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Learning from Japan: The EuropeanCentral Bank and the EuropeanSovereign Debt CrisisDaniela Gabora

a University of the West of England, Bristol, UKPublished online: 02 May 2014.

To cite this article: Daniela Gabor (2014): Learning from Japan: The European CentralBank and the European Sovereign Debt Crisis, Review of Political Economy, DOI:10.1080/09538259.2014.881010

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Learning from Japan: The EuropeanCentral Bank and the EuropeanSovereign Debt Crisis

DANIELA GABORUniversity of the West of England, Bristol, UK

(Received 1 July 2012; accepted 3 May 2013)

ABSTRACT What shapes central banks’ learning from the policy experiments of their peers?Both economic ideas and organizational interests play important roles. Thus, New Keynesianideas led central banks to interpret Japan’s experience with quantitative easing (2001–2006)through the impact on risk spreads, although the Japanese central bank never intended sucheffects. In turn, scholars and policy-makers alike ignored one critical lesson: successful policyinnovations depend on banks’ funding models. It is argued here that this was a crucialomission because the shift to market-based funding impairs the effectiveness of thetraditional crisis toolkit. Central banks must intervene directly in asset markets of systemicimportance for funding conditions, as the Bank of Japan did by buying government bonds.Hence, market-based finance engenders a trade-off between financial stability andinstitutional stability defined through central bank independence. During critical periods,central banks cannot preserve both. The ECB illustrates this trade-off well. Early in thecrisis, it outsourced financial stability to a (largely) market-dependent banking system toprotect its independence. With the introduction of Outright Monetary Transactions inSeptember 2012, the Bank recognized that the market-based nature of European bankingrequired outright purchases of sovereign bonds. This new instrument gave the ECBadditional powers to shape national fiscal decisions in the name of an independence thatno longer has theoretical justifications.

1. Introduction

In March 2001, the central bank of Japan radically changed its policies for dealingwith the ongoing economic crisis. In doing so, it placated growing criticism thatattributed the extended stagnation throughout the 1990s to ‘exceptionally poormonetary policy-making’ and ‘self-induced paralysis’ (Bernanke, 2000, p. 148).

Review of Political Economy, 2014

http://dx.doi.org/10.1080/09538259.2014.881010

Correspondence Address: Daniela Gabor, Bristol Business School, University of the West ofEngland, Bristol, UK, E-mail: daniela.gabor@uwe.ac.uk

# 2014 Taylor & Francis

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The central bank committed itself to increase bank reserves until the deflationaryspiral was reversed, relying on monetarist assumptions that injections of reservesare ‘uniquely inflationary’ (Borio & Disyatat, 2009; see also Bank of Japan, 2003).The merits of the new strategy were not immediately apparent. It took five yearsand a near doubling of the central bank’s balance sheet for quantitative easing pol-icies to generate inflation. In response, scholars agreed that unconventional mon-etary policies held little promise for central banking during ‘normal’ times(Blinder, 2010). Paradoxically, however, Japan’s experiment informed thepolicy innovations that large central banks elsewhere introduced after LehmanBrothers’ collapse in September 2008.

The aim of this paper is to show that the search for new policies is shaped bypowerful incentives to preserve institutional stability, as well as by existing theoreticalapproaches. Central bank policies do not transcend politics (Kirshner, 2003), parti-cularly in times of crisis that pose unique challenges to the existing theoretical andinstitutional frameworks (Blyth, 2002; Gabor, 2010; Peck & Theodore, 2012).

Thus, since New Keynesianism dominated the mainstream scholarship oncentral banking at the time (Woodford, 2007), this school of thought defined thequestions that scholars posed about the Japanese experience. Research focusedon the impact that outright purchases of sovereign debt had on interest-ratespreads (Bernanke & Reinhart, 2004; Ugai, 2006), yet downplayed a key lessonthat the Bank of Japan (2003) drew from its crisis experiments: that the fundingmodels of its counterparties1 shaped its policy innovations (Maeda et al., 2005).

The paper argues that the omission of bank funding models was significant inlight of the increasing shift to market-based financial systems, also known asshadow banking (Pozsar et al., 2010), in both the United States and Europe(Liikanen Report, 2012). In market-based financial systems, financial institutionsrely on short-term wholesale funding raised against collateral in repo markets(Gabor, 2012; Mehrling, 2012). This generates distinctive types of systemicrisk. Central banks have to unwind ‘liquidity spirals’—a combination offunding problems and fire sales in asset markets used as collateral—that criticallyundermine the ability of financial institutions to withstand a financial crisis (Brun-nermeier & Pedersen, 2009; Singh & Stella, 2012). Providing funding liquiditythrough emergency loans to banks is not enough to contain a liquidity spiral.Rather, the central bank must step in and support asset markets through outrightpurchases that restore market liquidity.

