Sat Jul 7th, 2012 at 07:51:17 AM EST
Two weeks ago I attended the annual Minsky Summer Seminar at the Levy Institute. There, Scott Fullwiler of Krugman's flashing neon sign fame made a very nice presentation on Central Bank Operations. He was unfortunate enough to have to compete for the audience's attention with the Germany-Greece Euro 2012 quarterfinal, and he bravely disregarded Bob Barbera's advice to just talk for 5 minutes and then take everyone to the bar to watch the game. In the end I think he managed to keep everyone's attention as his presentation was really nice. You can now see the slides online: @stf18
My Prezi on central bank operations from the Minsky conference a few weeks ago http://prezi.com/bv0dpvapapht/m ...
The companion paper, for those interested, is Modern Central Bank Operations - The General Principles
(June 1, 2008)
There are sharp differences between the two approaches that nonetheless remain. Among neoclassicals, the literature on central bank operations is not integrated into models of financial asset pricing or into the so-called "new consensus" model of the economy. Though the latter assumes interest-rate targeting, new consensus models are concerned with the strategy of monetary policy, not the tactics or daily operations; though well-established as a research topic for journal publications, monetary policy implementation remains "a side issue" in neoclassical monetary theory graduate textbooks like Walsh (2003) (Bindseil 2004, 1). Further, neoclassicals still do not consider money to be endogenously created in the banking system, as Marc Lavoie repeatedly notes; indeed, as Charles Goodhart has argued in a series of recent papers, there is in fact no private banking system whatsoever in the new consensus model (e.g., Goodhart 2008a).
This is disappointing, naturally, since the evidence published in the recent neoclassical literature on central bank operations has in fact been remarkably consistent with the endogenous money view of central bank operations. The horizontalist view that central banks only target interest rates directly (not reserve or monetary aggregates) and can do so as precisely as desired has been in particular repeatedly supported by this literature. While the relevant literature could fill several volumes, of special note here is the book by Ulrich Bindseil (2004), former Head of the ECB's Liquidity Management Section, which describes in substantial detail the operations of the Fed, ECB, and Bank of England in a manner that very nearly resembles the horizontalist story.
The purpose of this chapter is to describe ten general principles of modern central bank operations. These ten principles are not intended to be exhaustive or comprehensive; neither are the discussions of the individual principles necessarily exhaustive. Rather, these principles represent "what every economist should now be expected to know" given the large quantities of orthodox and heterodox research in this area and the empirical or anecdotal evidence contained in speeches and publications of central bank officials. As noted already, this research generally confirms the earlier points made by Moore (1988) and other authors associated in one way or another with the horizontalist literature
So hopefully (hah!) that settles the debate on endogenous money creation. Anyway, I think the single most important point (here I'll quote from the flashing neon sign
blog) is that
a central bank defends the payments system every day, every hour, every minute, at some price. This is the essence or fundamental truth of central banking, and anyone who fails to grasp it doesn't understand central bank operations
here is the rate that the central bank targets. In the US it's the federal funds rate
, and in the Eurozone that's probably the overnight interbank rate known as EONIA. And what's being defended is a safe and sound payment and clearing system, which is the lynchpin (though not the be-all and end-all) of financial stability. However, it appears that the ECB has been doing a crap job of targeting EONIA, or at any rate they are lazy. It's also possible that the ECB has been targeting money aggregates, which would be the ECB's own (and worrying) flashing neon sign. Seriously, does this look like the ECB has been targeting a rate?
For an explanation of the various rates in this chart (EONIA, deposit, marginal, etc) I refer you to my earlier post Central Banking 101: the EONIA heartbeat (February 26th, 2011). The present post will be based upon updating the charts from that article with the last 16 months of data: from February 2011 to June 2012. Much has happened in that time and I'll comment on all that below the fold. I encourage you to read the old post at this point.
So, let's look in more detail at what has been happening since the Great Clusterfuck began 5 years ago...
Now, As one can see from the 13-year chart above the fold, the EONIA is usually all over the place, sometimes spiking up, sometimes down. But there was a period of relative stability which I called "the EONIA heartbeat" which lasted about a year from mid-2009 to mid-2010. Here it is:
As explained in my diary of February 2011, these spikes are indications that banks are low on central bank reserves, and on the last day of a maintenance period they borrow frantically from each other to bring the period reserve average to where it needs to be. This chart includes the starting and ending dates of the reserve maintenance periods to make that clear without a doubt. You can even see a longer than usual reserve period around the Christmas vacation of the ECBankers, with a year-end spike in demand for reserves.
Moving on: after May 2010 the EONIA developed tachycardia, as discussed in the previous diary. Back then I was conjecturing that the cause of the tachycardia was a generalised lack of liquidity, exacerbated by the ECB's decision to withdraw liquidity from the system by "sterilizing" its sovereign bond purchases (the infamous SMP programme). So, what do we see in the data?
We see that it's the LTROs that dun it. Not only the tachycardia went away after the first 3-year "open bar" liquidity operation, but also the heartbeat itself disappeared (save for a single year-end spike). Now the EONIA is a tame rate, banks can obviously manage their liquidity without end-of-period scrambles and the ECB could target a rate if it so wished. I would say that this also vindicates the original hypothesis that the bond purchase sterilizations were withdrawing a liquidity that just wasn't there.
Let me go through the argument for that once more. I claimed that sovereign Euro bonds were already (as good as) money, by virtue of being eligible collateral for weekly refinancing operations which the ECB has been conducting at an unlimited tender (i.e., the ECB lends an unlimited amount against eligible collateral). Therefore, the SMP is just an asset swap. No new liquidity is injected into the system by bond purchases. What the ECB does is take credit risk off the balance sheets of the bondholders, but it does so in a liquidity-neutral fashion. When the ECB turns around and offers 1-week deposits at the repo rate "to sterilise the inflationary effects of the extra liquidity injected into the system by the SMP", it is actually attempting to withdraw an extra liquidity that just isn't there. As a result, the EONIA goes into arrest: banks, which (in the aggregate) had just about enough liquidity to meet their reserve requirement (as evidenced by the "heartbeat") now have less liquidity available. And it was the LTRO, flooding the banks with long-term liquidity against eligible collateral, that fixed it.