The ECB and the Eurozone debt crisis

ABSTRACT: This paper examines the ECB‟s policies since 2008 to argue that the Eurozone

crisis is (also) a crisis of central banking. It identifies three turning points in the ECB‟s struggle

to reconcile its allegiance to sound money principles with the consequences of securitized

(shadow) banking, documenting how exit strategies predicated on simplistic models of financial

intermediation contributed to the spread of sovereign debt pressures from Greece. In the absence

of a paradigm shift, institutional change should recognize that central banking can no longer be

conducted without explicit concerns for the importance of sovereign debt in new landscapes of

finance.

1
Introduction

Since 2010, the Eurozone debt crisis triggered a growing scepticism about the future of the

European Union. The role of the European Central Bank (ECB) in this process has been

discussed from two analytical angles. A first set of concerns, broadly structured through the

„sound money‟ doctrine at the basis of the EMU creation (Sadeh and Verdun, 2009), details the

implications of crisis policies, some taken under intense political pressure, for its independence

and credibility (Gerlach, 2010; Featherstone, 2011). A political economy perspective focuses on

the ECB‟s reluctance to endorse plans for private sector involvement in bailouts, attributed to

concerns about European bank exposure to sovereign risk and the associated threats to financial

stability. Both are underpinned by the idea that the ECB can and should return to its pre-crisis

model of conducting monetary policy, if appended with an improved (macro) regulatory

framework, a position strongly emphasized by the institution itself (Trichet, 2010; ECB, 2010;

Bini Smaghi, 2011). Indeed, since Lehman Brothers‟ collapse in September 2008 pushed the

ECB into unchartered territories, its rhetorical efforts were ostensibly preoccupied with a return

to the original central banking framework, captured through the Separation Principle. The

principle „relates to the dichotomy between the ECB’s monetary policy and its liquidity policy or,

in other words, between the formulation and implementation of monetary policy’ (Gonzales-

Paramo, 2008). In other words, central bank interventions in financial markets occur solely to

enforce interest rate decisions informed by economic analysis and technocratic judgment.

In this account, the key to strengthening the post-crisis EMU governance framework lies

in strengthening the fiscal arm, either through improved mechanisms for disciplining national

governments, or, in more optimistic accounts, through rapid steps towards political union

(Trichet, 2011). However, such a narrowing of the argumentative terrain crucially pushes in the

2
background what the crisis revealed to be the key weakness of ECB‟s underlying model of

central banking: the analytical neglect of structural changes in financial markets (Blanchard et al,

2010; Caballero 2010).

Yet new financial landscapes of finance, particularly the rise of collateralized lending, are

crucial to understanding how the ECB‟s efforts to reinstate „sound money‟ principles of

conducting monetary policy have mapped onto the European debt drama. The European crisis is

also a crisis of central banking because the theoretical framework underpinning the ECB‟s

institutional design promotes a separation of the domains of macroeconomic governance that

cannot be sustained in increasingly complex financial markets. If the Eurozone governance

framework is to be improved, the dominant paradigm of central banking has to abandon its

simplistic account of financial intermediation that predicates the conduct of monetary policy on

the efficient market hypothesis.

The paper is structured as follows. It first maps the ECB‟s narrative of crisis interventions

in light of changing modes of financial intermediation, alternatively described as impatient

finance that increasingly replaces the traditional long-term financing of productive activities with

short-term market activities (Crotty, 2003; Gabor, 2010), the financialization of banking activity

prompting banks to replace credit portfolios with market portfolios (Hardie and Howarth, 2009)

or the rise of shadow banking (Pozsar et al, 2010). It then offers a re-reading of the ECB‟s policy

repertoire, arguing that phasing-out strategies played an important role in the spread of sovereign

debt pressures from Greece. It shows how, at three turning points throughout the crisis, the ECB

struggled to reconcile its allegiance to „sound money‟ principles and the institutional primacy

these assign it in the European governance framework with the complex interplay between

European finance and sovereign debt dynamics. It lastly addresses the question formulated by

3
(Enderlein and Verdun, 2009) - under which conditions can EMU cope with a financial crisis in

the absence of a political union, since the ECB‟s trajectory throughout the crisis suggests that

strategic learning rather than paradigm change will inform institutional change. Without

downplaying the importance of reconsidering the relationship between the ECB and

decentralized fiscal decisions, the paper argues that the relationship between central banks and

financial markets merit similar attention in discussions of institutional re-design.

The ECB’s narrative of policy interventions

„The ECB’s actions since the onset of the financial crisis have been bold, and yet firmly

anchored within the medium-term framework of our monetary policy strategy.’ (Trichet, 2009)

Before the crisis, the ECB‟s success in achieving price stability was typically interpreted as

testimony to the effectiveness of its underlying principles of central banking (Cecchetti and

Schoenholtz, 2008). Thus „output legitimacy‟ compensated for the „democratic deficit‟

(Enderlein and Verdun, 2009) and also muted early concerns that Eurozone‟s governance

framework, built on the separation of fiscal and monetary policies, would prevent an effective

coordination during crisis (Buiter 1999; Dyson and Featherstone, 1999; Verdun, 2000).

Throughout the first stages of the crisis, similar to other central banks in high income

countries, the ECB addressed the unprecedented liquidity problems across a broad spectrum of

financial institutions by extending the volume and average maturity of its liquidity provision

(ECB, 2010a). To reaffirm its commitment to the Separation principle, ti raised policy rates in

July 2008 in response to forecasted inflationary pressures (Trichet, 2010).

