The spectre of deflation haunts the eurozone economy. Inflation in the 12 months to May 2014 was 0.5%, down from 0.7% to April and well below the target of 2% (see). Price deflation can result in deflation of the whole economy. With the prospect of falling prices, many consumers put off spending, hoping to buy things later at a lower price. This delay in spending deflates aggregate demand and can result in a decline in growth or even negative growth: hardly a welcome prospect as the eurozone still struggles to recover from the long period of recession or sluggish growth that followed the 2007–8 financial crisis.
The ECB is well aware of the problem. Its President, Mario Draghi, has stated on several occasions that the central bank will do whatever it takes to ward off deflation and stimulate recovery. At its monthly meeting on 5 June, the ECB Council acted. It took the following measures (see Mario Draghi’s press conference and the press release):
• The main refinancing rate it charges banks on reverse repos (when using open-market operations) was cut from 0.25% to 0.15%.
• The rate it pays banks for depositing money in the ECB was cut from 0% to –0.1%. In other words, banks would be charged for ‘parking’ money with the ECB rather than lending it.
• It will provide targeted lending to banks (targeted longer-term refinancing operations (TLTROs)), initially of 7% of the total amount of each banks’ loans to the non-financial private sector within the eurozone. This will be provided in two equal amounts, in September and December 2014. These extra loans will be for bank lending to businesses and households (other than for house purchase). The total amount will be some €400 billion. Substantial additional lending will be made available quarterly from March 2016 to June 2016.
• It will make preparations for an asset purchase scheme. Unlike that in the UK, which involves the purchase of government bonds, this will involve the purchase of assets which involve claims on private-sector (non-financial) institutions. Depending on financing arrangements, this could amount to quantitative easing.
• It will suspend sterilising the extra liquidity that has been injected under the Securities Markets Programme (operated from May 2010 to September 2012), which involved purchasing eurozone countries’ existing bonds on the secondary market. In other words it will stop preventing the securities that have been purchased from increasing money supply. This therefore, for the first time, represents a genuine form of quantitative easing.
The question is whether the measures will be enough to stimulate the eurozone economy, prevent deflation and bring inflation back to around 2%. The measures are potentially significant, especially the prospect of quantitative easing – a policy pursued by other main central banks, such as the Fed, the Bank of England and the Bank of Japan. A lot depends on what the ECB does over the coming months.
The following articles consider the ECB’s policy. The first ones were published before the announcement and look at alternatives open to the ECB. The others look at the actual decisions and assess how successful they are likely to be.
Articles published before the announcement
Mario Draghi faces moment of truth as man with power to steady eurozone The Observer, Larry Elliott (1/6/14)
What the ECB will do in June? Draghi spells it out The Economist (26/5/14)
Draghi as Committed as a Central Banker Gets, as Economists Await ECB Stimulus Bloomberg, Alessandro Speciale and Andre Tartar (19/5/14)
ECB’s credit and credibility test BBC News, Robert Peston (2/6/14)
90 ECB decamps to debate monetary fixes Financial Times, Claire Jones (25/5/14)
Monetary policy in a prolonged period of low inflation ECB, Mario Draghi (26/5/14)
Articles published after the announcement
ECB launches €400bn scheme, seeks to force bank lending Irish Independent (5/6/14)
The ECB’s toolbox BBC News, Linda Yueh (5/6/14)
ECB’s justified action will help but is no panacea for eurozone deflationary ills The Guardian, Larry Elliott (5/6/14)
Why Negative Rates Won’t Work In The Eurozone Forbes, Frances Coppola (4/6/14)
Germany’s fear of QE is what’s stopping us from cracking open the Cava The Telegraph, Roger Bootle (8/6/14)
Euro area economic and financial data ECB
- Why has the eurozone experienced falling inflation and a growing prospect of negative inflation?
- Explain how the Securities Markets Programme (SMP) worked (check it out on the ECB site). What countries’ bonds were purchased and why?
- What is meant by sterilisation? Why did the ECB sterilise the effects of the assets purchased under the SMP?
- If it is practical for the ECB to set a negative interest rate on the deposit facility for banks, would it be practical to set a negative interest rate for the main refinancing operations or the marginal lending facility? Explain.
