`

The Federal Reserve and the ECB

BUSINESS ECONOMICS
AFIQ NORDIN AQIB DURANI BUJAR BERISHA LUJJA SULAIMAN MIRZA ZIA MOHAMMAD USMAN G1212639 G1210847 G1217167 G1217141 G1213229 G1210517

A comparison of central bank monetary policy in postcrisis U.S. and EU

TABLE OF CONTENTS

Table of Contents

1. 1.
1.1
1.1.1 1.1.2 1.1.3 1.1.4

Introduction ................................................................................................. 4 Central Banks .............................................................................................. 5

Role of Central Banks.......................................................................................... 5
Control Money Supply ......................................................................................................... 5 Lender of Last Resort.......................................................................................................... 5 Banking Industry Supervision ............................................................................................. 6 Manage Foreign Exchange Reserves ................................................................................. 6

1.2
1.2.1 1.2.2 1.2.3

How Central Banks Increase Money Supply ........................................................ 7

Open Market Operations (OMO) ......................................................................................... 7 Reserve Requirements ....................................................................................................... 7 Discount Rates .................................................................................................................... 8

2.
2.1 2.2
2.2.1 2.2.2

The US, the Sub-Prime Crisis and the Federal Reserve .......................... 9
Origins of the Crisis ............................................................................................. 9 The Federal Reserve Response ........................................................................ 10
Quantitative Easing ........................................................................................................... 10 Maturity Extension Program (Operation Twist) ................................................................. 11

3.
3.1
3.1.1 3.1.2 3.1.3 3.1.4 3.1.5

The EU, the Sovereign Debt Crisis and the European Central Bank .... 13
Origins of the Crisis ........................................................................................... 13
Greece............................................................................................................................... 13 Italy 14 Portugal ............................................................................................................................. 14 Ireland ............................................................................................................................... 15 Spain ................................................................................................................................. 15

3.2
3.2.1 3.2.2 3.2.3

The ECB Response ........................................................................................... 15

Main Refinancing Operations (MRO) ................................................................................ 16 Long-Term Refinancing Operations (LTRO) ..................................................................... 16 Dollar Line Swaps ............................................................................................................. 16

4.
4.1.1 4.1.2 4.1.3

Reasons for Divergence ........................................................................... 18

Bank Mandates ................................................................................................................. 18 Bank Structure .................................................................................................................. 19 Aggregate Demand ........................................................................................................... 20

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5.

Conclusion................................................................................................. 22

Bibliography ...................................................................................................... 23

INTRODUCTION

1. Introduction
While the crisis in the US and the EU differ in terms of causes, magnitude and timing, the underlying issue is similar; lack of liquidity in the market. Lending the US froze up on the fall of Lehman Brothers in 2008, while in the EU, bloated sovereign debt and large budgets deficits has made it difficult for member nations to raise additional capital in the bond markets. It is therefore surprising to witness the two central banks adopting different approaches to put an end to the crisis.

More fascinating are unconventional monetary policy tools adopted by the Federal Reserve. Historically low short-term interest rates in the US meant that standard open market operations would be inadequate in addressing the liquidity issue effectively. Meanwhile in the EU, terms of EU Treaty make it illegal for the ECB to provide direct financial support to governments (Alessi, 2012). This forced the two central banks to look for other ways to increase liquidity in their respective markets.

In this paper, we briefly highlight the roles of central banks and tools employed by them to increase money supply. We also explore the events preceding the financial crisis in both continents, as well as prevailing economic conditions before looking at the different monetary policy tools adopted by the US Federal Reserve and the European Central Bank. Finally we attempt to understand the reasons why such a difference exists by looking at the central bank origins, mandates, and political and organizational structures.

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CENTRAL BANKS

2. Central Banks

Every country with a currency of its own has some sort of central bank, an authority that is responsible for controlling money supply in an economy. In the US, it is known as the Federal Reserve, while in the EU, the European Central Bank.