4
 With Lehman Brothers‟ collapse in September 2008, worsened perceptions of

counterparty risk saw frozen credit markets (Hoerdahl and King, 2008) and brought an

increasing differentiation of central bank responses (see Figure 1). Alongside rapid cuts in policy

interest rates, counterparties in systemically important financial systems introduced outright

interventions in private asset markets. Credit easing measures sought to improve credit

conditions in impaired market segments by changing the composition of the central bank‟s

balance sheet (Bini Smaghi, 2009) through the replacement of illiquid assets with short-term,

risk-free reserves (Gagnon et al. 2010). In contrast, the ECB explained that distinct institutional

features warranted a focus on bank refinancing to reflect the bank-based nature of the European

financial system (Trichet, 2010; ECB, 2010). It announced that Enhanced Credit Support would

provide unlimited liquidity through „fixed rate, full allotment‟, at longer maturities (up to six

months), extended participation (from 140 to around 2200 eligible counterparts) and eased

collateral requirements (accepting a broader range of private assets). Since these measures

allowed banks to exchange a broader range of (illiquid private) assets on their balance sheet for

longer-term (three and six months) central bank liquidity, the ECB viewed the effects of its

unconventional measures to be similar to the credit easing adopted elsewhere (Trichet, 2009).

5
Figure 1 Timeline of unconventional policy measures

Sept. 2008
Lehman Brothers January 2010 May 2011
US Fed, BofE, BofC, BofJ Onset of European US Fed
Credit easing sovereign debt crisis End of QE2
(purchase of private assets) (Greece)

Oct. 2009 November 2010

March 2009
US Fed
US Fed, BofE US Fed Second QE round
Feb. 2010
Quantitative easing QE completed
(purchase of sovereign assets) BofE IRELAND bailout April 2011
QE completed
PORTUGAL
bailout

Jul Jan Jan Jan

2008 Sept Nov 2009 Mar May Jul Sept Nov 2010 Mar May Jul Sept Nov 2011 Mar May

GREECE bailout
ECB ECB
ECB
Covered bonds ‘Addicted to liquidity’
Securities Market
ECB program
program
Enhanced credit support Sept. 2010
July 2009 (Credit easing)
(Bank refinancing vs. market
interventions) May 2010 ECB
ECB Interest rate rise
October 2008 ECB Phasing out (Separation Principle)
ECB Initiation phasing out 6m and 1y LTRO
LTRO European Financial SMP Suspended
Announcement CBPP
1year LTRO Dec. 2009 Stability Facility European Stability
June 2010 Mechanism
May 2009
March 2011

By March 2009, the extraordinary decision by the Federal Reserve and Bank of England to

initiate a programme of quantitative easing (outright purchase of government bonds that expands

the central bank balance sheet) raised an uncomfortable dilemma. To explain why the ECB

resisted similar measures, Trichet (2009) invoked pragmatism, principles and exit strategies. The

ECB‟s operational framework involved collateralized short-term loans to commercial banks, in

contrast to other central banks that routinely sold/purchased sovereign debt to implement

monetary policy. Enhanced credit support was thus a natural extension of the pre-crisis

operational framework. Furthermore, outright purchases would blur the separation of

6
responsibilities at the core of EMU‟s design whereas decisions to reverse bond purchases would

involve politically controversial effects on member state‟s sovereign markets.

Soon after, the ECB changed course. In May 2009 it announced two distinct measures

destined to improve European banks‟ funding conditions. First, it committed to provide

unlimited one-year liquidity through three full-allotment operations (ECB, 2010a). Second, it

detailed plans to purchase EUR 60bn of covered bonds - debt securities issued by banks and

covered by a pool of assets, typically mortgages and public sector loans - from July 2009. The

ECB identified several reasons for changing its mind about market interventions: the covered

bond market, heavily impaired by the post Lehman deleveraging, offered an important, cross-

border source of long-term funding for European banks, it carried less risks since banks kept

these instruments on balance sheet while easing financing conditions for both banks and the pool

asset markets (Beirne et al. 2011).

Four months later, the ECB interpreted improved conditions in money markets and the

covered bond market as evidence that its extraordinary liquidity measures had improved

financing conditions for Eurozone banks. By December 2009, it announced its plan to unwind

emergency liquidity measures (Trichet, 2010), despite warnings that some banks, particularly

Greek and Irish, had virtually no access to market funding (Maccario, 2009).

Although these warnings materialized throughout the first months of 2010, the ECB

ostensibly maintained commitment to exit strategies. As Greece‟s fiscal deficit scandal saw

increasing market concerns about its ability to service its debt, its response was consistent with

Ecofin‟s: that Greece alone was responsible for finding a solution (Featherstone, 2011). Indeed,

bailout negotiations unfolded during April 2010 without envisaging a direct role for the ECB.

Then, after intense political pressures, on May 3 the ECB relaxed collateral constraints to accept

7
downgraded Greek sovereign (guaranteed) debt, under the proviso that a European political

solution had to cement the credibility of the fiscal consolidation plan. A week later, it went

further. It introduced the Securities Market Programme (SMP), committing to purchase

Eurozone government bonds (in the secondary market). It also announced the restart of its long-

term refinancing operations.

