Goldman Calls For QE In Europe: "How Far Can The ECB Go In Using Its Balance Sheet. The Short Answer Is: A Lot Further"

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Even as the eyes of the world are currently frozen in a spot in time from ten years ago, and Wikileaks is making doubly sure of this by releasing the entire record of Metrocall pager (remember those?) intercepts starting at 9:55 am on 9/11/01, the world itself continues onward, and especially those who determine its global policy of "Prevention of Harm to The Status QuoTM" are busier than ever this weekend. Chief among these is and always has been the one financial firm which has infiltrated "sovereign" decision-making more than anyone in history: Goldman Sachs, whose alumnus, incidentally, is about to replace Jean Claude Trichet at the helm of the world's largest and most undercapitalized central bank (yes, a central bank can be undercapitalized - read on). Which is why the following note just released by Goldman's Dirk Schumacher is of particular attention. Mere hours after Goldman economist Sven Jari Stehn said that FOMC "easing at the September meeting is very likely—around 75% according to our model", Goldman is now taking on European monetary policy, and specifically the question of further quantitative easing, across the pond, where printing money has always been a far more touchy subject than in the US, courtesy of the German experience with hyperinflation (when gold soared, but apparently accoding to just released brainstorming by that intellectual titan Paul Krugman, for the completely wrong reasons: see gold is now a deflation hedge according to the Nobelist, and has nothing to do with debasing currencies - the NYT columnist just debunked 2000 years of logic and common sense). As a result, the key line in the Schumacher note is the following: "How Far Can The ECB Go In Using Its Balance Sheet.  The Short Answer Is: A Lot Further." To be sure, this is not surprising: after all Zero Hedge first predicted that following the latest market trouncing on Friday, in the aftermath of the ECB's admission of failure on Thursday (who can forget Ze Price Stabeeleetee), see "ECBCTRL+P: The Next Steps In The European Implosion", but we are nothing but a simple blog, which predicts what will happen but certainly does not set policy for a corrupt and failed regime. That's Goldman's job. And what is stunning is the brazenness with which it does it now. To sum up: to Goldman both the Fed and the ECB have to engage asap in yet another episode of bonus-preserving currency debasement, middle class be damned. And, we have very little doubt, they will.

Amusingly, Goldman is magnanimous enough to let us know that this policy will result in the ultimate end of the ECB either through its terminal loss of credibility as a monetary policy setting venue, or, and this is Zero Hedge's take, Germany's decision to say enough, and reinstate the Bundesbank as the ultimate mechanism of monetary decision-making... Yes, that would be DEM decision-making, not EUR.

Yet following that brief detour, Goldman proceeds to discuss the inevitable outcome of such a concerted approach, with the rhetorical question: "How to recapitalise the ECB and the national central banks (if needed)." (Yes, the ECB's endless viability is not guaranteed, someone please notify Roubini). Alas, it will be more than needed, especially after reading Goldman's conclusion, which makes the strawman of currency, Eurozone failure all too clear, should the ECB not engage down this suicidal path:

Given the capital position of the ECB and the limited possibilities for recapitalisation, one could argue that the SMP cannot be expanded much further. But, as already mentioned, the ECB’s implicit exposure with respect to peripheral sovereign debt through the collateral posted by banks is already very large. To be sure, the ECB is marking its collateral to market prices and the losses would be significantly lower than the nominal figures suggest. But it is easy to see how these haircuts would be insufficient in a sovereign default involving any of the bigger countries.


Thus, the argument that the ECB should not increase the SMP further as this may risk its financial health ignores the fact that the ECB is already heavily involved. Moreover, halting the SMP could lead to a similar or even bigger threat to the ECB’s financial health if this meant that a potential liquidity crisis for one of the bigger Euro-zone countries could turn into a disorderly default.

And there you have it: while the world is caught in teary-eyed ruminations over the past, the seeds of a far more painful, and certainly tearful future, were just planted by none other than the bank which always ultimately gets what it wants, no matter how disastrous the implications of its policy are for everyone but Goldman.

The full must read note from Goldman is below, which very appropriately comes on the "10 year anniversary" - 10 years which have seen the American experiment peak, and begin its slow grind into historical irrelevance. Following Goldman's advice should merely precipitate the downward slope and at least make the pain that much briefer.

