E-Book, Englisch, 116 Seiten
Zaman The Impending Demise of the Euro. The Impact of Monetary Policy on the Sustainability of the Euro
1. Auflage 2018
ISBN: 978-3-96067-676-8
Verlag: Diplomica Verlag
Format: PDF
Kopierschutz: 0 - No protection
E-Book, Englisch, 116 Seiten
ISBN: 978-3-96067-676-8
Verlag: Diplomica Verlag
Format: PDF
Kopierschutz: 0 - No protection
The aim of this thesis is to study the impact of expansionary monetary policy on the European economies through the conceptual framework of the Austrian Business Cycle Theory. The European Central Bank has continually reduced interest rates as a policy measure to counter the sovereign debt crisis and this thesis examines the implications of this venture. From Germany’s perspective, the viability of reverting to the Deutschmark in times of monetary instability is also explored. The results, based on the deductive reasoning principle of the Austrian School, are also discussed.
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Chapter 3: Central Banks and Monetary Union:
Now, let us discuss in detail, the major roles of a central bank. The mission of a central bank is to provide the nation with a safe and stable financial system. Its main functions are: (i) being the bank of the government and commercial banks, (ii) being the lender of last resort, and (iii) regulating the banking system and managing monetary policies (Parkin et al., 1997).
Being the bank of the government means financing its spending which can be done in two ways. It can be done either by issuing a direct loan which is equivalent to money printing, or alternatively, by selling government bonds. The central bank changes the supply of money by buying or selling bonds in the bonds market in what is called open market operations. If it wants to decrease the amount of money in circulation it sells existing bonds in the market, thereby removing money from the existing supply. On the other hand, if the central bank wishes to increase the amount of money in the economy, it buys bonds by creating money (Blanchard, 2003). The price of these bonds and their interest rates has an inverse relationship. The lower the bond price, the higher the interest rate and vice versa. Thus, financing debt through open market operations can be used to control the interest rate in financial markets.
Being the bank of the commercial banks imply keeping their reserves, regulating the banking sector and acting as their lender of last resort. When central banks extend credit to commercial banks in times of a credit crunch, it means they are serving the purpose of being a lender of last resort. Restoring the cash levels of commercial banks helps to avoid a possible bank run. In theory, the central bank can also regulate the money supply by increasing the minimum reserve requirement.
A central bank can also directly set the interest rate at which commercial banks borrow funds. Increasing the interest rate makes it more costly to loan money from the central bank, encouraging commercial banks to cut down on their lending, while a fall in the interest rate naturally stimulates lending. The banks are required to keep a specific fraction of their deposits on reserve, to be made available for customer withdrawal. Banks can find themselves below the reserve requirement set by the central bank if they have made a lot of loans or if an unusually large number of people have withdrawn funds. Banks borrow from each other when the need arises for additional cash reserves to meet this reserve requirement. The interest rate increases when there is too much demand from banks looking to borrow and too little supply from banks willing to lend. A central bank, like the Federal Reserve of the United States, then intervenes by buying bonds from the banks. This gives the banks more money in the form of reserves to lend to banks that need it. In the process, funds available to be lent to other banks become more abundant, and a correspondingly lower interest rate reflects this. So, a question may now arise regarding from where exactly a central bank can get hold of this money to buy the bonds. Paul (2008) provided a simple answer to this query by stating that the central bank creates the money out of thin air by writing checks on itself and then giving them to the banks.
3.1 The European Central Bank (ECB):
The European Central Bank (ECB) is at the heart of European monetary union. The ECB was envisioned in the Maastricht Treaty (1992) and legally formed in 1998. It is responsible for issuing the euro, which is a single currency for nineteen out of the twenty eight nations that are European Union (EU) members. Moreover, the ECB conducts monetary policy with the mandate of maintaining price stability in the eurozone. It also manages the foreign exchange reserves of the nineteen national central banks in the eurozone (countries using the euro) and operates a payments platform among those banks called TARGET2.
The European System of Central Banks (ESCB) consists of the European Central Bank (ECB) and the national central banks of the EU member states. The ESCB is governed by the decision-making bodies of the ECB, which consists of the Governing Council and the Executive Board (ECB, 2002). The Governing Council (comprising nineteen national governors) of the ECB is empowered to formulate monetary policy, while the Executive Board of six members is responsible for implementing the monetary policy according to the guidelines established and decisions made by the Governing Council. If its multinational nature is taken into consideration, the ECB is definitely quite distinct from all other central banks. It is responsible for shaping the combined monetary policy in a system consisting of nineteen countries, each of which retains considerable control of the other relevant economic policy instruments.
3.2 Money Creation by the ECB:
Now, let us take a look at how the ECB can use monetary operations to indulge in money creation. To start off, when governments wish to spend more than they receive in taxes, they issue bonds. The ECB is not supposed to buy these bonds outright. However, this changed with the recent sovereign debt crisis, as will be discussed in detail later.