Such central bank interventions in asset markets allow financial institutionsto continue to use these assets as collateral. However, when the collateral in ques-tion consists of sovereign bonds, the political nature of central bank actions is dif-ficult to deny. Outright purchases of government bonds, guided by financialstability concerns, may be interpreted as ‘monetizing’ government debt, a strategyat odds with the principles of central bank independence that have prevailed sincethe 1980s (McCallum, 1995), particularly in the design of the European CentralBank (Sadeh & Verdun, 2009). To address such concerns, the Bank of Japan rede-

1Counterparties included domestic banks, foreign banks, securities firms and money-market brokers(Maeda et al., 2005).

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fined independence as ‘self-discipline’ through the ‘Banknote Rule’, a form ofpre-commitment that capped purchases of government bonds below banknotesin circulation (Yamaoka & Syed, 2010). Thus, a market-based financial systemgenerates a trade-off between financial stability and institutional stability in theform of central bank independence. Central banks cannot preserve both.

The rest of this paper is organized as follows. At the outset, the unconven-tional Japanese measures are outlined and contrasted with the dominant paradigmof central banking at the time. Next, it is shown how other central banks interpretedthe Japanese experience in divergent ways. The ECB, in particular, focused on thedistinctiveness of the bank-based European financial system (Cour-Thimann &Winkler, 2012; Trichet, 2009). The bank-based approach ignored the shift in theEuropean banking business models towards wholesale market funding, documen-ted in the Liikanen Report (2012), which generated the same trade-off betweeninstitutional stability and financial stability faced by central banks in market-based financial systems. It was only with the introduction of Outright MonetaryTransactions in September 2012 that the ECB recognized that the prevailingmarket-based nature of European banking required direct market interventions.This new instrument did not, however, mark a radical rethink of the crisis-manage-ment framework, but was instead used to preserve the central bank’s role in theEuropean institutional architecture.

2. Pioneering ‘Unorthodoxy’ in Japan

Throughout the 1990s, the Bank of Japan failed to revive the Japanese economy.Having lowered its policy rate to zero in response to the collapse of an asset pricebubble, the central bank appeared to have run out of options. Some scholars disagreed.According to Krugman (1998), Japan had a credibility problem. Private agentsviewed zero interest-rate policies as temporary and reversible. Without theoreticaland political support, fiscal policy could not address this problem. Instead,Krugman suggested that the central bank should generate inflationary expectationsthrough a ‘promise to be irresponsible’. Bernanke (2000, 2003) went even further.He attributed the recession to ‘exceptionally poor monetary policy making’ andsuggested a menu of policy options including a depreciation of the yen, ceilings onlong-term interest rates and central bank-financed tax cuts (see also Ball, 2012).

In 2001, the Bank of Japan announced that it would ‘flood banks with excessreserves’, in order to generate inflation (Maeda et al., 2005; Ugai, 2006). Quanti-tative easing entailed the following three pillars (Shiratsuka, 2010). First, thecentral bank committed itself to maintain exceptional measures until theeconomy returned to a sustained positive rate of inflation. Secondly, it changedthe operational target to bank reserves, replacing the short-term interest-ratetarget. Finally, to achieve the target, the Bank announced that it would rely ontwo instruments: collateralized loans (refinancing operations) that supply reservesto banks and outright purchases of Japanese government bonds.2

2The Bank of Japan also introduced lower-volume outright purchases of private assets, mainly asset-backed securities, to restore market liquidity and strengthen financial stability.

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The shift to reserve targeting was underpinned by a monetarist understandingof inflation, whereby excess reserves would prompt banks to increase credit, sti-mulating aggregate demand and inflation (Oda & Ueda, 2005). Although theBank of Japan assumed that reserve injections were ‘uniquely inflationary’(Borio & Disyatat, 2009, p. 21), in practice it faced difficulties in determiningthe exact target required to trigger inflation. It started with a ¥1 trillion excessreserves target. By 2005, the target had been raised several times to around ¥30trillion, well above the ¥6 trillion required reserves (Maeda et al., 2005). Inother words, the Bank had to increase excess reserves to five times the requiredlevel before it managed to generate (low positive) inflation. The monetarist trans-mission mechanism performed poorly, as Post-Keynesians have convincinglyargued since the 1980s (Dow, 2004).