2.1

Role of Central Banks

2.1.1

Control Money Supply

Central banks control the money supply in a nation usually with the use of open market operations (OMO). Depending on the prevalent market conditions, the central bank can adopt either a contractionary, or an expansionary monetary policy. Contractionary monetary policies are adopted in the event that the economy seems to be overheating, i.e. short-run aggregate demand exceeds long-run aggregate supply. This involves the sale of government backed securities, such as bonds, in the market, which reduces the supply of money. Conversely, if the prevalent market conditions require an injection of money into the economy, the central bank adopts an expansionary monetary policy, in which it buys the government securities.

2.1.2

Lender of Last Resort

Central banks serve as the lender of last resort to financial institutions who are in the need to liquidity. By being a lender of last resort, central banks aim to prevent bank runs in case the bank is unable to let customer withdraw their deposits.

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2.1.3

Banking Industry Supervision

Central banks are also in charge of monitoring and regulation the behavior and practices of financial institutions. These efforts are often coordinated with a separate government regulatory authority, e.g. the Securities and Exchange Commission in the US.

2.1.4

Manage Foreign Exchange Reserves

To maintain strength of the currency, central banks hold on to reserves in the form of foreign currency, gold, SDRs, securities, etc. Large foreign exchange reserve gives central banks the ability to manipulate exchange rates in the foreign exchange market, a tool used to good effect by China to keep the Yuan artificially low giving the nations products a price advantage in the international markets. In addition, higher foreign exchange reserves allow a nation to deter a speculative attack on its currency. Post the 1997-98 financial crisis, many South East Asian nations such as Malaysia and South Korea have increased their foreign exchange reserves to deter such attacks. As of March 2012, Malaysia has gross reserves valued at MYR423.36billion (Bank Negara Malaysia, 2011), compared to MYR59.13 billion in 1997(Bank Negara Malaysia, 1997).

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2.2

How Do Central Banks Increase Money Supply?

It is inaccurately claimed that central banks continuously print physical money to increase money supply. Other than a few extreme cases such as Zimbabwe in 2008, or Hungary in 1946, where governments have actively engaged in the printing of money to meet debt obligations, central banks do not usually print money to increase money supply. In fact, increase in money supply primarily constitutes of increasing the supply of M2, and not M1.

However, this does not mean central banks do not print money at all. Central banks do print physical money and mint coins, but these are usually done to replace old or torn notes, and to update security features on the currency to prevent counterfeiting of the currency.

When we say a central bank has increased money supply, it has actually done so by the following methods:

2.2.1

Open Market Operations (OMO)

Through open market operations, central banks either buy or sell government securities such as bonds in the open market. Depending on the economic conditions, central banks either purchase bonds to reduce money supply, or sell bonds to decrease money supply.

2.2.2

Reserve Requirements

Central banks, through reserve requirements can set the set limits on how much money banks can lend out into the market. A high fractional reserve, often implemented when the central bank wishes to reign in aggregate demand in the market, means that the bank needs to set aside a

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higher amount of money as reserve, reducing the amount of money it can lend out. A lower reserve requirement does the exact opposite, giving banks the ability to lend out more of its capital.

2.2.3

Discount Rates

Discount rates are essentially interest rates borrowing banks need to pay to the Federal Reserve for short-term loans. A decrease in discount rate makes it cheaper for commercial banks to borrow, and therefore increase money supply in the market. Conversely, the Fed may increase discount rates to reduce money supply in the market, as it increases the cost of borrowing.

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THE US, THE SUB-PRIME CRISIS AND THE FEDERAL RESERVE

3. The US, the Sub-Prime Crisis and the Federal Reserve

3.1 Origins of the Crisis

The origins of the crisis in the US can be traced back to the early 2000s, during when shortterm interest rates were at record lows. Interest rates in 2002 fell below 2% for the first time since 1970 and remained low until 2005. This low interest rate regime meant that cost of borrowing was extremely cheap, encouraging both, prime and sub-prime borrowers to engage in rampant borrowing.