Banks will buy such a bond from the government, possibly by creating new money, because they know that it can be used as collateral. The ECB then accepts the bond (as collateral) in a reverse transaction, thereby lending money to the banks. A reverse transaction is an operation whereby the central bank conducts credit operations against collateral or buys/sells assets under a repurchase agreement (repo). Once the maturity date is reached (usually one week or a month), the ECB simply renews the loan and keeps the bond as collateral, if it wants to maintain the money supply. The ECB can continue to do this for as long as ten years. After this time period expires, the government will have to pay back the bond and normally does so by issuing another bond. Hence, the process goes on in this manner. In other words, the government never has to pay its debt; rather it simply issues new debt to pay for the old one. Moreover, from the interest payment that is paid to the ECB, a part of it actually flows back to the government, as ECB profits are remitted according to the capital of the different national central banks.
The ECB uses three main instruments for its monetary policy: (i) open market operations (ii) standing facilities and (iii) changes in minimum reserves.
According to Bagus (2010), there are basically two main ways to create money via open market operations. The first option enables a central bank to purchase or sell securities outright. As discussed earlier, this is how the Federal Reserve (Fed) of the USA prefers to carry out its open market operations. However, outright purchase or sale of securities is not officially a viable option for the ECB, when it comes to manipulating the money supply, and so it uses the other method by lending new money to banks through its lending facilities. This consists of the structural refinancing facility, the fine tuning facility, the long term refinancing facility and the main refinancing facility. In these facilities, securities are not purchased but used in reversed transactions: repos or collateralized loans.
In a repo, the ECB gets hold of a security with new money and sells it back at a higher price (difference is the amount of interest). A collateralized loan is similar to a repo with the only difference being the issue of legal ownership. In the case of a collateralized loan, ownership of the bond stays with the bank that pledged it as collateral, while in a repo, the ownership of the collateral changes to the ECB.
The ECB has always accepted a broader range of collateral compared to other central banks like the Fed of the USA, thus in essence, making its policies comparatively more flexible. The Fed only accepts or buys AAA rated securities in its open market operations. In contrast, alongside government bonds, the ECB also accepts mortgage backed securities, and other debt instruments that are at least rated A-. As an emergency measure, this minimum rating was reduced to BBB- during the sovereign debt crisis because of the poor ratings of Greek bonds. Eventually, the situation became so bad that the decision was made to accept Greek bonds, regardless of their rating.
The difference between open market operations and standing facilities (the marginal lending facility and the deposit facility) is that the initiative of open market operations lies on the part of the ECB, whereas banks initiate standing facilities. Through the deposit facility, banks can receive interest by depositing money overnight at the ECB (Bagus, 2010). The rate of the deposit facility is the lower limit for interbank rates. No bank would accept a comparatively lower rate for funds in the interbank market because it can get the deposit facility rate at the ECB. On the other hand, in the marginal lending facility, banks can borrow money from the ECB at penalty rates and it represents the upper limit for the interbank rate.
Finally, expansion of credit is also possible by reducing the required minimum reserves that banks must hold in their accounts at the ECB. The opposite scenario of money being taken out of the economy happens in the case of an increase in minimum reserves. This instrument was generally not used and required reserves for demand deposits were held constant at two percent till the end of 2011. However, this rate has been reduced to one percent since 18 January 2012.
3.3 Differences between the Bundesbank and the ECB:
Before the ECB came into existence, the government of France knew that giving assurance to the German government of ECB’s independence from political interventions was necessary for the implementation of a monetary union. The French politicians actually always felt confident that if the necessity arose, the ECB could be used to serve political purposes. Marsh (1992) argues that the most important motive behind the campaign for European monetary union was France’s desire to shackle the Bundesbank’s monetary dominance, and bring about the demise of the Deutschmark (DM).
On the other hand, German politicians believed that the ECB would be like a copy of the prestigious Bundesbank, thereby assisting in bringing stability to the rest of Europe. Marsh (1992) further observes that Germany is one of the few countries in the world where central bank presidents know that tough monetary policies can actually help to enhance their reputation. Hence, preserving sound money and the overall reputation of the Bundesbank always used to take precedence over other matters, including allegiance to the Chancellor. Due to the fact that Germany’s anti-inflation policy was a direct result of history, Dieter Hiss, the former president of the Berlin Landeszentralbank, questioned whether it would ever be possible to transfer this inflation-averse mindset outside German borders. He pointed out that Germany’s need for stability is the result of a painful learning process from a time when savings were wiped out twice within a period of less than thirty years. This form of behavior based on first-hand experience is difficult to pass on to others around the world. Therefore, the key to this German mentality lies firmly rooted in the experience of hyper-inflation of the 1920s.