In contrast to other central banks, the ECB offered no quantitative measures of its

intended bond purchases. This reluctance was explained by different guiding principles: rather

than easing financing conditions for governments, the ECB‟s bond purchases would be

conducted to stabilize market segments crucial to the transmission of monetary policy signals

(ECB, 2010a). The SMP portrayal as a temporary strategy to correct dysfunctional markets was

not only intended to reaffirm the commitment to price stability, but also, crucially, to the policy

framework deployed to achieve it. The ECB stressed its determination to defend its credibility

on inflation control (responding to mainly German concerns) by reabsorbing the additional

liquidity through sterilizations. It welcomed the establishment of the European Financial

Stability Fund (EFSF) in June 2010, a bailout fund set to raise market funding in order to provide

emergency support to crisis-ridden Member States without mandate to purchase government

debt.

The ECB viewed the EFSF as a mechanism that would allow it to return to its

conventional operational framework. Indeed, by September 2010, ECB officials expressed

concerns that some Eurozone banks had become addicted to its liquidity support and warned that

it was preparing to take action where governments failed to address the problem (Financial

Times, 2010). A first step in that direction was to phase out enhanced credit support by

suspending six month and one year liquidity operations. From that point onwards, the ECB‟s

8
defined its policy problem strictly through the consequences of „addicted banks‟ for its exit

strategy.

The consequences were immediately apparent during Ireland‟s mounting bond market

pressures in early November 2010. The ECB confirmed its reluctance to extend further liquidity

support to ailing banks1, instead urging individual governments, if necessary through the EFSF

facility, to support their banking systems. A week later (November 22nd), after intense denials,

Ireland formally initiated bailout procedures. Although the Irish government initially sought to

involve senior bondholders, it eventually accepted ECB‟s arguments that write downs might

worsen financial market nervousness. A similar sequence of events resulted in a Portuguese

bailout in April 2011, a few weeks after responsibility for Eurozone crisis management was

institutionalized in the European Stability Mechanism (ESM), envisaged to replace the EFSF in

2013.

The ECB expressed concerns towards the ESM‟ failure to establish a set of firm rules to

bound member states to fiscal responsibility2 (Financial Times, 2011). In response, it stepped up

its exit measures. During March 2011, it invoked inflationary pressures to raise policy interest

rates and (informally) suspended SMP bond purchases despite pressures in the Portuguese bond

market. By May 2011, it had on its balance sheet around Euro 76 bn of sovereign debt, less than

10% of its assets and far lower as a proportion than the US Fed or Bank of England (Gagnon et

al, 2010). Its resolve to stay out of sovereign bond markets continued even as increasingly

apocalyptic scenarios accompanied the discussions of a second Greek bailout throughout June

1
At that time, Irish banks had accumulated around EUR 130 bn emergency liquidity loans from the ECB, around a
quarter of the overall crisis liquidity support.
2
„a union with centralized monetary policy but decentralized economic policies needs appropriate mechanisms to
balance the independence of the countries and their economic interdependence... Either we prove that we are able
to find the new, strong, reinforced governance concept that will fit with a constellation of sovereign states [….] or
[..] to take a new leap in the European institutional framework towards a political federation’.

9
2011 and then Italian sovereign bond market pressures in July 2011. Through this, the ECB

reinforced the dominant narrative of the European debt crisis: fiscal misbehaviour of individual

governments rather than a systemic consequence of the macroeconomic governance framework

(De Grauwe, 2011).

Even if the ECB‟s insistence on returning to the pre-crisis institutional set-up can be

understood through what Enderlein and Verdun (2009) described as the importance of

predictability of its actions, it glosses over the controversial role played by the underlying

theoretical framework in the great financial crisis. Indeed, Lehman‟s bankruptcy prompted

proponents to recognize that the failure to theorize financial intermediation led central banks to a

dangerous neglect of financial innovation (Blanchard et al, 2010; Caballero, 2010).

Central banking and financial intermediation

At the heart of the ECB‟s policy narrative lays a specific theoretical understanding of the role of

the central bank in macroeconomic management. Indeed, ECB‟s two pillar strategy combines

two analytical perspectives, both governed by „sound money‟ principles (see Sadeh and Verdun,

2009 for an overview). The long-term, monetary pillar stresses the importance of the long-term

relationship between money (aggregates) and prices. In policy practice, this involves monitoring

monetary aggregates with the purpose of cross-checking the effectiveness of the economic pillar

that guides the day-to-day formulation and implementation of monetary policy. The economic

pillar is firmly embedded in a one instrument (policy interest rate) – one objective (price

stability) New Keynesian framework (Arestis and Sawyer, 2008) according to the following

principles:

a) Economic stability best achieved through price stability, which can and must be pursued

10
through the central bank‟s influence over aggregate demand: changes in central banks‟ interest

rate bring the economy back to its potential and inflation to target (set at 2% for Eurozone).

b) A clear hierarchy of policy authority at the heart of what Verdun (1996) termed the

„asymmetrical construction of EMU‟ where supranational money functions without

supranational fiscal policies, a marked departure from the traditional origins of central banks,

historically constituted as agents of government debt. In this account, „scientific‟ monetary

policy is informed by sophisticated models of dynamic individual behaviour whereas the

„alchemy‟ of theoretically weak, inevitably politicised fiscal decisions (Leeper, 2010) is

compounded by ineffectiveness: rational agents recognise future tax burdens/interest rate

increases created by fiscal activism and reduce current demand accordingly (the Ricardian

equivalence). The policy problem in fiscal terms involved the design of fiscal rules consistent

with debt sustainability that discouraged discretionary policies while allowing for automatic

stabilizers to smooth (some of) the negative effects of business cycles (Blanchard et al, 2010).