- Why has the ECB, up to now, been unwilling to engage in quantitative easing? What has changed?
- Why may the introduction of a negative interest rate on bank deposits in the ECB have only a very small effect on bank lending?
- How much is broad money supply growing in the eurozone? Is this enough or too much? Explain.
- What else could the ECB have done to ward off deflation? Should the ECB have adopted these measures?
At the Mansion House dinner on 15 June, the Chancellor, George Osborne, and the Governor of the Bank of England, Sir Mervyn King, announced a new monetary policy initiative to increase bank credit. The idea is to stimulate borrowing by both firms and households and thereby boost aggregate demand.
There are two parts to the new measures:
1. Funding for lending. The aim here is to provide banks with cheap loans (i.e. at below market rates) on condition that they are used to fund lending to firms and households. Some £80 billion of loans, with a maturity of 3 to 4 years, could be made available to banks under the scheme. The details are still being worked out, but the scheme could work by the Bank of England supplying Treasury bills to the banks in return for less secure assets. The banks could then borrow against these bills in the market in order to lend to customers.
2. Providing extra liquidity to banks through six-month repos. The Bank of England will begin pumping up to £5bn a month into the banking system to improve their liquidity. This is an activation of the ‘Extended Collateral Term Repo Facility’ (see also), which was created last December, to provide six-month liquidity to banks against a wide range of collateral.
But whilst it is generally accepted that a lack of borrowing by firms and households is contributing to the slowdown of the UK economy, it is not clear how the new measures will solve the problem.
In terms of the supply of credit, banks have become more cautious about lending because of the increased risks associated with both the slowdown in the UK economy and the euro crisis. They claim that the issue is not one of a shortage of funding for lending, but of current uncertainties. They are thus likely to remain reluctant to lend, despite the prospect of extra loans from the Bank of England.
In terms of the demand for credit, both businesses and consumers remain cautious about borrowing. Even if bank loans are available, firms may not want to invest given the current uncertainties about the UK, eurozone and world economies. Consumers too may be reluctant to borrow more when people’s jobs may be at stake or at least when there is little prospect of increased wages. Even if banks were willing to lend more, you cannot force people to borrow.
Britain fights euro zone threat with credit boost Reuters, Matt Falloon and Sven Egenter (14/6/12)
Debt crisis: emergency action revealed to tackle ‘worst crisis since second world war’ Guardian, Larry Elliott, Jill Treanor and Ian Traynor (14/6/12)
Q&A: Funding for lending scheme Financial Times, Norma Cohen (15/6/12)
Bank lending plan: How will it work? BBC News (15/6/12)
Bank of England’s loans to high street banks start next week Guardian, Phillip Inman (15/6/12)
Mervyn King: Bank of England and Treasury to work together The Telegraph (15/6/12)
Bank of England offers £80bn loans Channel 4 News, Sarah Smith (15/6/12)
Bank funding scheme plans unveiled Independent, Holly Williams (15/6/12)
Banking: King hits panic button Independent, Ben Chu (15/6/12)
Bankers raise doubts on credit scheme Financial Times, Patrick Jenkins and Sharlene Goff (15/6/12)
We should not pin our hopes on Britain’s plan A-plus Financial Times, Martin Wolf (15/6/12)
Throwing money at banks won’t solve economic crisis, Ed Balls says Guardian, Patrick Wintour (15/6/12)
UK lending plan faces risk of low take-up BloombergBusinessweek, Robert Barr (15/6/12)
Will Bank of England’s new lending schemes work? BBC News, Robert Peston (15/6/12)
Bank and Treasury’s plan A-plus for UK BBC News, Stephanie Flanders (15/6/12)
- How would the schemes incentivise banks to lend more?
- Explain what is meant by the Extended Collateral Term Repo Facility. How similar is it to the long-term repo operations of the ECB (see the news item More bank debt to ease bank debt)?
- What factors are likely to determine the take-up of loans from banks?
- Will the new arrangements have any implications for taxpayers? Explain.
- To what extent are fiscal and monetary policy currently complementary?
- What is the significance of calling the new measures ‘Plan A-plus’? What would ‘Plan B’ be?