During the same time, the real-estate market in the country was booming, and it is therefore no surprise that much of the borrowing was directed finance residential housing. The housing bubble hit its peak in 20062007, after which it began to decline continuously to record lows until 2012(Standards and Poors, 2012). Due to the bursting of the bubble, houses stated losing value, and were now worth less than what homeowners owed on their mortgage. This led to extremely high levels of foreclosures as sub-prime borrowers now defaulted on their loans. The falling housing market did not help lenders either, as the value of repossessed property kept falling.

Meanwhile, large investment and commercial banks were engaged in the securitization of these sub-prime mortgage loans, selling them to investors from around the globe as Mortgage Backed Securities (MBS) and Collateralized Debt Obligations (CDO). The high levels of subprime defaults and foreclosures meant sub-prime lenders and banks had to write-down large amount of loans as unrecoverable. Those firms that had purchased these MBSs and CDOs were not holding worthless paper, as their underlying assets; homes, were now loosing value rapidly. These large losses and debt write-downs led to the eventual nationalization or demise

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of large financial institutions such as Freddie Mac, Fannie Mae, the Federal Housing Administration and Lehman Brothers. It is the fall of the latter, at the time the worlds fourth largest investment bank that caused widespread panic in the financial markets and froze liquidity in the market. With markets unwilling to lend to each other, the financial institutions approached the Federal Reserve for a bailout.

3.2

The Federal Reserve Response

Low-short term interest rates meant any further reduction in the market would be too small to be effective. As a result the Fed opted to adopt two unconventional monetary policies to increase liquidity in the market,

3.2.1

Quantitative Easing

Like any standard OMO, quantitative easing (QE) involves the purchase of securities from the open market. However, unlike OMOs, in which government purchases are limited to just government securities, QE involves the purchase of non-government MBS as well. Through QE, the Fed has essentially created room for toxic assets on its balance sheet.

The first round of QE, named QE1, was conducted in late November 2008. Under QE1, the Fed purchased US$500 billion of MBSs as well as US$100 billion of government-sponsored enterprises such as Fannie Mae, Freddie Mac, and the Federal Home Loan Banks.(Federal Reserve, 2008). However, the Fed felt that the initial US$600 billion set aside was inadequate, and therefore increased the amount to be pumped into the market to US$1.8 trillion four months later. (Censky, 2010). However, the economy started to weaken in the summer of 2010, and therefore the Fed began QE2. 10 | P a g e

In November of 2010, the Fed announced its decision to purchase US$600 billion of long-term treasuries, as well as reinvestments of up to US$300 billion on its previous investments.

The Fed revisited its policy QE in 2012 again, announcing its decision to purchase up to US$40 billion of MBSs every month indefinitely. (US Federal Reserve, 2012).

It should be noted that the effectiveness of the policy has been questioned constantly. QE was previously used by the Bank of Japan in early 2000 (Shirakawa, 2002) to fight deflation. These efforts however were not effective and the central bank soon abandoned its use as monetary policy (Fujiki, 2001). There does however exist significant support for the policy within the United States. The general view in the US is that though QE has done little to spur consumption, it has been extremely effective in improving market confidence (Klyuev, 2009), and therefore preventing it from entering a deeper recession.

3.2.2

Maturity Extension Program (Operation Twist)

Since the Fed can no longer reduce short-term interest rates, it instead opted to drive down long-term interest rates. The objective of the program is to spur consumption of big-ticket items such as houses, cars and expansion projects, as it is cheaper to engage in long-term borrowing.

In the case of the Fed, it had, through QE1 and QE2, accumulated up to US$1.65 billion in bonds. These bonds included both, long-term (maturing date after more than 10 years) and short-term bonds (maturity data less than 5 years). Holding on to the short-term bonds until its maturity date is counterproductive as it would suck liquidity out of the market. The Fed therefore chose to replace these short-term bonds with long-term bonds. It did so by selling short-term

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treasury bonds, while at the same time purchasing long-term bonds. This effectively reduced yields on long-term bonds in the market, making long-term borrowing cheap.