This analytical position has been typically deployed to reconcile the claim that monetary

policy has no distributive consequences, since it allows markets to allocate resources in line with

price signals, with the pervasive concerns in the EMU literature that asymmetries in business

cycles could potentially engender distributional consequences through the real interest rate

channel (Enderlein, 2006). Since the one instrument-one target framework tailors decisions to

aggregate (Euroarea) price developments, individual countries with higher inflation rates would

experience unduly easy monetary conditions, feeding asset bubbles and external imbalances

(current account deficits). To minimize such dangers, the ECB maintained, national fiscal and

wage policies had to be tailored to dampening business cycles (Enderlein and Verdun, 2009).

Before 2008, markets appeared to sanction the effectiveness of this policy hierarchy, so

11
that monetary policy credibility appeared to override the repeated violations of the Stability and

Growth Pact. The 97 instances of excessive deficits before 2008, 60 of which would have

warranted sanctions (EEAG, 2011) had limited impact on sovereign bond markets. Throughout

the first EMU decade, bond markets discarded the credit risk associated with individual

sovereign borrowers, thus preserving the initial convergence attributed to the credibility of the

Euro plan.

c) A one instrument - one market - one target framework, premised on the efficient market

hypothesis. The ECB deployed open market operations to ensure that the unsecured overnight

interbank rate (EONIA) tracks its policy rate, consistent with the Separation Principle (ECB,

2010a). The focus of market interventions on the unsecured interbank segment crucially rests on

the assumption that efficient financial markets link all interest rates and asset prices through

arbitrage (Blanchard et al. 2010). What matters is the interest rate path: if a central bank can

anchor expectations of current and future short-term interest rates through both market

interventions and signalling (hence the emphasis on predictability and credibility), it will be able

to influence the entire yield curve (see Figure 2). Asset prices and interest rates thus move to

mirror policy intentions towards consumption, investment, aggregate demand and price stability

(the transmission mechanism).

12
Figure 2 Central bank and financial markets: normal times

(European) Central Bank

Second
pillar
Interbank (monetary Corporate
money market aggregates) bonds
Sovereign
Covered
(unsecured) bonds debt
Private
asset
ABS
MBS markets

Repo Commercial
markets paper

Price stability

Under these assumptions, „the details of financial intermediation are largely irrelevant‟

(Blanchard et al, 2010:4), except for banks. The recognition of banks‟ special role gave rise to

theoretical discussions about the „bank lending channel‟ (Kashyap and Stein, 2000), but had little

impact in policy practice (Blanchard et al, 2010). For example, although the ECB‟s monetary

pillar, explicitly predicated on the importance of credit and monetary aggregates (banks‟

liabilities), often indicated that monetary growth above the reference value (4.5 percent) required

tightening credit conditions, in practice the repeated conflicting signals sent by the two pillar

strategy were typically settled in favour of the short-term economic analysis (Arestis and

Sawyer, 2008). In other words, the flexibility of the two pillar approach (Enderlein and Verdun,

13
2009) functioned to divorce the conduct of monetary policy from concerns with the bank-lending

channel.

The implications were two-fold. First, the ECB‟s implementation strategy was guided by

the idea that intervention „in both the short-term or the long-term bond markets is either

redundant, or inconsistent‟ (Blanchard et al, 2010:4). Market interventions, conducted strictly

through the Separation principles, were limited to the unsecured interbank segment. Second, its

policy models premised that structural changes in financial markets were of no analytical

consequence. If anything speculation, in the spirit of Milton Friedman, would accelerate a return

to fundamentals. Price stability would ensure financial stability (Bernanke and Gertler, 2001),

while policy anxieties about asset bubbles could be addressed through Greenspan‟s „put‟ that it is

easier to clean after an asset bubble than to try and prevent it. A potentially source of instability,

banks‟ maturity/liquidity transformation, was to be addressed through a combination of lender of

last resort facility and micro level bank regulation (Blanchard et al, 2010).

Why finance matters: securitization and central banking activity

The ECB‟s plea for a return to normal policy-making, albeit supported by „wiser‟ bond markets,

views financial intermediation as a process of raising funds through retail deposit activity and

channelling them to deficit units (for productive activity). Since any deficit or excess of liquidity

can be settled on the interbank market, central bank‟s presence there allows it exert significant

influence over financial actors‟ management of liquidity (and thus the transmission mechanism).

However, the 2008-2010 crisis rendered visible the increasing importance of new modes

of financial intermediation based on short-term, secured activity. The rapid growth of

securitization has been associated with a lengthening of financial intermediation chains (Shin and

14
Vinals, 2010) that saw the entry and increasing importance of shadow banks (Pozsar et al, 2010)

and a structural shift to impatient finance in banking models, defined as increasing dependence

on short-term market activity for both funding and revenue (Hardie and Howarth, 2009; Gabor,

2010).