Furthermore, the Japanese central bank experienced problems in meeting itsreserve target. During its zero-interest-rate policy period, it had used refinancingoperations to keep the overnight money market rate at the zero bound (Yamaoka &Syed, 2010). These ‘enhanced’ open-market operations consisted mainly ofrepurchase agreements (repos), which provided funding to a wider range of coun-terparties, on relaxed collateral requirements and at longer maturities3 (Baba et al.,2005). However, after 2001, refinancing operations often failed in ‘unsuccessfulauctions’ because counterparties were reluctant to hold excess reserves withoutmatching profitable opportunities (Maeda et al., 2005, p. 15). In response, thecentral bank turned to outright purchases of long-term government bonds. Asthe excess reserves target increased, so too did the volume of monthly purchases.By 2005, the Bank was buying ¥1.2 trillion of Japanese government bonds everymonth, three times more than at the start of the quantitative easing programme. Inrelative terms, sovereign bond-market interventions outpaced refinancing oper-ations as the driver of reserve growth (see Table 1). When the central bankhalted the programme, holdings of long-term government bonds amounted toaround 12% of GDP, whereas refinancing operations had risen to 7.5% of GDP.Private financial institutions preferred outright purchases to collateralized loans.

In sum, the Japanese ‘muddling through’ revealed two important issues in thedesign of unconventional policies. First, central banks must pay close attention tothe balance sheets of their counterparties, as their response to unconventionalmeasures depends on complex funding and investment decisions.4 In otherwords, financial institutions do not behave like the passive intermediary that themonetarist transmission mechanism assumes them to be, readily turning excessreserves into higher credit (Adrian & Shin, 2008). Secondly, these complexprivate financial decisions may require central banks to transcend their conven-tional preference for independence. Indeed, although the literature depictsreserves targeting as the ‘policy innovation’ in Japan (Spiegel, 2006), policy docu-

3The pooled collateral system, introduced in 2001, extended the range of eligible collateral to includecommercial paper, asset-backed securities and bank loans (Maeda et al., 2005). The average maturityof repo operations increased from two months to above five months by 2004.4The Bank of Japan staff put it as follows: ‘counterparties regard the Bank’s operations as financialtransactions for a wide variety of purposes rather than a means merely for accumulating their CAB[reserves] for immediate reserve requirements and settlement needs’ (Maeda et al., 2005, p. 8).

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ments suggest that the Japanese central bank viewed its interventions in the long-term sovereign bond market as its key innovation and problem (Maeda et al.,2005). The Bank portrayed outright purchases as a last-resort option, given thereluctance of its counterparties to hold excess reserves injected through refinan-cing operations. It worried, however, that its holdings of long-term governmentbonds would be difficult to unwind and that markets might interpret these inter-ventions as disguised support for fiscal authorities (Yamaoka & Syed, 2010).

The Bank of Japan addressed these concerns through an ad hoc institutionalinnovation that reframed independence as ‘self-discipline’. Specifically, it insti-tuted a Banknote Rule, which ensured that its holdings of government bondswould be lower than the value of banknotes in circulation. The Banknote Ruleserved as a self-imposed, atheoretical ‘pre-commitment technology’ (McCallum,1995) to reassure markets that the central bank did not make support for governmentdebt part of its policy objectives in crisis. In turn, the Bank of Japan demonstratedlittle interest in providing a theoretical explanation for why private financial insti-tutions preferred outright purchases of government bonds to refinancing operations.

3. Interpreting Japan

Research on the Japanese experience has devoted little attention to either themechanisms of implementation or their monetarist underpinnings. Instead,research focused on risk spreads and yield curves, issues that better fit the domi-nant New Keynesian approach to central banking. In effect, scholars explored amonetarist policy regime with New Keynesian lenses and thus turned thecomplex story of the Japanese quantitative easing into a simple narrative aboutsuccessful signalling to homogeneous financial markets.

New Keynesian ideas influenced central banking practice throughout the1990s (Clarida et al., 1999; Woodford, 2007). A New Keynesian central bankwould be committed to delivering price stability, at a zero output gap, by manip-ulating a short-term market interest rate.5 New Keynesianism also proclaimed a

Table 1. Unconventional instruments, Japan, 2001–06, ¥ trillion

Dec. 2000 Dec. 2004 Mar. 2006

Long-term Japanese government bonds 45.1 65.1 63.7Short-term funds-supplying operations 47.5 56.3 44.9Othersa 14.2 23.1 44.4Total 106.8 144.5 153.0aIncluding treasury bills underwritten.Source: Bank of Japan statistics and Maeda et al. (2005).

5In its most formal set-up, this policy regime entailed an explicit commitment to an inflation target(or band). Indeed, the IMF (2006) report applauded the rapid spread of inflation targeting from itsinitial pioneers, New Zealand, Canada, the United Kingdom and Sweden in the early 1990s, to 22countries by 2007, with another 50 planning to adopt explicit or implicit inflation targets at the time.