The European Central Bank does not provide direct support to eurozone countries by buying new bonds. However, it can give indirect support by helping banks buy such bonds. In a move announced on 8 December, the ECB will increase the maximum term of its ‘longer-term refinancing operations’ (LTROs) from the current 13 months to three years. In other words, it will effectively provide three-year loans to banks by purchasing banks’ assets on a ‘repurchase (repo)’ basis, whereby banks agree to buy back the assets at the end of the three-year term.
The hope is that banks will use these loans (at an annual rate of 1%) to purchase new bonds from countries such as Italy and Spain. If banks are more willing to buy them, this should help reduce the interest rate at which governments are forced to borrow. Banks would benefit from the ‘carry trade’, whereby they borrow at a low interest rate (from the ECB) and lend at a higher rate to governments by buying their bonds.
To encourage banks to take advantage of these new longer-term repos,the ECB announced that the assets it was prepared to purchase would include securitised assets with a rating of single A (the highest rating is AAA). In other words, it would accept assets with a ‘second-best rating’.
But although the scheme would allow banks to make a clear gain from a carry trade, banks may be reluctant to use such loans to increase their holdings of sovereign debt of countries with large debt to GDP ratios, given concerns in the market about the riskiness of such assets.
Articles and podcast
ECB repo extension a fillip for sovereigns Financial News, Matt Turner (15/12/11)
Doubts over ECB move to boost bond sales Financial Times, Tracy Alloway (15/12/11)
ECB Chief Plays Down Hopes for Bigger Bond Purchases Wall Street Journal, Tom Fairless And Margit Feher (15/12/11)
Eurozone crisis ‘misdiagnosed’ BBC Today Programme, George Magnus (16/12/11) (second part of podcast)
Banks snap up €500bn in loans from European Central Bank Guardian. Larry Elliott (22/12/11)
Analysis: ECB cash to give indirect boost via banks Reuters, Natsuko Waki and Steve Slater (22/12/11)
Demand for ECB loans rises to €489bn Financial Times, Tracy Alloway and Ralph Atkins (21/12/11)
ECB’s rescue of eurozone banks is temporary BBC News, Robert Peston (21/12/11)
ECB Press release
ECB announces measures to support bank lending and money market activity ECB (8/12/11)
- Explain how repos work. What is the difference between repos and reverse repos?
- What is meant by the term ‘carry trade’?
- Why may banks be unwilling to gain from the carry trade possibilities of the ECB’s new 3-year LTROs by using them to fund the purchase of new sovereign bonds? What risks are entailed by their doing so?
- How do these new long-term repo operations differ from quantitative easing? Explain whether or not the effect is likely to be similar
- What are the arguments for and against the ECB engaging in a round of substantial quantitative easing?
By measuring the size and growth of the money supply we can begin to assess the appetite for saving, spending, and borrowing by households and firms and the appetite amongst banks and building societies to supply credit. In this blog we use figures released by the Bank of England in Monetary and Financial Statistics (Bankstats) to begin such an assessment. But, of course, the very first problem we face is measuring the money supply: just what should be include in a measure of money?
One measure of money supply is known as M4. It is a broad measure of money reflecting our need to use money to make transactions, but also our desire to hold money as a store of wealth. According to the Bank of England’s figures the amount of M4 money at the end of October was £2.19 trillion. To put this into some context, the GDP figure for 2009 was £1.4 trillion, so the amount of M4 is equivalent to about 1½ times GDP.
What M4 measures is the stock of notes and coins and sterling-denominated deposits held by households, firms (non-financial corporations or NFCs) and other financial corporations (OFCs), such as insurance companies and pension funds. These groups are collectively referred to as the non-bank private sector or sometimes as the M4 private sector. As well as the deposits that most of us are familiar with, such as sight and time deposits, sterling-denominated deposits also include other less well known, but liquid financial products, such as repos (sale and repurchase agreements) and CDs (certificates of deposit). Repos are essentially secured loans, usually fairly short-term, where individuals or organisations can sell some of their financial assets, such as government debt, to banks in return for cash. Certificates of deposit are a form of time deposit where certificates are issued by banks to customers for usually large deposits for a fixed term.