Shadow banks are defined as a range of nondepository financial institution3 that perform

maturity and liquidity transformation without access to lender of last resort (central bank)

liquidity, emerging in the context of the US financial innovations since early 1980s (Pozsar et al,

2010; Adrian and Shin, 2009). There, traditional banks responded to competitive pressures

arising from regulatory restrictions and the entrance of non-bank financial intermediaries by

shifting some activities in the shadow banking arena. The multiplication of intermediaries

brought with it a shortening of maturities and a growing demand for collateral (triggered by

demand for leverage) since the profitability of each actor in the chain essentially depends on

funding at lower interest rates (Shin et al, 2010). This transformed „deposit-funded, hold to

maturity lending conducted by banks into a more complex, wholesale funded, securitization-

based lending process‟ (Pozsar et al, 2010: 15). European banks played two distinct roles in the

US based chain of intermediation, either as direct players through US subsidiaries or as high-

grade structured investors (typically German Landesbanks through off-balance sheet entities)

seeking to acquire high quality private collateral to comply with Basel II requirements. On a

smaller scale, similar processes of securitization took place in Europe, where the euro-

denominated ABS issuance increased to around €400 billion in mid-2007 (Pozsar et al, 2010).

The impact of securitization on the conduct of monetary policy is typically discussed

thorough the bank-lending channel and risk-taking channel. Thus, (Altunbas et al, 2009)

3
Pozsar et al, 2010 list the following categories: “finance companies, asset-backed commercial paper (ABCP)
conduits, limited-purpose finance companies, structured investment vehicles, credit hedge funds, money market
mutual funds, securities lenders, and government-sponsored enterprises.”

15
documented how European banks engaged into securitization were able to delink (to varying

degrees, depending on bank size) lending activity from monetary policy decisions. An opposite

effect is captured by the emerging literature on the risk-taking channel, which suggests financial

markets might (and have) interpret(ed) commitment to the path of the short-term interest rate as a

liquidity guarantee (Bini Smaghi, 2010), prompting a search for yield (Rajan, 2005) and

cementing shadow banks‟ confidence in their ability to roll-over very short-term debt (Adrian

and Shin, 2008), a powerful example of how central bank action can contribute to the operations

of impatient finance. Yet the analytical focus on how policy rate manipulations influence banks‟

lending/investment decisions (the asset side) underplays the importance of collateral for banks‟

funding strategies (liabilities side) for the conduct of monetary policy although ‘the perceived

quality of collateral influences the scale of market spreads over and above the overnight rate at

which the central bank lends to banks’ (Bini Smaghi, 2011).

Through securitization, banks were allowed access to large pools of funding on wholesale

markets against collateral – known as repo operations (see Figure 3). Thus shadow banking

turned the manufacturing of loans into the manufacturing of collateral and shifted the core of

banks‟ funding away from traditional sources, deposits and the unsecured interbank market (the

site of central bank‟s interventions), to repo segments in both European and US jurisdictions.

The rapid growth in the EU repo market was facilitated by concerted regulatory efforts to

allow the use of collateral across different jurisdictions. The euro area repo market tripled in size

between 2002 and 2008, to around EUR 6 trillion, around 65 per cent of the euro area‟s GDP,

roughly the same size as the US repo market (Hordahl and King, 2008). In comparison, by then

the European covered bond market had reached EUR 2.4 trillion (Beirne et al, 2011). Large

European banks dominated the repo market (20 largest produced 80% of trading) and traded

16
primarily at short maturities (under a month). The collateral composition showed two thirds

sovereign bonds (termed GC, general collateral), the rest privately issued, high quality assets

(Hordahl and King, 2008), reflecting the risk aversion characteristic to providers of wholesale

funding - institutional cash pools (corporate, pension funds, municipalities).

Figure 3 Shadow banking and new financial linkages

Unconventional
mon. policy
Central bank
New Consensus
representation

Shadow banking

Easing
liquidity
Interbank conditions
money
market
(unsecured)
Repo market
(secured) MBS Corporate
bonds

Covered Private
bonds asset
markets ABS
Sovereign
bond Commercial
paper
market

The consequence of a greater reliance on market funding is that repo markets become the conduit

for contagion through financial markets (Arestis and Karakitsos, 2011). Indeed, Lehman‟s

collapse produced a run on the repo market rather than the traditional manifestation of a financial

crisis, a run on bank deposits, as concerns of counterparty risk reduced willingness to provide

short-term liquidity. A second consequence relates to changes in the relationship between

sovereign debt and private financial actors in two aspects: spillovers in the markets for collateral

(Gorton and Metrick, 2009) and constraints on bank funding arising from sovereign-bank loops.

17
 First, (shadow) banks‟ ability to raise market funding is constrained by the size and

composition of its collateral portfolio. Indeed, recent theoretical innovations that explore the

linkages between sovereign risk and banking risk recognize that banks hold government debt

because, among other reasons, it enables access to collateralized interbank lending (Bolton and

Jeanne, 2010). Therefore, periods of funding uncertainty in repo markets can have sizeable

implications for collateral markets (Hoerdahl and King, 2008). In the US repo market, risk

aversion narrowed acceptable collateral to increasingly scarce „safe heaven‟ US government

bonds and lowered repo rates. The opposite happened in Eurozone. Aside from greater

availability of sovereign collateral, repo rates were driven upwards by increasing discrimination

between sovereign collateral from different Member States.

Indeed, an unexpected consequence of EU‟s financial integration turned out to be that

perceptions of funding risk for private financial institutions have different consequences on the

liquidity of Member States‟ sovereign bond markets (Gorton and Metrick, 2009). The tiering of

collateral allows highly rated sovereigns to reap „collateral premiums‟ (Bolton and Jeanne, 2010)

but can potentially traps lower rates sovereigns (Greece) into a vicious circle where concerns of

collateral liquidity translate into higher funding costs. This channel is likely to strengthen in the

future. The ECB‟s Euro Money Market Survey (ECB, 2010b) confirmed the trend towards

increased (short-term) collateralized interbank lending accompanied by a decline in the volume,

liquidity conditions and efficiency of the unsecured interbank market.