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new age of technocratic, model-based central banking, with a well-defined trans-mission mechanism6 (Clarida et al., 1999). According to this framework, centralbanks influence short-term interest rates thorough collateralized loans to banks(refinancing operations) that change liquidity conditions on the interbankmarket, where the marginal cost of liquidity is set. Furthermore, efficient financialmarkets ensure that short-term rate changes filter through to long-term interestrates and asset prices (Blanchard et al., 2010).

Under the efficient markets hypothesis, assets are perfectly substitutable andinvestors should not form preferences for a particular asset class. Conversely,central banks cannot change yields on a financial asset by outright purchases orsales, either in regular open-market operations—the ‘irrelevance proposition’—or through extraordinary interventions (Eggertsson & Woodford, 2003). Sincemarkets determine yields on financial assets from the expected future path ofshort-term interest rates (Woodford, 2007), the central bank controls aggregatedemand by anchoring expectations of current and future short-term interestrates. The New Keynesian transmission mechanism thus stresses yield curvesand risk spreads, all determined in efficient markets. In turn, the institutionalmake-up of financial markets has no analytical relevance.

In contrast, studies of the ECB point to its complex view of financial interme-diation (Issing, 2008). Its pre-crisis two-pillar strategy combined two analyticalperspectives. The economic pillar guiding its day-to-day interest-rate decisionsrelied on New Keynesian models with micro-foundations (Cecchetti & Schoen-holtz, 2008). The monetary pillar stressed the importance of long-term relation-ships between money (aggregates) and prices, and, through that angle, ofEuropean banks’ balance sheets. However, on close examination, the two-pillarregime did not mark a significant departure from the prevailing wisdom. Whenthe data underpinning the two pillars presented conflicting signals, the centralbank chose the short-term economic analysis (Arestis & Sawyer, 2008). Whilethe theoretical literature produced by the ECB recognized the importance of hetero-geneous bank behaviour (Altunbas et al., 2009), New Keynesian ideas guided theactual conduct of monetary policy.

Furthermore, the ECB mirrored its more overtly New Keynesian peers inviewing financial stability as a second-order objective subordinated to price stab-ility (see Bernanke & Gertler, 2001). The Eurozone architecture posed additionalchallenges, as interest-rate decisions could have financial stability implicationsbecause individual countries with higher inflation rates would experienceunduly easy monetary conditions, feeding asset bubbles and external imbalances(Enderlein, 2006). Nevertheless, European treaties framed financial stability asprimarily a national matter, to be addressed by governments through fiscal andincome policies (Enderlein & Verdun, 2009). The ECB could ‘contribute’ tofinancial stability as long as this did not affect the pursuit of its primary

6In policy practice, variations across inflation-targeting regimes mainly materialized in the details ofimplementation. Central banks differed in the price index targeted, the exact nature of commitment(a point or a band) and the time horizon for achieving the target, arguing that different structuralcharacteristics translated into different paces of dissipation of interest-rate decisions (IMF, 2006).

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mandate, price stability. European Union institutions only called this methodo-logical nationalism into question in 2010 (see Cour-Thimann & Winkler, 2012),when the European Council created the European Financial Stability Facility.

At the zero bound, the New Keynesian literature suggests two options. Thefirst, described as ‘the signalling channel’, stresses that the management of expec-tations should continue to be the tool for influencing market expectations about thepath of short-term interest rates (Eggertsson & Woodford, 2003). Central banksmust convince markets that the commitment to low interest rates will be main-tained until economic conditions improve. In this view, commitment alone suf-fices to reduce long-term interest rates (Blinder, 2010). The second avenue—described as the portfolio-rebalancing channel—involves direct central bank inter-ventions in markets no longer assumed to be perfect (Bernake & Reinhart, 2004;Blinder, 2010; Gagnon et al., 2010). If investors prefer certain assets in momentsof crisis (the preferred habitat theory), then central banks can influence either termpremiums or risk premiums through outright purchases. Buying long-term govern-ment bonds may prove particularly effective since sovereign yields set a floor forprivate yields. If the central bank can reduce sovereign yields, it can shift inves-tors’ preferences to higher yielding, private debt instruments, thus compressingboth term and risk premiums (Blinder, 2010). Such unconventional New Keyne-sian central banking is successful if it triggers portfolio rebalancing.

In accordance with this New Keynesian research agenda, the empirical analy-sis of the Japanese programme focused on signalling and portfolio effects (seeUgai, 2006 for a review). It produced an unclear picture. Whereas Bernanke &Reinhart (2004) found a significant impact on government bond yields (com-pressed term premiums), later literature found limited (Baba et al., 2005) orlittle evidence that purchases of long-term government bonds had triggered port-folio-rebalancing effects (Oda & Ueda, 2005; Ugai, 2006). Instead, scholarsbroadly agreed that quantitative easing largely worked through the signallingchannel. Hence, what mattered in a crisis was not so much the exact choice ofunconventional instruments, but credible commitment. Scholars confirmed theNew Keynesian narrative: ‘crisis’ central banking remains a policy rooted in thesuccessful management of expectations.