The Bank of England’s figures also allow us to analyse the actual holdings of M4 by households, private non-financial corporations and other financial corporations. Consequently, we can analyse the source of these particular liabilities. Of the £2.19 trillion of M4 money at the end of October, 42% was attributable to OFCs, 11% to PNFCs and 47% to households. Interestingly, the average shares over the past 10 years have been 28% OFCs, 14% NFCs and 58% households. Therefore, there has been a shift in the share of banks’ M4 liabilities away from households and towards other financial corporations (OFCs).
So why the change in the composition of Sterling M4 liabilities held by the banking system? Part of the answer may well be attributable to Quantitative Easing (QE): the Bank of England’s £200 billion purchase of financial assets. It appears that a large part of this asset-purchase strategy has resulted in other financial corporations (OFCs) – our insurance companies and pension funds – exchanging assets like government bonds for cheques from the Bank of England. Of course, these cheques are deposited with commercial banks and the banks are then credited with funds from the Bank of England. A crucial question is whether these deposits have facilitated additional lending to households and firms and so created credit.
A major ‘counterpart’ to the private sector sterling liabilities that comprise M4 is sterling lending by banks to the non-bank private sector. Of particular interest, is lending to that bit of the private sector comprised by households and private non-financial corporations. The latest Bank of England figures show that in October net lending to households (including unincorporated businesses and non-profit making institutions) was £1.5 billion. This compares with a 10-year monthly average of close to £3.9 billion. Meanwhile, net lending to private non-financial corporations in October, which over the past 10 years has averaged just over £2.1 billion per month, was -£2.2 billion. The negative figure for PNFCs indicates that more debt was being repaid by firms to banks than was being borrowed.
The net lending figures indicate that lending by banks to households and firms remains incredibly subdued. This is not to say that QE has in any way failed since one cannot directly compare the current situation with that which would have resulted in the absence of QE. Rather, we note that the additional deposits created by QE do not appear to have fuelled large amounts of additional credit and, in turn, further deposits fuelling further credit. The limited amount of credit creation for households and private non-financial corporations helps to explain the relatively slow growth in the stock of M4 held by households and PNFCs. While the stock of M4 increased by 6% in the year to October from £2.06 trillion last year, the stock held by households and PNFCs grew by around 2½%.
It is of course difficult to fully appreciate the extent to which the subdued lending numbers reflect restricted bank lending despite QE, or the desire for households and firms to improve their respective financial positions. One could argue that both are a symptom of the same thing: the desire for banks, households and firms alike to be less susceptible to debt. Clearly, these balance sheet effects will continue to have a large impact on the economy’s activity levels.
Business loans and mortgage approvals falls Financial Times, Norma Cohen (29/11/10)
UK mortgage approvals fall, M4 at record low on yr – BOE MarketNews.Com (29/11/10
Drop in mortgage approval levels The Herald, Mark Williamson (29/11/10)
Mortgage approvals dip to eight-month low Independent, Sean O’Grady (30/11/10)
Mortgage approvals fall to six month low BBC News (29/11/10)
Gross lending up £1 billion in October Mortgage Introducer, Sarah Davidson (29/11/10)
M4 statistics are available from the Bank of England’s statistics publication, Monetary and Financial Statistics (Bankstats) (See Tables in Section A.)
- What do you understand by a narrow and a broad measure of the money supply? Which of these describes the M4 measure? Explain your answer.
- What other liabilities do you think might be included on the balance sheet of the UK’s banking system which are not included in M4?
- What do you understand by credit creation? Explain how the exchange by OFCs (e.g. insurance companies and pension funds) of government debt for cheques from the Bank of England could facilitate credit creation?
- What factors can affect the extent of credit creation by banks? How might these have affected the ability of QE to get banks lending again.
- What is meant by net lending? And, what does a negative net lending figure show?
- What do you understand by ‘balance sheet effects’? Illustrate with respect to households, firms and banks.
The governor of the Bank of England, Mervyn King, made an important speech in New York on 25th October. The Governor’s speech was a wide-ranging discussion of the banking system. At the heart of it was a fundamental economic concept: market failure. The market failure that King was referring to stems from the maturity transformation which occurs when banks borrow short, say through our savings or wholesale funds from other financial institutions, and then lend long as is the case with mortgages. Of course, the positive outcome of this maturity transformation is that it does allow for funds to be pooled and this, in turn, enables long-term finance, something which is incredibly important for business and households. However, King believes that banks have become too heavily reliant on short-term debt to finance lending. Indeed he went so far as to describe their levels of leverage as ‘extraordinary’ and ‘absurd’. He argued that such a system can only work with the ‘implicit support of the taxpayer’.