The consequences of sovereign debt instruments „going special‟ are not restricted to the

dynamics in public debt markets alone. Banks‟ dependency on market funding creates a

„sovereign-bank loop‟ that further ties banking systems into the dynamics of the sovereign, as the

literature on unconventional monetary policy suggests (Bini Smaghi, 2009; Gagnon et al, 2010).

18
The efficient market hypothesis underlying New Keynesian models implies that the type of asset

purchase has no relevance because of the crucial assumption that assets are perfectly

substitutable. Policy works through the signalling channel, so theoretically commitment to

maintain the interest rate at the zero bound is enough. However, once the perfect substitutability

assumption is relaxed, the purchase of government bonds boosts bank reserves (aiming to

stimulate lending) and simultaneously activates a portfolio rebalancing channel (Joyce et al,

2010). Since government debt is the risk free instrument that acts as a floor for pricing private

instruments (Bini Smaghi, 2009), the reduction in sovereign yields increases demand for higher

yielding assets and can thus contributes to easing financing conditions for private financial actors

(see Joyce et al, 2010 for UK and Gagnon et al. 2010 for the US). The opposite also holds. The

pressures on sovereign yields arising from collateral concerns feeds into higher risk premiums

demanded on banks debt issuance (Banco de Espana, 2010), a negative feedback loop highly

illustrative of the fragility characterising banking models reliant on market funding.

Against the background of such complex financial relationships, the questions about post-

crisis institutional reconfigurations acquire a new urgency. At three turning points throughout the

crisis, the ECB policy responses illustrated the factors constraining institutional change.

Turning Point 1, May 2009: Strategic appropriation

The May 2009 decision to introduce the Covered Bond programme was taken in a changed

ideational terrain. The US Fed and Bank of England predicated the purchase of first private asset

and then sovereign bonds on the recognition that ‟sound money‟ principles could not provide

adequate guidance for preventing a financial meltdown and that government bonds are special.

This allowed the ECB to recognize that European banks were dependent on market funding and

19
take policy actions in response to evidence that enhanced credit support failed to improve banks‟

financing conditions even if it allowed them to economize on the key collateral then acceptable

for market funding - sovereign bonds (Cheun et al, 2009). The covered bond market provided an

ideal instrument for the strategic appropriation of unconventional policy measures implemented

elsewhere because a) it involved long-term, collateralized market financing distinct from the pre-

crisis reliance on short-term funding and b) the dominance of German banks in the Eurowide

covered bond market (at the time, the share of covered bonds on the German banks‟ balance

sheet rose to almost 25%) reduced the scope for (political) contestations.

Yet this strategic appropriation did not go far enough because ideational path dependence

prevented the ECB to adequately consider how crisis policies would articulate with impatient

banking. While insisting on the importance of lengthening funding horizons, the ECB predicated

the parallel introduction of „full allotment‟ one-year liquidity injections on the assumption that

banks would behave, according to the „sound money‟ account, as passive actors in the

implementation of monetary policy decisions (Adrian and Shin, 2009). This implied that

liquidity injections through the banking sector would increase lending to companies and

households, boosting deposits and thus curtailing dependency on either short-term market

funding or ECB liquidity. Yet banks‟ behaviour quickly showed the dangers of nostalgia for the

days of predictable monetary control. After May 2009, banks made increasing recourse to

longer-term ECB refinancing (see Figure 4), whose contribution to the ECB balance sheet rose to

almost 25% by January 2010 (nearly EUR 670bn), replacing short-term liquidity. In comparison,

covered bond purchases accounted for less than 2% of the ECB asset side at the time (around

EUR 29bn). Instead of shifting banks‟ activities from market portfolios to lending to companies

and households, crisis measures perversely replaced dependency on short-term market funding

20
with dependency on ECB liquidity.

Ironically, the ECB‟s liquidity policies temporarily supported a virtuous sovereign-bank

loop, allowing governments to withstand the fiscal pressures of what turned out to be Europe‟s

isolated year of „fiscal activism‟ (partly aimed at providing direct support to banks exposed to

US financial tensions). Banks demanded sovereign debt securities for two reasons. The scarcity

of profit opportunities attending the global deleveraging left sovereign debt markets as important

sources of yield differential (Lapavitsas et al, 2010). Banks also increased holding of government

debt to ease access to repo funding (Bolton and Jeanne, 2010). Indeed, throughout 2009,

Euroarea sovereign bond spreads remained contained despite the post-Lehman GC collateral

discrimination. However, the events throughout the first months of 2010 demonstrated that this

fragile equilibrium rested on the ECB‟s willingness to maintain its generous liquidity provision.

Figure 4 ECB's asset side composition (excluding gold), selected months

21
Turning point 2, May 2010: sound money or too little, too late?

For some, the unprecedented departure from sound money principles rendered the ECB policy

ostensibly less predictable, if not damaging to the price stability objective (Gerlach, 2010;

Featherstone, 2011). Yet a cursory look at the ECB‟s asset side dynamics suggests a more

nuanced picture. Instead of using May 2010 as an opportunity to overcome the constraints

imposed by the „sound money‟ hegemony and introduce institutional innovations that would

allow it to address the complex relationships produced by financialization, the ECB took the

opposite route. After the initial sizeable bond market interventions in May and June 2010

(around EUR65 bn, which the press speculated were mostly Greek), the pace of purchase slowed

markedly: a EUR15 bn increase by November 2010 (the Irish bailout). Far more significant, the

ECB allowed outstanding long-term liquidity to halve to EUR 335bn in an effort to address the

„addicted banks problem‟.

