In order to be effective, a central bank must act as a monopoly. It, just like Sauron, must control all. That’s the point.
All central banks thus routinely corner markets. If they didn’t, they would compromise their own position.
They alone determine the ultimate cost of money via their lender of last resort status and ability to control reserves. They also, however, influence general interbank rates through their dominant position in their respective government’s debt. That fact alone means they can influence not just the short-term cost of money, but also longer term rates and curves. Or at least that’s the hope.
So what happens if that monopoly position is compromised?
As Harvard economist Benjamin Friedman once noted:
The influence of monetary policy over interest rates, and via interest rates over nonfinancial economic activity, stems from the central bank’s role as a monopolist over the supply of bank reserves. Several trends already visible in the financial markets of many countries today threaten to weaken or even undermine the relevance of that monopoly, and with it the efficacy of monetarypolicy. These developments include the erosion of the demand for bank-issued money, the proliferation of nonbank credit, and aspects of the operation of bank clearing mechanisms. What to make of these threats from a public policy perspective — in particular, whether to undertake potentially aggressive regulatory measures in an effort to forestall them — depends in large part on one’s view of the contribution of monetary policy toward successful economic performance.
The standard explanation for central banks’ ability to affect such large markets through such small operations is that transactions by the central bank are fundamentally different from transactions by private market participants. When a central bank buys securities, it makes payment by increasing the reserve account of the seller’s bank, thereby increasing the total volume of reserves that the banking system collectively holds. When a central bank sells securities, it receives payment by reducing the reserve account of the buyer’s bank, thereby reducing the total volume of reserves. No other market participant can either increase or reduce the total volume of reserves. The central bank is a monopoly supplier (and withdrawer) of reserves.
Being a monopolist is of little value if nobody needs, or even wants, to have whatever the monopoly is of.
The ECB, by its very construct, is only a quasi monopoly. It controls euro reserves, but it depends on national central banks to influence their respective bond markets, of which there are many. Until the recent crisis, the last point didn’t matter much since all bond yields and curves were pretty much converged at what we might presume was the cost of borrowing of the strongest members.
Intervention in repo markets used to be easy, since all bonds were considered a like-for-like. Each member’s bond was willingly accepted as collateral privately and at the ECB. Theoretically, it didn’t matter which market the ECB targeted for its market operations (though the largest and most liquid made sense).
But the crisis changed all of this. While euro liquidity was still in theory available against the bonds of any member, the market’s preferences began to change. And they changed because of growing counterparty concerns.
Understandably it was the countries with the weakest banking systems (and greatest counterparty issues) which immediately became more dependent on ECB liquidity than others. Ironically, this tied up ever more collateral at their respective central banks. The Greek banks, for example, were prominent users of the ECB’s first LTRO operation back in June 2009.
More Greek bonds tied up at the ECB, arguably meant less bonds available for the market. In a small bond market like Greece, such a change could have had a big impact on market liquidity. One thing is for sure, it was in the latter half of 2009 that the European bond market started showing signs of impaired efficiency, as evidenced by failed settlements in particular, and this was primarily led by the Greek market.
As a European Repo Council’s white paper in 2010 noted:
The CSD has reported that settlement efficiency in government securities has fallen from over 99.1% to 97.6% in February 2010 (in terms of value and excluding accumulated delivery failures). As the settlement system has not been changed, the CSD believes the increase in delivery failures was due to a shift in trading behaviour which has been reflected in an increase in uncovered short positions. These almost doubled over the year to May 2010, to reach EUR 200 billion, and buy-in notices in the first two months of 2010 equalled those sent over the whole of 2009.
As we’ve already noted, such market inefficiencies can lead to frozen or illiquid markets, which can unfortunately lead to quality perception issues. It might also encourage market participants to turn to alternative hedging markets like credit default swaps (a point that should possibly be considered when trying to determine whether bond markets lead CDS markets, or vice versa).
Of course, under a normal central bank monopoly, a market freeze of this sort isn’t quite the death knell for bond yields as it proved in Greece. The central bank can easily grease the market by coming up with a host of creative facilities to ease constraints — some of which can involve cooperation between the central bank and the debt agency itself.
In the Eurozone there are limits. Once the market decides to drop your market, there’s very little the central bank can do to restore its monopoly influence. You can’t persuade the market to keep trading Greek bonds when there are many other (and clearly better) options still available.
Which means until the best collateral starts to trade at the weakest member’s cost of funding, you can’t expect a resolution. All bonds must be considered a like-for-like once again, especially in terms of funding. Simply put, multiple bond curves can’t work in a currency union.
The point was also stressed by Benjamin Friedman in his 1999 central bank monopoly paper:
Because of the substantial economic heterogeneity that prevails across the participating countries, Europe’s new monetary union is very likely to prove unstable in its current form. Much speculation, recently diminished by the euphoria surrounding the euro’s successful introduction (to date only as a unit of account), has focused on whether some crisis or other may drive one or more of the union’s eleven member countries to abandon the project, and if so, just what that would mean.
A more likely outcome, however, is that the pressures of such a crisis — or of repeated crises — would force the creation of a broader union, importantly including coordination of fiscal policies across the member countries (beyond the existing obligation under the Maastricht Treaty to limit government deficits to 3% of national income) as well as fiscal transfers among them.
The logical starting place for such fiscal transfers would be lender-of-last-resort policy and deposit insurance, both of which arise as natural adjuncts of monetary policy even though they are essentially fiscal functions, and both of which (especially lender-of-last-resort actions) may be easier to introduce politically because they arise in the context of actual or threatened financial crises rather than as an aspect of ordinary ongoing circumstances. Beyond lies the entire range of intergovernmental revenue sharing schemes, as well as personal tax and transfer systems, that would enable a member country enjoying a monetary policy that is right for its economic needs to help ease the burden on another member country that is forced to accept the same monetary policy even if its needs are sharply different. Just how far the European Union will go along this route, if that is indeed the probable outcome, is no doubt a matter of the specific time horizon in question. But the thought that monetary union may in time force the evolution of a deeper, more fundamentally political level of unification is probably not inconsistent with what the euro’s original architects had in mind.
In other words, one Eurobond which brings them all together and in the
darkness system binds them.