Nonetheless, charting exceptional circumstances with New Keynesian lensesleft several questions unanswered. First, scholars paid little critical attention toeither the monetarist intentions of the Japanese programme or to the broader setof options available to the Bank of Japan. The literature left unexplored the viabi-lity of Bernanke’s earlier ideas, including money-financed tax cuts or ceilings onlong-term bonds, although the latter instrument had been the standard practiceduring the Keynesian years of the Federal Reserve (Gabor, 2010). When con-fronted with such questions, scholars typically pointed to the ‘peculiarities’ ofthe Japanese political economy that did not allow for a radical break with the pre-vailing orthodoxy. Like the Bank of Japan, scholars were reluctant to renounce orradically modify existing cognitive frameworks, particularly if they had influencein policy making (Ball, 2012). Indeed, Ball (2012) suggests that Bernanke toneddown his earlier suggestions once he became a central banker.

Remarkably then, except for one ‘implementation’ paper produced by theJapanese central bank (Maeda et al., 2005), we have no detailed, critical

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account of the problems that the Japanese strategy had faced.7 Private financialinstitutions were written out of the story of the Japanese experience, eventhough the Bank readily recognized that the behaviour of its counterpartiesguided its policy innovations. In particular, private banks preferred to sell lessliquid Japanese government bonds to the central bank, rather than take collatera-lized loans. Yet scholars made limited attempts to understand why banks werereluctant to hold excess reserves injected through refinancing operations. Afterall, Blyth (2013) persuasively argues, economists can hardly shift between econ-omic theories with incommensurable claims. Since New Keynesianism shaped the‘important’ questions, and this school found banks’ balance sheets to be of no rel-evance to central banks (Blanchard et al., 2010), the story of the Japanese quan-titative easing became a story of successful signalling to homogeneous financialmarkets and little else.

In sum, the key policy lesson drawn from the Japanese experience was a NewKeynesian one. It stressed that central banks should rely on interest rates, cementcredibility and avoid, if possible, unorthodox changes in its balance sheet. AsBlinder (2010) put it:

To begin with the obvious, I think every student of monetary policy believes thatthe central bank’s conventional policy instrument—the overnight interest rate(‘federal funds rate’ in the US)—is more powerful and reliable than QE. Sowhy would any rational central banker ever resort to QE? The answer ispretty clear: under extremely adverse circumstances, a central bank can cutthe nominal interest rate all the way to zero and still be unable to stimulate itseconomy sufficiently. (Blinder, 2010, p. 3)

4. What Scholarship Failed to Notice: The Rise of CollateralizedFinance

Economists and policy makers seldom recognize the importance of new ideas, ornew economic relationships, in an objective, rational fashion. Instead, they tend todiagnose policy challenges by deploying given sets of economic ideas and reject-ing others (Ban, 2011; Blyth, 2002; Widmaier et al., 2007). The New Keynesianlessons drawn from the Japanese experience are a clear example of this. The NewKeynesian academic and policy mainstream filtered out the Japanese banks’concern with sovereign bond-market liquidity during the crisis, because of theincommensurability of theoretical perspectives (the New Keynesian lack of inter-est in financial institutions’ funding decisions) and the conflicting politicalagendas (the challenges to central bank independence raised by outright purchasesof government bonds).

In contrast, the Bank of Japan’s ‘implementation’ paper suggests that coun-terparty institutions engaged in unconventional policy measures to secure future

7A second paper produced by the Bank of Japan and presented at the Bank for International Settle-ments symposium on ‘Low Inflation and Deflation’ touches upon the liquidity implications of thedifferent instruments, but in reference to the funding costs that Japanese banks faced in US dollarmoney markets (see Baba et al., 2005).

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liquidity and to obtain profits (Maeda et al., 2005). Refinancing operations couldnot mitigate the first concern for long. These would only improve liquidity tem-porarily, since counterparties had to return the central bank’s loan when the oper-ation matured (typically under a year) and receive in return the collateral, theliquidity of which depended on market conditions. In contrast, outright purchasesallowed financial institutions to improve future liquidity by selling the less liquidgovernment bonds to the Bank of Japan.8 Counterparties factored liquidity riskinto their decisions to engage in unconventional monetary policy operations.

