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Dublin Opens Pandora's Box

What the Irish crisis already revealsabout the Eurozone project...

The IRISH GOVERNMENT may havediscovered a fatal flaw in the Eurozone central banking system –the discount window, writes Robert Thorpe at the Cobden Centre.

In 2008 the Irish government bailed outAnglo-Irish Bank and effectively nationalized it. Since then theyhave been periodically supplying more bailout funds to it as losseshave emerged. Because of this, together with the bailouts of otherIrish banks and loss of tax revenues the Irish state’s finances arevery bad. Currently the interest rate on Irish bonds is 8%, muchhigher than the Eurozone interest rate, indicating that the marketconsiders the possibility of default to be high.

Many commentators have pointed out thathaving separate states issuing their own bonds and using their owntax policies within one currency area is destabilizing. But thecurrent crisis in Ireland has revealed a problem that may be muchbigger in the long run – the European Central Bank’s discountwindow.

The ECB, like most central banks,controls the rate of interest by two methods. They perform Open Market Operations,which are the buying and selling of bonds in exchange for base money.If the central bank buys a bond using base money then it increasesthe amount of base in circulation as reserves between the commercialbanks. The central bank is also the lender-of-last resort. As part ofthat role the bank makes short term loans to the most marginal, thatis most unstable, commercial banks. This is the “discount window”which the European central bank calls the marginal lending facility.The central bank can alter the rate of interest by offering discountwindow loans at higher or lower rates, though modern central banksdon’t generally do this, they use OMOs instead.

The problem the ECB now faces is thatit must make discount window loans to Irish banks that are owned bythe Irish state. The ECB is, in effect, lending to the Irishgovernment. As Ambrose Evans-Pritchard at The Daily Telegraph wroteyesterday: “…the ECB is already propping up Ireland and Club Medby unlimited lending to local banks that then rotate into their owngovernment debt in an internal ‘carry trade’.”

Since the ECB discount window rate is1.75% and the interest rate on Irish government bonds is ~8% thatmeans that Ireland is getting a good deal.

The ECB could stop this lending anytime, and probably will. The problem, though, is the impartialitynecessary in central banking. In the 19th century the Bank of Englandwould occasionally lend to commercial banks having problems; it wasthe lender of last resort. But, as Bagehot pointed out, many problemswere caused by the central bank playing favourites.

Commercial banks with good connectionsat the Bank of England got loans and other banks without connectionsdidn’t. So, it became a policy that the central bank should offerdiscount window loans at a rate higher than the prevailing interestrate to all commercial banks if they posted good collateral. Latercentral banks began performing regulatory probes into banks thatborrowed from the discount window facility, thereby increasing thedisincentive for banks to use it. The advantage of this system to thecentral banks was that the market knew that any commercial bank couldborrow from the discount window, and that reduced the risk the bankstook when lending to each other. This made monetary expansion mucheasier for the central bank to initiate than it had been before.

In the current situation, though, theECB must play favourites. The ECB could justify that if it decidesthat the assets posted as collateral by the Irish banks are notsatisfactory, and therefore that those banks are insolvent, notmerely illiquid. But that would be mean that the ECB would beeffectively judging that the Irish state is insolvent. Politicallyspeaking, can a central bank make that judgement? If the ECB allowsIreland to continue borrowing from the discount window then the otherwobbly Eurozone countries will follow Ireland — they willnationalize banks and use them to access the discount window. But ifthe ECB cut off lending to Ireland then this increases uncertaintyfor other Eurozone banks and states greatly.

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Built on anti-Corn Law radical Richard Cobden's vision that "Peace will come to earth when the people have more to do with each other and governments less," the Cobden Centre promotes sound scholarship on honest money and free trade. Chaired by Toby Baxendale, founder of the Hayek Visiting Teaching Fellowship Program at the London School of Economics, the Cobden Centre brings together economists, businesspeople and finance professionals to better help these ideas influence policy.

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