The Fed had originally implemented the policy in 1961, under the Kennedy administration (The Economist, 2011). The policy was given this unusual name due to a twist in the yield curves, and is derived from a Chubby Checker dance that was popular during the 1960s, known as The Twist.

Like QE1, the effectiveness of Operation Twist too is debatable. The policys first implementation in 1961 has long been considered a failure. Early studies into the effectiveness found that the policy had little impact on yield curves. However, proponents of the policy claim that these studies did not properly isolate the influence of the policy (The Economist, 2011)

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THE EU, THE SOVERIGN DEBT CRISIS AND THE EUROPEAN CENTRAL BANK

4. The EU, the Sovereign Debt Crisis and the European Central Bank
4.1 Origins of the Crisis

What is fascinating about the crisis in the EU is that every country has its own causes for the sovereign debt crisis. However, the underlying problem in all the cases is the same; large government budget deficits, financed by uncontrolled government borrowings.

During the 1990s and early 2000s, favourable market conditions allowed governments to continue borrowing from the markets, despite high levels of government debt. However, the financial crisis froze the capital markets in 20072008, making it difficult for these governments to raise capital. Below, we will briefly go through the causes of crisis in Greece, Italy, Spain, Portugal and Ireland.

4.1.1

Greece

Greece ran extraordinarily high levels of budget deficits since the 1980s (Organisation for Economic Cooperation and Development, 2012) to finance public sector jobs and pension schemes. At the same time, tax collection measures in the country were extremely lax, and rampant with corruption. In 2010, the Greek government is said to have lost up to US$20 billion in tax evasion(Torchia, 2010). Since government spending outstripped revenues, it opted to raise capital from international debt markets. Prolonged borrowing eventually pushed GDP-todebt in the country beyond sustainable levels. So much so, that it had exceeded the limited set by the Maastricht Treaty. The government resorted to misreporting national statistics on government spending, GDP growth and government debt to a significant degree to maintain its EU membership. The true extent of government borrowing was revealed in 2010, after

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undergoing a financial audit in which it was revealed that the GDP to debt ratio of the country stood actually at 130%, the highest in the EU (European Comission, 2010).

4.1.2

Italy

The Italian debt situation differs from rest of Europe in that despite having among the highest GDP to government debt ratio in the EU, most of the government debt is owned by citizens, who themselves do not have large debts obligations of their own in the form of mortgages and loans. More importantly, Italy has been much more prudent in its government expenditure than Greece. The government collects more in taxes than it spends on public services. Instead, much of Italys borrowings are directed towards the servicing of principal and interest obligations on its previous debt (Knight, 2011). It is the sheer size of the economy, and its sluggish growth that are a major cause of concern among investors. According to the World Bank, Italian GDP grew by a mere 0.4% in 2011, compared to a 10-year bond yield of 4.67%(Financial Times, 2012). Investors fear that Italian debt obligations will outgrow GDP far more quickly that it may be unable to service it. In short, as investor uneasiness increases, reflected by rising interest rates on Italian government bonds, the nation will essentially be increasing its future interest obligations by meeting its current interest payments.

4.1.3

Portugal

Like Greece, Portuguese debt woes are caused by a bloated and inefficient public sector. Hiring practices in the nation were such that it had a large number of redundant public servants, while heads and top management of various inefficient public-private entities received inflated salaries and bonuses (Dirio de Notcias, 2011).

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4.1.4

Ireland

Similarly to the U.S., the Ireland had a massive real-estate bubble, which made up 25% of the nations economy. The bubble burst in 2007, and in an effort to calm markets, the government announced that it would back all four national banks and its losses from the real estate market. This turned out not to be a good idea, as the banking system imploded anyways, leaving the nation with GDP to debt ratio of 106% (Matthews, 2011).

4.1.5

Spain

Spain during the years preceding the financial crisis behaved in an extremely fiscally responsible manner. Of all the EU members, it was the only nation to have abided by the pact of limiting the GDP-to-debt ratio to less than 60%. Unlike Greece and Portugal, most of the Spanish borrowing is cyclical, i.e. borrowings due to the onset of a recession. Spain was unlucky enough to have a property bubble that burst immediately as the country was moving into a recession.

