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Banks and governments: The deadly embrace

Banks and governments: The deadly embrace

4 min. 26.11.2013 From our online archive
For more than five years, the world has been hit by the worst economic crisis since the Second World War. Recovery, however, can only come if the central bank's role is more clearly defined, argued Prof Paul de Grauwe at an event in Luxembourg.

For more than five years, the world has been hit by the worst economic crisis since the Second World War. Its influence has been widespread and multiple. To this day many countries still face problems with regards their banking systems and soaring unemployment.

It is clear that previously held beliefs and practices are no longer working. Policies need to change, argues Paul de Grauwe of the London School of Economics, which will allow governments and banks to release their stranglehold on each other. The Monetary Union, he also claims, has made sovereigns more fragile.

A conference organised by the University of Luxembourg’s Centre for Research in Economic Analysis (CREA) on Friday, November 22, sought to demonstrate that only by taking a new approach and implementing new policies will world economies begin to see any signs any of sustained recovery from the current crisis.

Financial unity requires a well-defined central bank role

The event was introduced by Michel Beine, Professor of International Economics at the University of Luxembourg who set the scene by saying: “The consequences of the financial crisis are still making headlines today, national banking systems are in trouble, southern European countries are plagued by high levels of unemployment and some political voices call for the splitting up the European monetary union.”

Against this backdrop, Beine asked: “Is the ECB (European Central Bank) in a position to implement effective policies to overcome the crisis?” The challenge of responding this question fell to well-known economist Professor Paul de Grauwe.

De Grauwe began by taking a frank look at the implications for the financial markets of monetary union. He argued that financial unity has made sovereigns more fragile. “Governments in a monetary union cannot issue their own currency and, therefore, cannot always pay out on the maturity of a bond,” he explained. “This is not the case in the UK because they can produce their own currency, meaning a more credible guarantee upon maturity.”

“This inability to guarantee payment leads to distrust in bond sales, increased interest rates and the withdrawal of liquidity from international markets. As a result, governments have been forced to introduce immediate and intense austerity measures, leading to recession and greater debt/GDP ratio increases. This in turn leads to a default crisis.”

De Grauwe even proposed that financial unity without an adequately defined role for the central bank is the underlying cause of the collapse of several southern European economies.

ECB, stop pretending to do real things

He then moved on to the role of the European Central Bank. “Central banks were originally created to deal will the inherent instability of capitalism, especially the financial markets. They were given a twofold role: to be a lender of last resort to banks to counter panic and a run on banks, and to be a lender of last resort to governments, thus preventing their collapse.”

However, De Grauwe continued, “Banks and governments currently hold each other in a deadly embrace because when banks collapse, the sovereign is also in deep trouble. They are simply too closely linked.”

So, how can the ECB be the lender of last resort to both parties? According to De Grauwe this is a massive challenge.

Bearing in mind the purpose of a lender of last resort is to recreate the liquidity lost as mentioned before, the ECB “appears” to have been one-sided. “Although it announced its Outright Monetary Transaction Programme in September 2012, it is yet to buy a single government bond,” said De Grauwe. “In the face of our current crisis the ECB needs to be more aggressive, we need even more liquidity and, in my opinion, in a different way.”

He challenged the ECB to “Stop pretending to be doing real things here. Bypass banking systems when creating liquidity and give it directly to governments which are less fearful of taking action. Fear is exactly why we are in this mess.”

Additional information:

Outright Monetary Transaction Programme (OMT): In September 2012 the European Central Bank introduced its Outright Money Transaction Programme which pledged to buy the bonds of struggling member economies in the condition that they meet certain strict conditions. The OMT offers unlimited purchases in an attempt to improve liquidity and head-off the deepening crisis.

Paul de Grauwe: Paul de Grauwe holds a PhD in Economics from Johns Hopkins University and is Professor of Economics at the London School of Economics. Prior to that he was Professor of Economics at Katholieke Universiteit Leuven (Belgium) and visiting scholar at the IMF (International Monetary Fund). Paul was also been a member of the Belgian Senate for more than 10 years and is the author of many academic articles and books. He is the author of the best-selling text books “The Economics of the European Monetary Union” and “International Money: Post-war Trends and Theories.” He is also a well-known columnist in international newspapers such as the Financial Times.