The gradual liquidity withdrawal saw a host of political, economic and financial factors

converge on European sovereign bond markets, activating the collateral spillovers and sovereign-

bank loops described above. Indeed, de Grauwe (2011) argued, Eurozone sovereign debt

pressures are indicative of a systemic rather than individual member state problem, epitomizing

the vulnerability to market sentiment in the absence of a central bank. Without central bank

intervention, bond markets may constrain government‟s ability to implement countercyclical

policy. Restoring creditworthiness relies on markets‟ abilities to distinguish between recession-

ridden countries where automatic stabilizers and bank rescue programs temporarily increase

borrowing requirements and instances of unsustainable public debt dynamics, when „bond

traders are notoriously short-sighted […] their time horizons are days or weeks, not years or

decades‟ (Cecchetti et al, 2010:1).

22
 The power of collateral associated with securitization compounds this problem. The

combination of tiering in the Euro repo collateral, the Greek sovereign debt pressures and the

ECB‟s strategies for countering „liquidity addiction‟ produced an increased scrutiny of collateral

as banks faced prospects of substituting cheap ECB liquidity obtained against a wide range of

collateral with market funding carrying stricter collateral requirements. The „banks‟ desperate

pleas‟ for ECB bond purchases, reported by Financial Times (2010b), can thus be viewed as a

plea for central bank intervention to contain collateral spillovers, worsened by threats of

sovereign default. In other words, rather than demonstrating the limited effectiveness of central

bank interventions to lower sovereign yields (Joyce et al, 2010), the ECB‟s refusal to make

commitments to either volume or path of purchases at a time when bond markets were betting on

an Ireland bailout and the US Fed announced a second round of quantitative easing can be

alternatively interpreted as an instance of „too little, too late‟ policy intervention. If ever ECB‟s

predictability could have contained system-wide threats to financial stability, the autumn of 2010

was the moment to do so. On the contrary, the lack of central bank guarantees or the half-hearted

measures implemented after June 2010 saw bond market concerns about growth prospects

(pervasive for Eurozone countries with long-standing competitiveness issues and ongoing

austerity programs) require higher yields as doubts were raised about collateral quality.

The refusal to design a sizeable and predictable bond purchase strategy further

compounded the problems of domestic banks through sovereign-bank loops, a scenario clearly

illustrated by difficulties faced by Spanish banks in raising market funding in the second half of

2010 (Banco de Espana, 2010) and the failure of the three bailouts to achieve the ECB‟s stated

purpose, as banks in Greece, Portugal and Ireland continue to depend on its emergency liquidity

support.

23
Turning point 3, March 2011: putting politics in its place

In the context of the ESM agreement, March 2011 marked the moment when the ECB chose to

signal that its role as temporary crisis backstop was no longer necessary. The ECB resolved its

ongoing exit strategy dilemma by effectively pressuring Eurozone politicians into reaching a

political solution to the debt crisis (be it better fiscal rules or political union), a scenario

predicted by research on possible conflicts between monetary and fiscal policies (Howarth and

Loedel, 2005). The rise in policy rates and the suspension of SMP purchases despite renewed

pressures in Greek, Spanish, Italian, Irish or Portuguese bond markets point to a gamble that

widespread concerns for Eurozone survival could yield a political solution that in turn would

allow the ECB to design change on its own terms.

Yet the ECB‟s agenda for change only recommends small departures from the pre-crisis

policy framework: a more medium-term orientation and the recognition that price stability and

financial stability are complementary (Bini Smaghi, 2011). The danger, Blanchard (2011)

pointed out, is in the emerging consensus among central bankers that these two can be achieved

largely independent of each other. Thus, the pre-crisis approach to conducting monetary policy

will continue to be deployed in the pursuit of price stability, whereas financial stability can be

achieved through the introduction of systemic regulatory and prudential concerns under the tag

of macroprudential policy (Hanson et al, 2010), as if systemic risk considerations can be treated

in separation from interest rate decisions. In other words, the details of financial intermediation

are relegated to the macroprudential domain whereas monetary policy „normalization‟ sees a

return to the pre-crisis premises that efficient markets will smoothly transmit central bank

interventions on the unsecured interbank segment, despite evidence from the ECB‟s Money

Market data that the trading on that segment is increasingly replaced by repo funding. Indeed, the

24
average trading volume on collateralized interbank markets reached three times the volume of

the unsecured interbank segment by September 2010.

Where next?

The danger of ECB‟s piecemeal reform is that its actions appear to contribute to the radical roll-

back of welfare states across the Euroarea, threatening its political legitimacy. A radical

reconfiguration would involve overcoming the political and ideological constraints of the

European governance project to reorient central banking to a various instruments – various

markets strategy in the pursuit of economic growth and employment (Arestis and Sawyer, 2011).

It is too early to tell whether the ongoing European debt crisis can produce the ideological

mutations necessary for such a paradigm shift.

The ECB‟s navigation of the complex environment of the Eurozone debt crisis points

instead to the importance of strategic learning. As Hay and Wincott (1998:956) suggested, a

radical reconsideration of dominant policy paradigms and the institutional configurations they

underpin depends on actors‟ appraisal of what is „feasible, legitimate, possible and desirable‟.