Here the distinction between funding liquidity and market liquidity becomesimportant (see Brunnermeier & Pedersen, 2009). A financial crisis increases thepreference for holding highly liquid assets—the most liquid of which is centralbank money—in order to preserve funding liquidity, or banks’ ability to meetliabilities and settle positions (Mehrling, 2012). Lender-of-last-resort supportfor banks (through refinancing operations) and deposit guarantees can restorefunding liquidity if the banking system depends on retail deposits. If, in contrast,financial institutions rely on wholesale markets to raise funding against collateral,market liquidity becomes important in a crisis. Such liquidity captures the abilityto trade (large volumes) of debt instruments with a small impact on price. Becausethe loss of liquidity in a market increases price volatility, the asset traded in thatmarket becomes more expensive as collateral. The cash lender calculates themarket value of the collateral portfolio on a daily basis, and makes margin calls(requiring the cash borrower to post additional collateral) if the price of collateralfalls (Gabor, 2012). In other words, perceptions of collateral liquidity are crucialfor banks’ ability to preserve access to collateralized market funding.

In financial systems that rely on wholesale funding, market and fundingliquidity become intertwined. Reduced market liquidity renders assets moreexpensive or impossible to use as collateral to raise funding in wholesalemarkets, worsening funding liquidity, and forcing asset fire sales that furtheraffect market liquidity. The ensuing ‘liquidity spiral’ (Brunnermeier & Pedersen,2009) will eventually trigger a full-scale financial crisis. Financial institutionsmust pay close attention to the liquidity of markets where collateral trades ifthey do not wish to get caught in a liquidity spiral. This explains why Japanesebanks preferred outright transactions with, rather than borrowing from, thecentral bank. Refinancing operations would mitigate problems with fundingliquidity, whereas outright purchases allowed them to keep only the most liquidcollateral, and dispose of less liquid tranches in exchange for reserves.

Had scholars sought to link Japan’s challenges with banks’ concerns aboutsovereign bond-market liquidity, they would have noticed two important develop-ments. First, Japanese banks had increasingly turned to collateralized lending,abandoning the unsecured interbank (call) market (Baba & Inamura, 2004).Thus, the collateralized (repo) segment of Japanese money markets registered a

8According to Maeda et al. (2005, p. 14), banks ‘seeking to sell a large amount of securities tend toprefer government bonds purchasing operations of the Bank to market transactions, as market liquid-ity of some issues is low. In fact, counterparties tend to sell government bonds with shorter remainingmaturities that are less liquid in the market’.

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five-fold increase between its launch in 1996 and 2001. By 2001, its shareamounted to 22% of all money-market transactions, whereas the share of the unse-cured market fell from 31% in 1996 to 6% in 2001), a trend later replicated in theEuropean crisis (Levels & Capel, 2012). It is well documented that the US finan-cial systems mirrored this increased reliance on wholesale funding, driven by rapidgrowth in shadow banking (Pozsar et al., 2010). What the literature tends to ignore,however, is that the European banking sector underwent similar transformations.Between 2000 and 2008, Eurozone banks doubled their balance sheets to nearlyE33 trillion. Since customers’ deposits, the traditional funding source, could notsupport such rapid growth, European banks instead relied on wholesale, cross-border funding markets (Liikanen Report, 2012). In particular, the collateralizedsegment, the repo market, increased rapidly. It tripled in size between 2002 and2008, to around E6 trillion, and nearly 25% of overall Eurozone bank liabilities,an order of magnitude similar to that of the US repo segment (Hoerdahl & King,2008). Eurozone wholesale money markets thus experienced faster integrationthan retail financial services. Starting with the 1990s, from the liabilities side, thedistinction between bank and market-based financial system became blurred.Large financial systems, including the European financial system, became increas-ingly market-based and dependant on collateralized wholesale funding.

The second development to note was that highly liquid sovereign bondmarkets became key sources of collateral for this new model of bank funding.Sovereign collateral secured around 80% of collateralized funding (repo) agree-ments in the US and Eurozone before 2008 (Hoerdahl & King, 2008), a sharethat has increased since then because markets for private collateral tend to loseliquidity faster during crisis (Gorton & Metrick, 2009; Singh & Stella, 2012). Insum, banks can renew collateralized funding during crisis if they can continueto access collateral markets of high quality and high liquidity, particularly sover-eign bond markets.

5. Stabilizing Market-based Financial Systems: The Trade-offbetween Financial Stability and Institutional Stability

Crises in market-based financial systems materialize through liquidity spirals.This, Mehrling (2012) persuasively argued, implies that we need a new paradigmof ‘crisis’ central banking that places (collateral) market liquidity at the core ofstabilization efforts. Since government bond markets supply the preferred formof collateral (Gourinchas & Jeanne, 2012), safeguarding financial stability inthe presence of liquidity spirals requires central banks to intervene directly in gov-ernment bond markets. Thus, the collateral function of government bonds gener-ates a trade-off between financial stability and institutional stability that can onlybe solved by rethinking central bank independence.