From Goldman Sachs:

Potential and limits of the ECB’s balance sheet

Like other central banks around the world, the ECB has used its balance sheet in various ways over the past couple of years to stabilise the financial system and  prevent a systemic event involving either a credit institution and/or the government of an EMU member country. This has led many to ask how far the ECB can go in using its balance sheet.

The short answer is: in principle a lot further. But the ECB has to take into account two constraints: its price stability mandate and its financial health. Neither of these two constraints is currently binding. Moreover, the ECB’s financial health is only a constraint to the extent that it could endanger the ECB’s credibility. While a central bank’s credibility is one of its most valuable assets, the ECB may be forced at some point to risk some of its credibility in order to prevent a serious financial crisis. Moreover, with respect to a further expansion of the SMP, the ECB is already significantly exposed to peripheral sovereign debt through its refinancing operations.

Monetary policy in crisis times

Central banks around the world have resorted to a broad range of ‘non-conventional’ measures in order to support growth and stabilise the financial system. Providing sufficient liquidity to the banking sector, for example, was crucial in the early stages of the crisis and central banks have used their balance sheets aggressively so that
funding problems for banks would not turn into wider problems for the whole financial system.

The measures taken by central banks have differed according to the institutional and operational framework of each central bank, as well as the underlying financial system. One important difference has been the varying degree to which central banks were willing to expose their balance sheet to financial risks. Asset purchases made by the Bank of England, for example, were undertaken by an off-balance-sheet vehicle backed by government guarantees. Assets purchased by the ECB, however, are sitting on the ECB’s balance sheet, which implies a higher degree of financial risk for the ECB.

Renewed tensions in peripheral debt markets have now led the ECB to reactivate its Securities Markets Programme (SMP) and the ECB has bought a total of around €130bn of peripheral debt. In our view, these actions by the ECB were dictated by circumstances and form part of its responsibility as a ‘lender of last resort’.  Nonetheless, they raise the issue of how far the ECB can go in using its balance sheet and what, if any, the limits are.

The ECB’s balance sheet has grown strongly with the non-conventional measures

The ECB’s balance sheet stood at around €2trn at the end of August. Table 1 shows a breakdown of this balance sheet into its main categories. The numbers in the first row of the table show the figures for August 2011, and the figures beneath refer to January 2008. As this comparison shows, several items have increased
substantially in size since the start of the crisis.

The box below explains each main item on the ECB’s balance sheet in more detail. But one characteristic of the balance sheet’s liability side is of particular  importance in assessing the ECB’s ability to use its balance sheet. This refers to the fact that the ECB can finance its asset side through the issuance of non-interest-bearing and nonredeemable debt (central bank reserves it can generate at will and which therefore do not constitute a liability in the economic sense). Because of this, the ECB has a much greater degree of freedom than a commercial bank when it comes to the overall size or composition of its balance sheet.

A central bank’s balance sheet grows over time. This is because a growing economy needs a bigger stock of base money, which in turn implies a bigger central bank balance sheet. It is therefore no surprise that the ECB’s balance sheet has increased significantly since the inception of the Euro (Chart 1). The expansion of the
ECB’s balance sheet, however, hasn’t been steady. While it grew more or less in synch with the overall economy from 2000 until 2008, the increase since the onset of the crisis has been much faster (Chart 2).

There are several drivers behind the strong increase in the ECB’s balance sheet. The rise in the gold price, for example, led to an automatic increase in gold holdings (the value of the ECB’s gold holdings has more or less doubled over the last three years). More important, however, was the surge in liquidity provision once the ECB switched to full allotment in its refinancing operations, coupled with an increase in the duration of long-term refinancing operations, in the middle of 2008.

Overall lending to Euro-zone credit institutions increased from less than €500bn before the collapse of Lehman to around €800bn in the fourth quarter of 2008 (see Chart 3). More recently, the ECB’s covered bond program and its SMP have contributed to the overall increase in its balance sheet. The purchases under the covered bond program have been stopped at around €60bn, whereas the SMP remains active, with cumulated purchases since inception of around €130bn.

