From the comments, on eurozone sterilization

From this post, on the ECB and the new bailout procedures:

No, but it can tighten policy just as easily by raising the rate paid on cash in its deposit facility. Indeed, this is part of its usual operating procedure: the headline “repo rate” lies at the center of a corridor, with the deposit rate at the bottom. Already there are enough excess reserves sloshing around that the deposit rate is arguably the true risk-free short rate. There are currently 350 billion euros in the deposit facility (so this is the marginal rate paid on cash for a lot of banks!), and the EONIA overnight rate is at 0.1%, far closer to the 0% deposit rate than the 0.75% repo rate.

As long as this continues, the ECB can just follow its normal operating procedure, keeping in mind that the “true” rate is 75 basis points below the rate it’s announcing. There’s no real effect from having greater or fewer excess reserves outstanding; in my view, the “sterilization” program is a meaningless way of appeasing people who still hew to some kind of crude monetarism and don’t understand how the ECB’s policy actually works.

The critics are right about one thing, though; the taxpayers are the residual claimants here. If the ECB buys lots of Italian and Spanish debt and then they either default or leave the Euro, a hole will be blown in its balance sheet, and if insolvent it will require a taxpayer bailout. (And even if it’s not insolvent, profits that would otherwise have been remitted to taxpayers will disappear.) This is a fairly likely scenario.


'the taxpayers are the residual claimants here'
As is always the case with sovereign debt - until either the taxpayers reject/revise/repudiate the debt terms or the sovereign has no taxpayers, that is.

And do note that currently, the ECB has no claim on any taxpayers of its own, as the ECB is not a sovereign in customary terms.

The entire process of creating something resembling a transnational or supranational 'state' is fascinating - and something which does not fit well into older frameworks. Of course, at some point the EU will fail, and it may not even be successful in reaching such goals. But at an example, it is much like the slave based democracy of those Athenian voters who had completed military training, though the EU is an attempt to deal with another problem, by trying to find a political solution to the inherent problem of nation states using war as a method of statecraft.

Of course, it helps to have been engaged in genocidal warfare for generations to show that a need for a better method is required in an age where most threats have reached global dimensions. The ECB is unlikely to form the basis for a true international central bank, but if and when one is founded, the ECB's history will form part of its foundational awareness.

The comment that "If the ECB buys lots of Italian and Spanish debt and then they either default or leave the Euro, a hole will be blown in its balance sheet, and if insolvent it will require a taxpayer bailout." is incorrect.

Central banks can't become "insolvent" because they can create money at will. Indeed, some central banks, eg Chile's, function perfectly well with a negative net asset position. And printing more money would not lead to inflation in current circumstances, when the demand for liquidity is so strong.

Exactly, I was already wondering about that insolvency bit.

I am pretty sure that I am not on the hook for the possible default as a result of the ECB bond buying program above the guarantees we've already given.

This part confused me as well. Isn't it funded in resource terms by "current Euro holders" and people on Euro fixed incomes?

It doesn't matter whether they pay taxes or not.

Maybe they were thinking about this in terms of the US non-Fed bailout? There, the bailout expenses were added to the budget.

"7. The notion of “unlimited” but “sterilized” bond-buying interventions is a problematic one.  How much “Dran-O” is there to remove the newly created money?  Surely the ECB can’t respond by selling from its current portfolio of periphery bonds."

The ECB likes to sterilize on the liability side by issuing one week deposit liabilities. Bond market interventions are considered to be sterilized if they are financed by deposits, and not base money.

" . . . the taxpayers are the residual claimants here. If the ECB buys lots of Italian and Spanish debt and then they either default or leave the Euro, a hole will be blown in its balance sheet, and if insolvent it will require a taxpayer bailout."

Not necessarily. First of all Spain and Italy have no reason to default as long as the ECB continues make advances enabling them to service their debts to the ECB. And if, for some reason, Spain or Italy should decide to default the ECB can convert their liabilities to 'equity' and continue to value it at whatever they want to. Likewise if they leave the Euro.

Also not sure a central bank can even become 'insolvent'. Many central banks operate just fine with negative equity; Chile is a notable example. Central banks are the creators of money. How can the ECB ever fail to honor their own liabilities as they become due? Negative equity for a central bank is an embarrassment, hardly an impediment to continuing its central banking functions.

German taxpayers can sleep well.

Until they get cross border bank regulation in place in the EU this will be a repeated game. You can monitor the sovereigns budgets all you want, but if the sovereigns have to bail out their national banks all the time--Ireland, England, Spain--then you are missing the real source of the liabilities.

Yes, to commenters above- no central bank/currency has ever failed. The delusions continue unabated.

It would fail if countries abandoned its currency? That's not possible in the Chilean example.

The whole point of Draghi's announcement that the purchases would be sterilized was to signal that OMT would have no effect on inflation. That was clearly his intent, and that's how the markets have percieved it:

If Draghi had indicated that he would not be sterilizing the bond purchases, in other words, that he would be expanding the monetary base, inflation expectations would have risen, as they nearly always do in such cases.

More importantly it is utterly bewildering that the commenter attaches such importance to the ECB having sufficient capital. This clearly is based on a fundamental misunderstanding of the nature of central banking. Central banks simply cannot default. The only support the ECB requires is the political support of the nations that guarantee the legal medium of payment nature of the money it issues. This political support does not require the financial support of those nations. In fact it is ridiculous to believe that nations that can, and sometimes do, default are required to provide the financing of an institution that cannot by definition itself default.

I was the commenter in question.

First of all, I think everyone is missing the point by fixating on the statement about insolvency. My emphasis was on the fact that the taxpayers are residual claimants, which is true no matter how we expect the central bank's balance sheet to be structured. If the ECB suffers losses, then it will have fewer income-generating assets than otherwise, and less will be remitted to taxpayers. A loss is a loss; the distinction between the central bank's balance sheet and sovereign balance sheets is important for political and institutional reasons, but it does not affect the ultimate incidence.

Now on to the subtler point about whether insolvency matters. It is true that some central banks have managed to operate quite well with negative equity. (And, inversely, many central banks have done a disastrous job while retaining positive equity.) Negative equity makes monetary policy ever-so-slightly less credible, since the central bank no longer has the unquestioned ability to deal with a drop in base money demand of any size. But if the gap isn't large, it can be left alone (assuming the central bank starts with some credibility), and over time seignorage income will heal it; the thought experiment of a near-100% drop in base money demand isn't very plausible anyway.

If, on the other hand, the equity hole is so huge that it exceeds the PDV of future seignorage income, the central bank is in real trouble, and a bailout is probably necessary for monetary policy to be effective. But extremely large losses -- on the order of the ECB's entire current balance sheet -- would be necessary for this to happen.

To avoid any ambiguity about the central bank's condition, governments often require that it maintain a positive equity buffer, without counting future seignorage income. This is true for both the Federal Reserve and the ECB. Assuming that they won't change this policy anytime soon, any losses by the ECB that exceed their current loss reserves and equity would necessarily prompt a taxpayer bailout, in which case it would be quite obvious that the taxpayers were losing. But they would be losing in equal measure if the ECB decided to trod through with negative equity; rather than paying upfront and then receiving a normal stream of seignorage income, taxpayers would simply receive less than the normal amount of seignorage income going forward.

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