing from central banks.

Turner made clear that this was a policy that should be reserved for the most intractable deflationary recessions – where monetary policy can’t work (because businesses and households are already so clogged up with debt that they don’t want to borrow) and fiscal policy can’t do the trick either (because governments are over-indebted too). While he advocated the medicine for Japan, he was wary about giving it to the United States, Britain or the euro zone.

The ECB, it should be added, is not engaging in overt monetary financing. That’s forbidden under the Maastricht Treaty. But it is arguably engaging in the covert variety. This is the source of most of the friction between Mario Draghi, president of the ECB, and Jens Weidmann, the Bundesbank boss – both of whom are based in Frankfurt, where I spent part of last week.

The biggest clash was over Draghi’s promise last year to buy potentially unlimited amounts of government bonds from peripheral euro zone countries. Weidmann unsuccessfully opposed the plan. Draghi was right. If he hadn’t pledged to do “whatever it takes” to save the euro, the single currency might well have collapsed. That said, all such operations have a cost. Draghi’s drug may have taken some of the pressure off governments to make their economies more competitive.

 Weidmann and Draghi clashed again this month over Ireland’s “bailout” by its central bank. The extremely complex transaction involved the Irish central bank receiving 25 billion euros of extremely long-dated Irish government bonds after IBRC, a bust nationalised bank was liquidated. Dublin did not itself have the cash to fill the hole in IBRC’s balance sheet. It has effectively borrowed the money – equivalent to 15 percent of GDP – cheaply from its central bank.

Weidmann would have preferred the euro zone governments to lend Dublin the money via their bailout fund, the European Stability Mechanism (ESM). But the other governments weren’t rushing to provide the cash and Dublin wasn’t keen either, as the interest rate would have been higher than issuing bonds to its central bank.

Although the Irish bailout was a deal between Dublin and its central bank, the ECB could have blocked it. But to do so, two-thirds of its governing council would have had to vote against the operation – and Weidmann didn’t have enough support.

Draghi, meanwhile, didn’t actually back the deal. He merely “noted” it. The ECB concluded that the new arrangements for supporting IBRC were preferable to the previous scheme – which many observers also thought amounted to monetary financing.

As with Draghi’s bond-purchasing promise, the impact has been hugely positive. Irish 10-year government bond yields are now only 3.7 percent. Investors now view the country as on the road to recovery.

But the Bundesbank is, understandably, worried about precedents. The next time a bank gets into trouble in the euro zone, what is to stop a government from bailing it out the Irish way – by getting its central bank or the ECB itself to print the necessary money?

The pressure to engage in such monetary financing may be particularly strong given that the ECB is about to take over responsibility for supervising lenders. That means that, if and when there are future banking blow-ups, the ECB will be criticised for having failed to monitor them properly and could then be browbeaten to prop them up. The Irish, Spanish and Dutch central banks have all been lambasted for alleged lapses in supervision during the crisis – as, indeed, has Draghi himself following the recent troubles at Italy’s Monte dei Paschi.

A further difficulty is that the euro zone doesn’t yet have a fund for bailing out banks. The nearest thing it has is the ESM, whose decisions require unanimity. Just one government can veto a bailout. This means that, if there is a stand-off between the ECB and governments over who should prop up an ailing bank, the ECB may blink first.

Covert monetary financing may sometimes be the least of several evils. But if it becomes too common and transparent, there is a risk of debauching the currency. The Bundesbank’s constant warnings are a healthy counterpoint to that temptation.


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