4.2

The ECB Response

Unlike the US Fed, the ECB chose not to engage in outright purchase of bonds. Instead it chose to address the liquidity issue in the market through its version of open market operations, comprising of Main Refinancing Operations (MRO) and Long Term Refinancing Operations (LTRO).

There are two key points to note. Firstly, unlike the Fed, the ECB does not purchase bonds outright from the market. Instead, it enters into a repurchase agreement with a borrower, who

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puts up collateral in exchange for a cash loan. Secondly, the EU Treaty makes it illegal for the ECB to provide direct financial aid to distraught governments. Instead, the ECB interacts with commercial banks that in turn lend to the governments.

4.2.1

Main Refinancing Operations (MRO)

MROs are essentially repurchase agreements, in which financial institutions put up collaterals, usually bonds, on which the ECB provides a cash loan. MROs usually have a maturity of one week(European Central Bank).

4.2.2

Long-Term Refinancing Operations (LTRO)

A LTRO is just like an MRO, except the former has a longer maturity period. Until 2008, the LTRO had a maturity of three months. Lately however, the ECB has introduced LTROs with maturities of six, twelve and thirty-six months (Financial Times).

4.2.3

Dollar Line Swaps

In addition, the ECB, along with the Fed reactivated dollar swap lines to increase liquidity in the market. In a dollar swap line, the Fed lends US Dollars to the ECB in exchange for Euros for a specified period of time at an extremely cheap rate. Through this, the ECB gets access to emergency rescue funds in case things go bad, and then lend it local commercial banks according to prevalent monetary policy and guidelines. As such, the Fed does not expose itself to the financial instability in the EU, as it has lent to a central bank, making it essentially risk free.(Izzo, 2011)

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Dollar swap lines do not solve the underlying issue in the EU as such. It does however help the ECB buy time by reducing pressure on the markets while policy makers search for a permanent solution. Dollar line swaps had been used immediately after the September 11 terrorist attacks, and again extensively during the financial crisis. The lines were shut down in February of 2010, but were reopened in May 2010 to help liquidity in the EU zone. The swap agreements are expected to be operational until February 2013.(Federal Reserve, 2011)

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REASONS FOR DIVERGENCE

5. Reasons for Divergence

So far we have discussed how the two central banks chose to deal with a somewhat similar problem, lack of liquidity in their respective markets in different ways. On one hand, the Fed chose to adopt a policy that floods the market with liquidity, while the ECB eases liquidity in the market with cautious refinancing operations, rather than purchasing securities outright. This divergence in policy stems from three main areas, namely, mandates, structures and underlying economic issues.

5.1.1

Bank Mandates

Mandates are essentially one line statements that explain the mission of a central bank and define the scope of the central banks responsibilities. The Federal Reserve defines it mission as Stable prices, moderate long term interest rates and maximum employment (Federal Reserve, 2000). On the other hand, the ECBs mandate comprises of Maintaining price stability over the medium term(European Central Bank). It is here where the difference between the two central banks is apparent. Just as the Fed has a broad mandate, the ECB has a narrow mandate. It boils down to one number; 2%. Prices can rise by no more than 2% over the medium term (European Central Bank). This difference can be explained by looking into the respective origins of the central banks and prior crisis that help frame their philosophy.

The US, Federal Reserve and the Great Depression

The Great Depression is one of the defining moments in US history. It effects how the US conducts its politics as well as its economics. Considerable research has been conducted on the causes of the Great Depression, but a key highlight is the failure of the Fed to act decisively.

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The Fed had adopted a laissez-faire approach, opting not to inject money into the economy, in the hope that the market forces will sort itself out. As the market forces took their course of action, more than 20% of the population lost their jobs (Swanson, 1972). GDP during the four years between 1929 and 1933 declined by 30%, the stock market lost 90% of its value. This was a turning point in the way how Fed would handle subsequent crisis.

