Posted by WARREN MOSLER on 6th January 2013
> (email exchange)
> On Jan 6, 2013 6:41 AM, Andrea wrote:
> Some interesting points made by Ulrich Bindseil and Adalbert Winkler (ECB) in
> their October 2012 paper
> How about these authors rethinking fiscal policy in the light of this?
The results of our analysis are as follows:
• A central bank that operates under a paper standard with a flexible exchange rate and without a monetary financing prohibition and other limits of borrowings placed on the banking sector is most flexible in containing a dual liquidity crisis.
• Raising interest rates to attract funding / capital inflows, while being the standard economic mechanism in normal times, may fail to equilibrate demand and supply in a confidence crisis as higher interest rates make it less likely that borrowers will be able to serve the debt. As a result, within any international monetary system characterized by some sort of a fixed exchange rate, the availability of inter-central bank credit determines the elasticity of a crisis country’s central bank in providing liquidity to banks and financial markets, notably government bond markets. Thus, the sustainability of fixed exchange rate systems depends on the elasticity of inter-central bank credit, i.e. the ability and willingness of the central banks of “safe haven countries” to provide loans to central banks of countries in financial distress (gold standard and peg to another country’s currency) and on the elasticity of liquidity provision by the common central bank (monetary union).
• In a monetary union, like the euro area, international arrangements are replaced by a common central bank that provides lender-of-last-resort lending to banks. In the institutional set-up of the euro area where national central banks are in charge of the actual conduct of central bank operations with a country’s banking system, this provision of liquidity is reflected in the “TARGET2 balances”. At the same time, the comparison of a central bank of a euro area type monetary union with a country central bank operating under flexible exchange rates and a paper standard, like the US Federal Reserve, shows that central banks under the former framework have a similar capacity in managing dual liquidity crises as long as the integrity of the monetary union is beyond any doubt.
• Collateral constraints matter systematically under all monetary frameworks. As a result, a central bank confronted with a dual liquidity crisis has to be in a position to adjust collateral constraints in order to enhance the elasticity of its liquidity provision and to limit bank defaults and a deepening of the crisis. If done prudently, this may actually reduce central bank risk taking.
• Banks and securities markets can be subject to a liquidity crisis. However, while lender of last resort activities vis-à-vis banks are a widely accepted toolkit of a central bank, outright purchases of securities have been a controversial tool of central bank liquidity provision in financial crisis since the days of the real bills doctrine. Monetary financing prohibitions (regarding Governments) are a specific case of banning direct lending or primary market purchases of securities, namely securities issued by governments. If the central bank is either not allowed, or it is unwilling to conduct outright purchases of securities, the banking sector – supported by the central bank – can in principle act as the lender of last resort for debt securities markets. However, this is subject to additional constraints, i.e. the banks’ ability and willingness to perform this role. Moreover, it has specific drawbacks as, for instance, the possibility of diabolic solvency loops between banks, the issuers of debt securities, including the government and the real economy may arise.
• Borrowing limits of banks, i.e. quantitative credit constraints deliberately imposed by the central bank to limit the borrowing of banks from the central bank, accelerate a crisis because – if enforced – they signal to banks and markets that at those limits the central bank’s elasticity of liquidity provision ends. As a result, those limits push all banks (potentially) affected into a state of fear of becoming illiquid and hence into a state of strict liquidity hoarding.