A central bank guided by New Keynesian concerns with risk spreadsaddresses this trade-off indirectly. When it purchases private assets and govern-ment bonds in order to trigger portfolio adjustments (Gagnon et al., 2010), thebank also improves market liquidity and limits price volatility. Central bank inter-ventions thus enable financial institutions to use these assets as collateral in private

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repo markets. Such interventions signal central banks’ willingness to counteractliquidity spirals, albeit at a cost to central bank independence.

In contrast, refinancing operations have less predictable consequences forcollateral markets. On the one hand, relaxed collateral requirements allow com-mercial banks to ‘park’ privately issued, illiquid assets at the central bank(ECB, 2010). High-quality collateral can, instead, be used to raise privatefunding. Commercial banks may also use some of the newly-obtained reservesto strengthen collateral portfolios by purchasing assets (government or privatepaper). Central bank lending to banks (lender-of-last-resort liquidity) thus out-sources the task of financial stability to commercial banks because it ultimatelyrelies on banks’ willingness to sustain the liquidity of asset markets that comeunder threat during a crisis (Cour-Thimann & Winkler, 2012). On the otherhand, when refinancing operations come to maturity, banks have to replacecentral bank reserves, obtained against low-quality collateral, with market liquid-ity on tighter collateral requirements.

Perceptions of collateral liquidity then become important drivers of demandfor assets. Financial institutions have every incentive to be ‘disloyal’, and react toshort-term instability in collateral markets, when the central bank no longercommits to providing direct support. Exit from refinancing operations may thusamplify, rather than mitigate, the destabilizing interaction between funding liquid-ity and market liquidity. In short, outsourcing financial stability allows centralbanks to preserve their independence from political influence, but it only worksif private banks are willing to make portfolio decisions that contain liquidityspirals, which is a risky wager at best.

6. Policy Journeys after Lehman

The fall of Lehman Brothers highlighted the vulnerabilities of collateral-basedfinance. US financial institutions became increasingly reluctant to lend to eachother except against very high-quality sovereign collateral (Gorton & Metrick,2009). Funding problems forced financial institutions to fire sell assets in orderto meet liabilities. This reduced the portfolio of assets that retained high collateralquality and thus undermined market liquidity (Singh & Stella, 2012). In short, theLehman Brothers experience demonstrated that collateral-intensive fundingmodels are vulnerable to liquidity spirals.

The Federal Reserve responded to this new form of bank run with extraordi-nary refinancing operations (Hoerdahl & King, 2008). As it became clear that thecrisis would be felt outside of US financial markets, central banks in large financialsystems lowered policy interest rates to the zero bound. Suddenly, the Japaneseprecedent became important. After all, the triggers were similar: asset bubblesinflated through innovative financial practices. Most central banks resorted tolarge-scale interventions in asset markets, alongside lender-of-last-resort liquidity(Gagnon et al., 2010), albeit at a faster pace than the Bank of Japan. Aggressivepolicy action sought to avoid the deflationary pressures that characterized theJapanese quantitative easing. In contrast, the ECB announced that it would godown the path initially preferred by the Japanese central bank (extraordinary refi-nancing operations) and channel its interventions through the banking sector

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because of the bank-based nature of the European financial system (Trichet,2010).

In contrast, the Anglo-American central banks did not link outright assetpurchases to the market-based nature of their financial systems. Instead, Bernanke(2009), by then at the helm of the US Federal Reserve, noted that heighteneduncertainty about the economic environment would reduce banks’ willingnessto extend credit. The Bank of England similarly warned that multiplier effectsdepended on banks’ credit decisions (Gabor, 2012). If deleveraging pressures orliquidity preference remained high, excess reserves created through quantitativeeasing would be ‘parked’ at the central bank rather than find their way intohigher bank lending.

New Keynesian ideas guided large-scale asset purchases. First, central banksfocused on reducing risk spreads without expanding their balance sheet (termedcredit easing). Central banks in the US, Japan and the UK intervened in illiquidassets markets9 to lower yields (Bernanke, 2009; Joyce et al., 2010). By March2009, the US Fed and the Bank of England turned to large-scale purchasesof long-term sovereign bonds. Similarly to the Bank of Japan, both instituted‘pre-commitment technologies’, by announcing a specific volume of intendedpurchases that was believed to be effective in triggering portfolio-rebalancingeffects. The Fed introduced changes with the third round of quantitative easingin September 2012, when it announced that it would purchase $40 billion of mort-gage-backed bonds every month until employment made a sustained recovery, towhich it added $45 billion of government bonds at its December 2012 meeting(Financial Times, 2013).