The constraints to paradigm change have been well illustrated by the strong opposition to the

Securities Market Programme from Germany and other Nordic countries. Perhaps the more

important question is under which conditions the ECB could recognize the perils of

subordinating its relationship with financial markets to the efficient market hypothesis. To

recognize the shortcomings of the one instrument – one market – one objective framework would

require the ECB to discard efficient market assumptions. And herein is the difficulty, since

outside the orderly terrain of efficient markets assumptions lies a complex and messy world

ridden by irreconcilable tensions, where models serve as anchors of intellectual identity and

25
reinforce hierarchies of policy authority (Dymski, 2010). From this perspective, the ECB faces

an institutional dilemma: its position in the institutional architecture of the Eurozone crucially

lies in its ability to portray itself as a technocratic institution, guided in its policy decisions by the

objectivity of the models it deploys.

A possible solution to this dilemma would involve the ECB to formally acknowledge that

changes in financial intermediation have rendered sovereign bonds a special class of asset. Its

credibility and technocratic image could be harnessed to convince member states and financial

institutions that its lender of last resort function (Buiter, 1999) needs to be expanded to reflect

the new tensions in financial markets through an explicit mandate for the ECB to act as buyer of

last resort for assets of sovereigns threatened by excessive volatility. Such a scenario is not far-

fetched. In fact, during the ESM negotiations, the European Commission had (unsuccessfully)

lobbied for instituting mechanisms that would protect sovereign debt from wide swings in

market sentiment. It envisaged either short-term lines of credit to allow governments to purchase

own debt or direct ESM interventions in sovereign bond markets to prevent a full-blown bailout.

In terms of the actual conduct of monetary policy, the Separation Principle will be

replaced with the Decoupling Principle outlined by (Borio and Disyatat, 2009), in a one

instrument – two markets – one objective framework. The Decoupling Principle stresses that

interest rate policy can be conducted independently of the size of the central bank‟s balance

sheet. Thus interest rate policy will target price stability, whereas liquidity management

decisions would allow the ECB to intervene in sovereign debt markets in line with its buyer of

last resort mandate. These purchases could be financed either by creating additional bank

reserves, which the Japanese experience with quantitative easing throughout 2001-2006 suggests

26
it not always and necessarily inflationary, by issuing its own bills or through the operations of a

modified European Stability Mechanism (Eurozone bonds).

Such an incremental change could offer an effective approach for shifting policy debates

away from endless disagreements over the debt crisis to a critical reflection on how to address

broader concerns with competitiveness, redistribution, the fragility of impatient finance and the

desirability (or inevitability) of a political union.

Conclusion

As observers pointed out, the ECB successfully addressed its „teenage challenge‟ by decoupling

EMU from political union considerations (Enderlein and Verdun, 2009). Such an approach

proved far more difficult after 2008 because of the difficulties in reconciling exit strategies with

the multi-layered complexity of interdependent financial markets and the crucial role played by

sovereign debt instruments.

The global financial crisis confronted the ECB with the consequences of the analytically

neglect of securitization and forced it to step outside the „sound money‟ framework where the

central bank‟s relationship with financial markets is of no analytical consequence. Nevertheless,

its reluctance to analytically link the power of collateral with business models dependent on

short-term market funding and long intermediation chains left it unable to curtail, and worse,

accelerated the spread of sovereign debt pressures from Greece to other „periphery‟ countries.

Its reform agenda predicated on the reinforcement of the pre-crisis governance

framework and the introduction of macroprudential policies cannot address the challenges raised

by new landscapes of finance. Sovereign debt instruments have become a special class of assets

because the shift to impatient finance places collateral at the core of efforts to raise market

27
funding. During „benign‟ periods, collateral constraints can be overcome because securitization

allows the creation of high-rated private collateral. However, (fundamental) uncertainty triggers

a relentless collateral scrutiny that, in the absence of predictable central bank interventions in

sovereign debt markets, penalizes fiscal efforts to provide automatic stabilizers or absorb the

costs of banking failures and disproportionately rewards „safe heaven‟ sovereigns. It also

worsens funding difficulties through a sovereign-bank loop because banks‟ costs of issuing debt

are influenced by sovereign premiums.

The ECB repeatedly modified its approach to the contradictions between its sound money

principles and structural changes in financial intermediation. Its May 2009 moment of strategic

appropriation recognized the importance of modifying bank funding strategies by interventions

in covered bond markets, yet its liquidity provisioning failed to overcome the sound money

treatment of banks as passive financial intermediaries. After May 2010, government bond

purchases were accompanied by a gradual withdrawal of long-term liquidity support that failed

to consider the implications for collateralized interbank lending or sovereign bank loops. Since

March 2011, the ECB‟ gamble for a political solution to the Eurozone crisis by refusing to

continue with its active role in crisis management has seen a rapid deterioration in „periphery‟

sovereign bond markets, with potentially irreversible consequences for Eurozone.

Instead the paper suggested a first step in the EMU‟s institutional overhaul could take the

form of a one instrument-two markets-one objective framework that decouples interest rate

policy, governed by sound money ideas, from balance sheet policy. This will enable ECB‟s

liquidity management operations to explicitly recognize that sovereign debt instruments

constitute a special class of assets that necessitate central bank support during times of

uncertainty.

28
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