The Tragedy of the Euro by Philipp Bagus

Author:Philipp Bagus [Philipp Bagus]
Language: eng
Format: epub, mobi, azw3, pdf
ISBN: 978-1-61016-553-2
Publisher: Ludwig von Mises Institute
Published: 2012-03-25T16:00:00+00:00

DIFFERENCES

One of the main differences between the ECB and the Fed is that the ECB has always accepted a broader range of collateral, making its policies more “flexible.” The Fed accepts or buys in its open market operations only AAA rated securities, namely treasuries, federal agency debt, or mortgage debt securities guaranteed by federal agencies.2 In the discount window, investment grade securities are accepted (rated BBB– and higher).3

The ECB has traditionally accepted a broader range of collateral in its open market operations. Beside government bonds, the ECB also accepts mortgage backed securities, covered bank loans, and other debt instruments that are at least rated with A–. This minimum rating was reduced as an emergency measure during the crisis to BBB–, and with the plan that it would expire after one year. Before the exception could expire, however, the measure was extended because Greece’s rating was in danger of falling too low. Finally, the exception was made for Greek bonds, which would be accepted irrespective of their rating.

Both central banks support government debt, but in different ways. While the Fed uses only government bonds or agency debt or securities guaranteed by agencies, fostering their demand, the ECB brings forward a bias for government debts by applying a lower haircut.

Another small difference between the Fed and the ECB lies in the way the money supply is altered, i.e., the way they produce new money. In their open market operations, the Fed prefers outright purchases of securities, whereas the ECB prefers reverse transactions.

Imagine that the Fed wants to increase bank reserves by $1000. It buys an additional $1000 worth of government bonds. Bank reserves are increased by $1000 as long as the Fed does not sell the bonds back to the banking system. The Fed receives the interest rates paid on the government bonds, remitting them back to the government in form of profit.

If the ECB has the aim of increasing the money supply by €1000, it auctions an additional €1000 in reverse transactions, accepting government bonds as collateral and applying haircuts. The ECB also receives interest payments on the loan. It remits these interest payments in form of profit to its member banks that send them along to their respective governments. When the loans come due, the ECB can roll-over the loan. In this case, the increase in bank reserves of €1000 is maintained. Government bonds are used de facto to create new money in both cases. The operation is undone when the Fed sells the government bond or when the ECB fails to roll over the loan to the banking system.

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