Wednesday, March 5, 2014

Prof. de Grauwe's Views on How a Central Bank Works!

This widely re-tweeted article by Prof. Paul de Grauwe contains, in my opinion, a couple of very elementary mistakes:

Why the European Court of Justice should reject the German Constitutional Court's ruling on Outright Monetary Transactions

I have commented on Prof. de Grauwe's blog as follows:

"I am amazed how a reputable LSE professor could publish a paper including such elementary mistakes. Upfront, if Prof. de Grauwe’s point was to show that a Central Bank like the ECB can function even with a negative equity, he has made that point sufficiently clear. I suspect, though, that most everyone involved with finances knows that.

To suggest that interest received by the ECB flows through to national Central Banks is baffling. The ECB has its own P+L statement. Its pay-out to owners comes out of net profit; not out of gross revenue! If there is no profit (for instance because it had to write down bonds), there are no pay-out’s. Check back with Switzerland’s Central Bank which could not make a pay-out for 2013 because it had taken losses on its gold holdings. As long as the ECB has a negative net worth, it cannot pay out dividends.

Prof. de Grauwe seems to overlook that, contrary to the ECB, the national Central Banks, owners of the ECB, CANNOT operate with a negative equity (because they cannot print Euros). Should national Central Banks be required to recapitalize the ECB, that may well require recaps on their own and that, dear Professor, is indeed tax payers money.

Theoretically it is true that the ECB could, in fact, buy ALL Eurozone sovereign bonds out there, I take it 8-10 trillion Euros, and simulatenously forgive all issuers the debt. All that would mean is that the ECB would run a 8-10 trillon Euro negative net worth but that would not hamper its operations. In fact, it could do that until doomsday. That’s the theory. Anyone suggesting that the practice would unfold the same way should take a walk outside the ivory tower.

If Prof. Grauwe feels that the GCC lacks understanding how central banking works, he should take note that courts are not required to understand central banking. Courts are required to understand things like statutes of the ECB, EU law and, in this case, German law. If its statutes do not allow the ECB to fully act like a Central Bank should, then the founders of those statutes did not sufficiently understand central banking. Then those statutes should be changed."


  1. As far as I know, the National Central Banks are doing the business of creating EURO in the same way as before the €-introduction. They are obliged to respect the conditions of the ECB-council and are free to act according to their actual local needs. Within these rules every NCB operates on its own responsibility and own account. Only the Emergency Liquidity Assistance could be stopped with a 3/4 majority of the ECB-council.

    1. What I have explained above is how the Governor of Austria's Central Bank (OeNB), a long-time friend, explained it to me. So I feel very sure that it is correct. Clearly, if, for whatever reason, the OeNB could not meet its financial obligations, it would be illiquid (in Schilling times it could have simply printed the Schillings). In practice, this would probably never happen because the ECB would support the OeNB. The point is, though: the OeNB could not help itself like in Schilling times; instead, it would depend on the help of someone else (ECB or government).

      What you are referring to is, I think, something different. Normally, when banks need ECB liquidity, they deal directly with the ECB; offer the ECB acceptable collateral (like highly-rated government bonds) and get funding in exchange. This system collapses when banks run out of hghly-rated bonds.

      The ECB then delagated the appraisal of 'acceptable collateral' to the national Central Banks. I. e. it is up to the BoG to determine whether or not collateral is acceptable. This lead to a system which, I believe, works as follows: the Greek bank issues a promissory note; the BoG garantees it and, bingo, you have a security which the BoG deems to be acceptable collateral (and gets funding from the ECB). Yes, that would be a way of independent printing money. However, this only works as long as the ECB goes along with it. In sum, the only institution which can print Euros is the ECB.

    2. Haha ;)
      H. Trickler

  2. In the UK, any loss to the Bank of England due to the QE program were to be paid by an agreement with the treasury. In the event a gain was made. As you say for OMT and the ECB The prof seems to think the goverments effected by OMT could aquire unrepaid purchasing power with no cost to anyone. Even without recapitilisation it would mean higher interest rates earlier for everyone else, who did not default. Also OMT would mean that the cost of borrowing for Spain portugal france Italy etc governements was being made at the descision of the ECB, and targeted by the ECB. I haven't read anywhere what those goverments would think of that for the long term.

  3. Also the profs article does not even mention the inflationary default situation if a central bank writes deposits against bonds and then those bonds go on to a default situation.