Therefore, when the financial crisis broke out in 2008, the Fed chose not to repeat its inaction, and for better or worse, the Fed acted to bail out the financial institutions.

Germany, the ECB and the Hyperinflation in the Weimar Republic

For the ECB, it was the hyperinflation of Germany between 1921 and 1924 that has defined monetary outlook. Germany, at the end of World War 1, had to sign the Treaty of Versailles as a condition of end of hostilities. Among the terms of the treaty was accepting the responsibility of the war, and paying heavy repatriations amounting to $31.4 billion (Magaa, 2005) (adjusted to 2012 rates, $442 billion. Previously, Germany chose to finance its war efforts through borrowings, rather than taxing its citizens, Unable to increase borrowing, the government resorted to printing money to meets its obligations. This led to a rapid devaluation of the German Mark, during which the mark halved in value every 3.7 days (Hanke, 2009). People carried money in wheel barrows to purchase bread. The currency had become worthless enough that the government chose to give away the currency notes to junk dealers for recycling.

5.1.2

Bank Structure

To put it simply, it is comparatively easier for the Fed to implement monetary policy. The Board of Governors and the Federal Open Market Committee decide on and announce policy 19 | P a g e

decisions based on recommendations from the regional Federal Reserve banks, member banks and advisory committees. In the ECB on the other hand, policy recommendations are subject to parliamentary approval from all 17 Euro member states. This makes monetary policy implementation an extremely frustrating diplomatic and political process, apparent during the recent passing signing of the Fiscal Stability Treaty in March 2012. The EU Treaty furthermore prevents the ECB from taking decisive steps such as taken by the Fed, e.g. it is illegal for the ECB to provide member nations with bail out packages.

5.1.3

Aggregate Demand

Another reason why Fed policies have been comparatively more aggressive is because of low aggregate demand in the US. High levels of unemployment means that people do not have a steady source of income, and are therefore being cautious in their consumption. This is the reason why the Fed plans to run QE3 indefinitely. In short, when the Fed says it plans to continue QE3 until market conditions improve, it is essentially saying until it sees improvement in aggregate demand. At present, there seem to be few signs of improvements in aggregate demand. Consumer confidence hit a four and a half year high in November 2012 (Rugaber, 2012), while Black Friday spending grew by 13% over the previous year to a all time high (Fox, 2012).

However, there is likelihood the optimism and spending is seasonal only. Consumer confidence dropped sharply during the summer of 2012. The November increase represents only the second consecutive increase in the past six months. This holiday shopping expenditure could be a result of people cutting down on year long consumption, only to spend during the holiday season.

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Current market conditions in the EU point towards weakening aggregate demand as well. Consumer confidence has been falling consecutively since early 2012, while business confidence in the EU has not risen since September 2011. Low business confidence in the market means that businesses will be reluctant to hire more personnel, negatively affecting disposable income in the market, while weakening consumer confidence is a sign that consumers are worried about uncertainties in the market, and will therefore hold onto consumption, reducing aggregate demand in the country.

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CONCLUSION

6. Conclusion

While Fed policies have been directed towards maintaining high liquidity in the market in order to boost the economy, the ECB has been implementing monetary policy directed towards only preventing a liquidity crisis. Given the deteriorating market conditions in EU nations, the ECB will have to decisively before member nations spiral into another recession.

Part of the solution is to expand the EU from just a monetary union, to a fiscal one as well. Under the current set-up, it is extremely difficult for the ECB to implement monetary policy effectively. The EU needs to ensure that any decision made in one member state does not affect another. Essentially, the EU will have to structure itself a little more like the US. Only after that, can the ECB act boldly like the Fed.

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BIBLIOGRAPHY

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Matthews, D. (2011, September 28). Everything you need to know about the European debt crisis in one post . Retrieved from Washington Post: http://www.washingtonpost.com/blogs/wonkblog/post/everything-you-need-to-knowabout-the-european-debt-crisis-in-one-post/2011/08/05/gIQAg69QwI_blog.html

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