In elaborating on the market failure arising from maturity transformation in today’s financial system, King notes
…the scale of maturity transformation undertaken today produces private benefits and social costs. We have seen from the experience of first Iceland, and now Ireland, the results that can follow from allowing a banking system to become too large relative to national output without having first solved the “too important to fail” problem.
In the speech, King considers a range of remedies to reduce the risks to the financial system. These include: (i) imposing a tax on banks’ short-term borrowing which could, to use the economic terminology, help internalise the external cost arising from maturity transformation; (ii) placing limits on banks’ leverage and setting capital requirements as outlined in the recent Basel III framework (for a discussion on Basel III see Basel III – tough new regulations or letting the banks off lightly?; (iii) functional separation of bank activities to safeguard those activities critical to the economy. King argues that whatever remedies we choose they should be guided by one fundamental principle: “ensure that the costs of maturity transformation – the costs of periodic financial crises – fall on those who enjoy the benefits of maturity transformation – the reduced cost of financial intermediation”.
Mervyn King’s speech makes considerable reference to our banks’ balance sheets. So to conclude this piece we consider the latest numbers on the liabilities of British banks. At the end of each month, in its publication Monetary and Financial Statistics, the Bank of England publishes figures on the assets and liabilities of Britain’s banking institutions or ‘MFIs’ (monetary and financial institutions). The latest release showed that British banks had total liabilities of some £8.15 trillion at the end of September 2010. To put it into perspective that’s equivalent to around 5½ times the country’s annual Gross Domestic Product. Of this sum, £3.75 trillion was classified as Sterling-denominated liabilities, so largely reflecting operations here in the UK, while £4.39 trillion was foreign currency liabilities reflecting the extent of over-seas operations.
The Sterling liabilities of our financial institutions are dominated by two principal deposit types: sight deposits and time deposits. The former are deposits that can be withdrawn on demand without penalty whereas time deposits require notice of withdrawals. Sterling sight deposits at the end of September totalled £1.16 trillion (31% of Sterling liabilities and 80% of annual GDP) while time deposits totalled £1.52 trillion (40% of Sterling liabilities and 105% of annual GDP). The next largest group of deposits are known repos or, to give them their full title, sales and repurchase agreements. Repos are essentially loans, usually fairly short-term, where banks can sell some of their financial assets, such as government debt, to other banks and this can help to ease any shortages in funds. Sterling-denominated repos totalled £197.8 billion at the end of September (8% of Sterling liabilities and 21% of annual GDP).
To conclude, the growth in our banking system’s liabilities has been pretty staggering. Compared with today’s liabilities of nearly £8.15 trillion, liabilities 13 years ago totalled £2.35 trillion. So over this period the banks’ liabilities have risen from a little below 3 times Gross Domestic Product to over 5½ times GDP. That is certainly worthy of analysis.
Mervyn King’s speech
Banking: from Bagehot to Basel, and back again The second Bagehot lecture, New York City (25/10/10)
Mervyn King mobilises his tanks Independent, Ben Chu (26/10/10)
Get tougher on banks, says banking governor Mervyn King’ Daily Mail, Hugo Duncan (26/10/10)
Mervyn King attacks ‘absurd’ bank risk BBC News (26/10/10)
Mervyn King says banking must be reinvented BBC News blogs: Peston’s Picks, Robert Peston (26/10/10)
Data on banks’ liabilities and assets are available from the Bank of England’s statistics publication, Monetary and Financial Statistics (Bankstats) (See Table B1.4.)
- What do you understand by the terms: (i) market failure; and (ii) maturity transformation?
- What is the external cost identified by Mervyn King arising out of maturity transformation?
- What does it mean to internalise an external cost? Can you think of examples from everyday life where attempts are made to do this?
- Consider the various ‘remedies’ identified by Mervyn King to reduce the riskiness of our financial system. (You may wish to download the speech using the web link above).
- Distinguish between the following deposits: (i) time deposit; (ii) sight deposit; and (iii) repos.