President, Center for Financial Studies, Goethe University; former member of the Executive Board of the European Central Bank; former member of the Executive Board of the Deutsche Bundesbank.
Has the experience of the crisis changed your view of the central bank policy tool kit?
Professor Issing: I would like to start by going back to the beginning of the ECB in 1998. The Maastricht Treaty gives the ECB the freedom to design its own instruments. There are almost no restrictions. By contrast, in the Bundesbank, everything was regulated in detail; what was not explicitly allowed in the law, the Bundesbank couldn’t do. At the ECB, things are very different. The treaty contains only general statements that the instruments had to be consistent with an open market economy.
So what did we do? We designed a tool kit that, at the time, I believe was the most modern in the world. And, it also showed its efficiency later in various crises. Just to take an example, we designed a minimum reserve system in which minimum reserves held by banks were remunerated at market interest rates. I think this was totally new in the world of central banking. And, it worked quite well and has continued to work well. Our main refinancing instrument was first the bi-weekly and later the weekly liquidity providing operation in which banks obtained liquidity backed by their collateral. On top of that, we had a system where we could provide liquidity at any time.
This tool kit was heavily tested on 9/11. On that day, we were afraid that the money market would collapse, so we provided banks unlimited overnight liquidity. They drew heavily on this for two days. By the third day, we were back to business as usual.
At that same time, as a result of a shortage of dollar liquidity in Europe, very quickly we organized a swap agreement with the Fed. This tool didn’t exist yet in 2001, but we were able to organize it in just a few hours. This was in addition to the tool kit that was then available.
These same instruments were used when the financial market crisis broke out. On 9 August 2007, the ECB was the first central bank to react to avoid a breakup of the money market.
Later on, as the crisis progressed, the ECB extended the maturity of the long-term refinancing operation – another tool which had existed from the beginning. Originally, these long-term operations had a maturity of three months. This was eventually extended to three years.
This was followed by a targeted liquidity providing operation designed to channel liquidity to banks in the periphery. I am not very sympathetic to this sort of intervention. Instead, I favor simply providing liquidity to the market, and then letting the market distribute it throughout the euro area. This worked perfectly at the beginning. But of course, in times of crisis, one might think about adding new instruments to your tool kit.
Where should we be looking now for financial stability risks given this experience?
Professor Issing: I would like to start by noting a substantial difference between the way in which the United States handled the crisis and how things were done in Europe. The U.S. authorities forced banks to recapitalize quickly. In the process, a number of smaller banks were closed. By contrast, in the euro area, nothing comparable happened. As a result, the crisis lasted much longer. Weak banks were not able to provide credit to the real economy; but also credit demand was weak. (One has to be careful in identifying the causes of weak credit growth.)
The situation has improved, but it is not yet back to normal. The recent stress test in Europe was an important step. After the test, some recapitalizations were demanded and organized. But I should note that there are still things that seem quite strange to me. For example, today Greek banks rely totally on Emergency Liquidity Assistance (ELA) by the Bank of Greece. The ECB has so far not stopped this. By a two-thirds majority vote of the Governing Council, it could. And, in the periphery even beyond Greece, there are still quite a number of banks with weak capital. This situation is a matter of great concern.
But the biggest financial stability risk we are now confronting is a consequence of the very low interest rates and ample liquidity provided by quantitative easing. This is a world-wide phenomenon. It is leading to a situation like ones we have seen in the past. Low interest rates induce people to take high risks. As a result, spreads among asset classes will shrink so that interest rate differentials no longer reflect differentials in risk. This is a situation that cannot continue. And, when there is a correction, the result might be a new financial crisis.
What do we need to do to preserve the benefits of global finance?
Professor Issing: Let me start by emphasizing that we should be under no illusion that we will not see a crisis again. What has to be avoided at all cost is a crisis of the dimension that we have seen after 2007.
I can point to improvements that will help mitigate a repetition of the recent experience. Foremost is the progress in regulation and supervision. In Europe, we now have the European Central Bank as the single supervisor. I should say that this is not a structure I would choose. But without a change of the treaty, it was impossible to realize the suggestion that we had made in the de Larosière group. We warned against mandating the ECB with banking supervision not least for reasons of conflict with monetary policy.
I am in favor of establishing an independent European Supervisory Authority. But, for that, one would have needed a treaty change. This is not feasible for years to come. So, the alternative of mandating the ECB was the only way out if one wishes to have a single supervisory authority in Europe. Or, to be more precise, first in the euro area, because non-euro-area members of the European Union can join, but cannot be forced into that. So, I think the ECB has made a good start. But we have to take care that conflicts between monetary policy and supervision are avoided as much as possible. I am afraid this is a mission impossible.
At the global level of regulation, I think that we will never see a fully level playing field. But major divergences in regulation must be avoided. Otherwise, regulatory arbitrage will create tremendous problems.
I am concerned that in some places we are now seeing a repetition of what has led to crises in the past. Quite a number of countries are highly indebted in a currency that is not their own. This means that they have issued bonds and taken on credit denominated in U.S. dollars. And, with strengthening of the dollar, we see now that these countries are in trouble. This brings me back to quantitative easing and its impact. This is not just an issue for the U.S. economy. The dollars created by the Fed’s balance sheet expansion spread all over the world. It is no surprise that, in this context, IMF Managing Director Christine Lagarde has warned that ending quantitative easing, or even thinking about raising interest rates, might create trouble in other parts of the world. But this is not an argument in and of itself to wait, because the situation will get worse if the Fed is waiting for that reason.