How much more can the ECB’s balance sheet grow, or change in composition? Quite considerably

Both the increase in the size of the ECB’s balance sheet and the change in its composition—more outright purchases of debt instruments under the covered bond program and the SMP—prompt us to ask: how much further can the ECB extend its balance sheet? The short answer is: considerably further. However, the ECB has to consider two constraints.

Constraint number 1: Price stability

The ECB’s “main task is to maintain the Euro’s purchasing power and thus price stability in the Euro area”. The size of the monetary base is, at least in the medium term, one deciding factor in the inflation outlook. The ECB therefore needs to take into account the medium-term implications for inflation of an expansion of its balance sheet. An unlimited increase in the monetary base would at some point translate into strong credit growth that would eventually lead to an overheating economy and a deteriorating inflation outlook.

The ‘price stability’ constraint, however, is less binding at the current juncture than during normal times. The ECB views its ‘enhanced credit support’, which is reflected in its increased balance sheet, as an important mechanism by which to ensure that its interest rate signal is correctly transmitted across the Euro-zone such that it can fulfil its mandate. There are no signs that the strong increase in base money has translated into a similar strong increase in broader money aggregates or credit to the private sector (Charts 4 and 5).

What is possibly more important than the fact that the increase in base money has not yet ‘spilled over’ into broader monetary aggregates is the ECB’s ability to expand its balance sheet and at the same time offset the potential inflationary implications through so-called sterilisation. The purchases under the SMP, for example, had no effect on the monetary base, as the ECB, through one-week fixed terms deposits, has absorbed broadly the same amount of liquidity that was injected into the
banking system through the purchases.

Overall, a potential conflict with the ECB’s price stability mandate is unlikely to prove a real hindrance for a further expansion of its balance sheet, or a change in its composition, if this were deemed necessary. This is not because the ECB might be willing to compromise on its price stability mandate. Rather, we think that there is, for the time being, no conflict. And, if there were a potential conflict, the ECB has all the necessary tools to separate its balance-sheet operations from pursuing its mandate.

Constraint number 2: Financial strength

The other constraint the ECB faces when it expands its balance sheet is its own financial strength. However, financial strength is again a less clear criterion in the case of central banks than in the case of regular commercial banks. We need to distinguish between two dimensions of financial health: the first concerns a central bank’s ability to cover its expenses, while the second refers to the value of a central bank’s assets vis-à-vis its liabilities.

A central bank could potentially run into financial trouble if its expenses were to overshoot its income. However, as long as its expenses are denominated in the  currency it issues, a central bank can never face a liquidity problem in the same way a commercial bank can. It could, in principle, simply create the money needed to pay its expenses. Any inflationary implications of the excess liquidity generated by such an operation could be dealt with through liquidity absorbing measures.

A central bank also faces fewer constraints than a commercial bank with respect to balance-sheet insolvency (the value of liabilities exceeding the value of assets). Negative equity does not necessarily prevent a central bank from operating; indeed, central banks have in the past continued to operate with negative equity.

Credibility matters

To be sure, the above considerations are rather theoretical, and it is reasonable to assume that the ECB will pay—and already is paying—special attention to its financial strength when using its balance sheet to conduct its ‘non-conventional’ measures. This is not so much because the above arguments do not apply in the case of the ECB but rather because the ECB’s credibility and independence may suffer if the general public were to see its financial health as weak, or if it were to become
technically insolvent.

Credibility, the belief of the general public that a central bank is willing and able to fulfil its mandate, is a necessary prerequisite for a successful implementation of monetary policy. It is easy to see that the trust of the general public would suffer if a central bank were considered not to be in a position to protect its own balance sheet. Moreover, the ECB’s independence may also be brought into question if a weak financial position were seen to be limiting the ECB’s room for manoeuvre. Thus, although a significant loss that had the potential to deplete the ECB’s capital would not imply that the ECB could not operate normally, the potential loss of credibility means that the ECB will take the ‘financial health’ constraint seriously. This is not to say that this would be binding to the extent that the ECB would rather risk a systemic event than have to show a weak balance sheet. But it nonetheless reduces the ECB’s flexibility in using its balance sheet.

