By Ignacio Ramirez Cisneros
Some considerations on the IMF’s Independent Evaluation Office (IEO) latest assessment on the handling of the euro crisis.
The most recent IEO assessment of the IMF’s role in the lending and structural adjustment programs in Greece, Ireland and Portugal (and Cyprus) makes reference to a past held belief within the IMF ‘that large current account imbalances were little cause for concern [for the IMF], and sudden stops could not happen within a currency union that issues a reserve currency’ (IEO 2016, 46). In the document, it is made clear that this understanding of EZ financial realities was mistaken given all the financial and economic turmoil since 2010.
In our view, however, the aforementioned past belief in the potential financial resilience of the EZ held by the IMF was indeed suitable when looking at the actual working mechanisms of the common currency area financial system. What made the economic crisis unsustainable, requiring (supposedly) IMF intervention, then were not the current account (CA) imbalances themselves, nor German ‘wage dumping’ –the driving force behind the disparities in competitiveness among EZ members-, but the delayed and inconsistent (and extremely unequal!) response by the EZ monetary authorities to the sudden stop of capital inflows.
It is a well-established fact that in spite of giving up national monetary policy for a euro-area wide policy, imposed by the ECB, each national central bank (NCB) keeps its own balance sheet and is required to enforce ECB policy in the (national) area of its jurisdiction. In addition, each NCB is allowed to provide Emergency Liquidity Assistance (ELA) to its national banking sector –though at a higher rate of discount than normal monetary policy transactions. This gives the NCB the authority as well as the obligation to maintain sovereign debt markets as liquid as necessary to ensure the policy rate transmission mechanism functions according to Eurosystem monetary policy. The latter is achieved by a combination of lending operations along with outright purchases to guarantee interbank lending rates do not deviate substantially from the ECB imposed policy rate.
The liabilities each euro-area NCB creates when carrying out these liquidity operations are denominated in the common currency –the same currency all issuances of EZ sovereigns are tendered in. Hence there should be no cause for concern that growing CA deficits should necessarily lead to sudden stops, as the IMF had properly estimated in their early appraisals of European Monetary Union risks, precisely because EZ peripherals have not and are not accumulating foreign debt. The denomination of NCB liabilities, Eurosystem liabilities (such as Target2 liabilities) and sovereign bonds is identical. In addition, the euro is an international reserve currency for which lack of demand is not a problem. Default risk then becomes purely an assessment of an exogenous policy choice since there are no external liabilities to finance.
Basel II regulations regarding bank exposure to sovereigns that hold investment grade rating further confirm the prior belief of the very low default risk for EZ members. Paragraph 54 states that bank ‘exposures to their sovereign (or central bank) of incorporation denominated in domestic currency and funded in that currency’ may carry a generalized risk weight of zero (see also Hannoun). That BIS risk weights depend heavily on specific debt rating agency models, shown to falter when needed most, is a serious issue in and of itself.
In view of the above, the case could be made that the euro does is not a foreign currency for the peripheral EZ members. Liquidity market operations and payment system transactions are conducted in the same common currency in which EZ sovereign liabilities are denominated. From this point of departure, any further analysis of IMF programs for the EZ peripheral nations must incorporate the new possibilities implied by this new perspective.
For example, the contagion from the US subprime crisis and subsequent financial meltdown to large EZ banks could have been thoroughly dealt with exclusively by the Eurosystem, that is, by the ECB and the NCBs of the euro area. No bank bailouts in the EZ, core or periphery, needed to be handled via the fiscal authority. The fiscal authority has many other domestic responsibilities and should not get involved in financial panics, at least not as the first firewall institution. Fiscal and income stabilizers provided by the fiscal authority require more time to take effect (Minsky 2008) than bold unconventional monetary policy actions by the ‘Big Bank’, which can buy assets in large quantities without prior legislative approval. This would have been the easiest way to counter momentary EZ peripheral members loss of access to international capital markets.
The need for lender of last resort action was most vital in the EZ periphery. The capital flow reversal they were experiencing was driving their interest rates to diverge from the German benchmark for the first time since the common currency came into effect. In such a situation using fiscal bailouts to stabilize the banking system, further increasing sovereign indebtedness, would only intensify the forces behind the divergence. Nevertheless, for yet to be disclosed reasons, the Eurosystem failed to act on its vital central bank mandate to be the first firewall institution during financial panics, perhaps in consideration of the outdated ideological canon to preserve its ‘independence’.