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The “Art of Central Banking” in yesterday and today’s crises

di - 27 Giugno 2013
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The main items of the balance sheet explain how the Fed decided to tackle with the menace, not only of an American recession, but of total disruption of the global financial and banking system. Of a secondary importance appear the discount window operations – the “old” lender-of-last-resort activity, providing temporary liquidity to the banking system. But the explosion is in “credit market instruments”: still in 2007, Treasury securities were “the only game in town”: T-bonds and bills as ammunition of the central bank to carry out its open market operations. In 2007, they occupy 78% of the Fed balance sheet: the core activity of a modern central bank in a financially sophisticated market (compare that with the holdings of Treasury securities by the Bank of Italy in the 1920s, in a still largely agricultural country, without a meaningful financial market: 6%). The 2.2 times increase in Treasuries between 2007 and 2012 reduces, however, their share in Fed balance sheet, while Government Sponsored enterprises-GSEs securities jump from zero to 34% .
This jump is the clear evidence of the origin and core of the American financial crisis. A very large part of GSEs securities is made of mortgage-backed securities, the instruments through which mortgage loans, and the associated risk, were spread all over the financial system. In particular, the central bank had to buy these securities to bail-out quasi-government agencies (Freddie Mac, Fannie Mae) that had amply purchased mortgage loans from lending banks.
Then, in the Fed’s balance sheet, we have the “depository institutions (banks) loans”: a relatively minor amount, 0.6 bln USD, and a small percentage of the total (however from zero in 2007), but it should be noted that, at the peak of the crisis, in 2008, this item was much bigger:  490.4 bln USD, and included a series of bail-out programs, aimed at financing ailing banks and non-bank institutions, again a very unorthodox way of central bank intervention.
What all this means? The ample purchase of Treasuries is evidence of an extremely expansionary monetary policy that, even with quasi-zero interest rates, continues to pump money into the economy: the “quantitative easing-QE”. In addition, as we have seen, in order to further ease its policy, the Fed bought large quantities of GSEs debt, which affected its balance sheet also in terms of quality, given the bankrupt state of these Entities. But in general this blowing up of the Fed balance sheet proved the effective way to limit the damages of the financial crisis and to prevent, as far as possible, a deep fall in American GDP: a panoply of interventions that would have been unthinkable in different times and monetary regimes: the “art” at its utmost (if not at its best…).
Is there a flip side? It might be found to the extent that this huge monetary expansion, rather than start-jumping the economy, ends up into a higher level of inflation. The jury is still out: so far, the post-crisis growth rate has been modest (see table 2), while inflation remains subdued, given the slack capacity in the system.
A similar pattern can be observed in the Bank of England balance sheet, as noticed at the start of these notes. Its expansion, to promote recovery and to bail-out the financial system, is still more pronounced than in the US.
A different pattern we observe in the Eurosystem: after a jump in 2008, connected to the first, violent phase of the crisis, its balance sheet contracted in 2009, barely changed in 2010, then grew substantially in 2011. Why?
To explain this we have to move to another important central bank, the German Bundesbank. For more than 20 years, between the mid-1970s and the mid-1990s, the Bundesbank “has conducted its policy under the banner of public monetary growth targets” (Neuman, 1999). The bank essentially accepted Milton Friedman’s monetarist view. Even though the growth target of money supply was rather nebulously formulated, the bank was no longer “a self-service shop” for banks. In this, it was facilitated by the transition from fixed to floating exchange rates after the dollar devaluation of early 1970s, that made possible a more independent monetary policy. It is widespread opinion that monetary targeting – based on a money supply policy oriented to the medium term and allowing deviation from the envisaged growth rate in the short term – proved its worth. Above all, monetarism created in Germany a stability culture, that has been successfully brought into the new Eurosystem. In the ECB’s Monetary Policy Strategy, mentioned above, it is not difficult to find policy attitudes of the German central bank.
In fact, the more modest expansion of the Eurosystem balance sheet (in comparison with the Fed or the Bank of England’s) (Fig 1) can be partly explained by the fact that the European banking system has been less severely affected by the huge asset quality deterioration that characterized the Anglo-Saxon banks, albeit with relevant exceptions. But the “Bundesbank legacy” is also present (BB as a template for the Eurosystem)
The different features of financial systems in America (a market-oriented system) and continental Europe (a bank-oriented system) are reflected in the components of central banks’ balance sheet. While, in facing the crisis, in the US the Fed has largely relied on security purchases, in Europe the Eurosystem has mainly intervened through an increase in its lending to banks (so far).
It’s interesting to observe that, even after a wide expansion of its balance sheet, the FedReserve balance sheet stays now at around 20% of the American GDP, while the Eurosystem’s at around 33%. This comparison, however, does not take into account that the Eurosystem’s is the consolidated balance sheet of ECB and all the full central banks of the euro-area: a situation quite different from the US, where the regional FedReserve Banks cannot be considered as fully-fledged central banks.

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