Finally, we also need to take into account the link between the price stability and financial strength constraints. If the ECB’s financial strength were to suffer to such an extent that a recapitalisation were needed, it could ‘print the money’ to recapitalise. This may in fact be the only option if these losses came from defaulting sovereign bonds, implying that governments would not be in a position to recapitalise the ECB. Recapitalisation through ‘printing money’, however, could prove to be inflationary, or at least perceived to be inflationary, which in turn would reduce the ECB’s credibility even further. The important point here is that these constraints could at some point reinforce each other.

A lot of exposure to peripheral debt already

In order to assess the ECB’s financial health in the face of the Euro debt crisis, we need to compare its capital with the exposure of the ECB to peripheral sovereign debt.

One open question in calculating the ECB’s capital is whether the revaluation account should be added to the €80bn of capital and reserves. Given that the revaluation account currently stands at more than €300bn, this would increase the ECB’s loss absorption capacity significantly. We are, however, sceptical about the extent to  which one should add the revaluation account to the capital position. After all, the revaluation account is meant to provide a buffer against future FX movements. Using these unrealised gains to offset losses under the SMP, for example, would imply an increase in the ECB’s risk with respect to FX developments.

Calculating the ECB’s exposure to peripheral debt is not straightforward either. There are two sources of exposure for the ECB and the national central banks with respect to peripheral sovereign debt. The first is the direct exposure through the SMP program, which currently stands at around €130bn. The second is the indirect exposure through banks that posted peripheral sovereign debt as collateral. Not all the data needed to calculate the ECB’s exposure to each peripheral country are published. Moreover, it is difficult to say at what level the ECB has bought peripheral debt and what haircut was applied with respect to the collateral posted. That said, ECB lending to credit institutions in the periphery provides us with an upper bound. In the case of Greece, for example, the ECB has lent more than €100bn. The respective figure for Ireland is similar and the exposure with respect to Portugal is a bit less than €50bn. Again, not all of this lending is necessarily backed by Greek government debt. But the figures nonetheless show that the ECB could face significant losses in the event of a default.

Overall, while it is difficult to come up with an exact calculation of the relative financial health of the ECB, it is easy to see that a systemic event involving one of the bigger peripheral countries could wipe out the ECB’s capital.

How to recapitalise the ECB and the national central banks (if needed)

The ECB would first try to cover losses through its monetary income in the event that losses would exceed income and would lead to a depletion of capital to the point where recapitalisation was needed. If the income were to be insufficient the ECB would have to rely on the national central banks for recapitalisation.

The national central banks in turn would try to raise the needed funds from their monetary income. The combined profit of the national central banks stood at around €12bn in 2010 (Chart 7), which suggests there are limits to the national central banks’ ability to recapitalise the ECB. Moreover, given that the assets acquired under the SMP are distributed among the Eurosystem, national central banks will be similarly hit by such a systemic event.

The national central banks would in that case need to ask their national governments for recapitalisation but, given the stretched fiscal situation of Euro-zone governments, this would not be a real option in the event of severe  losses for the ECB. Moreover, having governments to ask for recapitalisation would also carry the  threat of a loss of independence.

A systemic event could threaten the ECB’s financial position, with or without the SMP

Given the capital position of the ECB and the limited possibilities for recapitalisation, one could argue that the SMP cannot be expanded much further. But, as already mentioned, the ECB’s implicit exposure with respect to peripheral sovereign debt through the collateral posted by banks is already very large. To be sure, the ECB is marking its collateral to market prices and the losses would be significantly lower than the nominal figures suggest. But it is easy to see how these haircuts would be insufficient in a sovereign default involving any of the bigger countries.

Thus, the argument that the ECB should not increase the SMP further as this may risk its financial health ignores the fact that the ECB is already heavily involved. Moreover, halting the SMP could lead to a similar or even bigger threat to the ECB’s financial health if this meant that a potential liquidity crisis for one of the bigger Euro-zone countries could turn into a disorderly default.

Quid-pro-quo is important, not least because of credibility

All this is not to say that the ECB should not carefully consider whether to expand its balance sheet or not. Besides the risk to its financial health, it also needs to consider whether the return on investment in terms of a policy response from governments is high enough to compensate for the risks. ECB President Trichet made clear in yesterday’s press conference that the Central Bank expects governments to play their part. After all, the ECB’s credibility is not only endangered by a weak financial position. Being able to take a firm stand against governments will also determine how the general public views the ECB.