6.1. Bank-based Measures: The 2008–2009 Enhanced Credit SupportProgramme

In the first stages of the crisis, the ECB relied primarily on refinancing operationsto improve funding conditions for European banks, heavily affected by the post-Lehman deleveraging. Trichet (2009) invoked the bank-based nature of Europeanfinance when he announced refinancing operations at longer maturities (up to sixmonths), with more eligible counterparties (from 140 to around 2200) and easedcollateral requirements (a broader range of illiquid, private assets). The EnhancedCredit Support programme was further ‘enhanced’ in May 2009 with three long-term (one-year) refinancing auctions (known as LTROs).

It is important to point out that, despite the bank-based rhetoric, the ECB waswell aware that banks were not the passive monetarist vessels assumed by thetransmission mechanism of the Enhanced Credit Support programme. In 2009,Trichet (2009) called into question the assumption that banks would automaticallytransform the extra reserves into higher lending:

It may take some time, however, for the extra liquidity to be transformed intocredit. Just after the first 12-month funding operation we have seen that some

9Mostly mortgage securities backed by government-sponsored enterprises.

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part of the extra liquidity still remains within the banking system and is evencoming back to the central bank and being deposited with us temporarily.Banks will have to gain experience in using the longer-term credit that theyobtain from their central banks to expand their longer-term assets rather thanincrease the availability of short-term liquidity. We remind banks of theirresponsibility to continue to lend to firms and households at appropriate ratesand in suitable volumes. We all have to contribute, each of us with our ownresponsibility, to the continued functioning of our economy in these very diffi-cult times. (Trichet, 2009, p. 1)

Beyond the apparent inconsistency, the quote evokes well the difficulty that thecentral bank faced in interpreting and addressing this extraordinary conjuncture:no mandate for EU-wide financial stability, strict limits on institutional flexibilityset by legal prohibitions of monetizing government debt (eventually resolved toallow for interventions in the secondary market), and a highly interconnectedbanking system reliant on cross-border, short-term wholesale funding markets.Later in the crisis, the central bank made more explicit the intentions behind theEnhanced Credit Support programme: to ‘outsource [. . .] decisions determiningdemand and supply in capital markets’ to the banking sector (Cour-Thimann&Winkler, 2012, p. 800).

Initially, the ad hoc outsourcing of financial stability to commercial banksappeared to work. By the end of 2009, the ECB declared that funding conditionshad improved sufficiently across all market segments to allow it to initiate exitfrom unconventional policies (ECB, 2010; Trichet, 2009). Throughout that year,it also became apparent that institutional stability and concerns for central bankindependence referred exclusively to independence from government, as empha-sized in the European treaties (Trichet, 2009). The ECB did engage in outrightmarket interventions with clear redistributive consequences through the small-scale asset purchase programme focused on the European covered bondmarket (Gabor, 2012).10 It committed to purchasing E60 billion of coveredbonds between July 2009 and June 2010, around 10% of the liquidity providedthrough refinancing operations, through interventions in both primary and sec-ondary markets. The intervention was ostensibly political because it benefitedGerman and Spanish financial institutions that dominated the covered bondmarket11 (Beirne et al., 2011). Yet interventions met little political resistancebecause the ECB portrayed covered bonds as a long-term funding solutionthat would replace banks’ preference for short-term wholesale funding.Support for the banking sector, against collateral in extraordinary liquidity oper-ations, or directly through outright purchases of covered bonds, was not con-strued as a loss of independence either in scholarly or in the central bankdiscourse.

10Covered bonds are long-term debt securities issued by banks and covered by a pool of assets, typi-cally mortgages and public sector loans. The covered bond market offered European banks an impor-tant cross-border source of long-term funding and carried fewer risks, since banks kept theseinstruments on their balance sheets.11The share of covered bonds on the German banks’ balance sheets rose to almost 25%.

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6.2. The Securities Market Programme

At first, the ECB refrained from direct interventions in sovereign bond markets. Itrefused on several grounds to engage with the terms of the (New Keynesian)debate carried on elsewhere. For the ECB, outright purchases undermined the sep-aration of responsibilities fundamental to the Eurozone and were explicitly prohib-ited by European treaties if undertaken to monetize government debt or if theyraised political challenges for future exit strategies (Trichet, 2009). Offloadingsovereign bonds would encounter fierce resistance from governments concernedwith the impact on their cost of funding (Borio & Disyatat, 2009). In contrast,the Enhanced Credit Support strategy engendered an automatic exit mechanism.At maturity, the central bank would return the collateral in exchange for thereserves it had provided. While the strategy did affect sovereign bond markets,the effects depended entirely on demand and supply factors governing privatebanks’ portfolio decisions.

Then, in May 2010, the central bank announced that it would buy eurozonegovernment bonds (ECB, 2010). Without any New Keynesian intent, the Securi-ties Market Programme made explicit that the ECB had no choice but to abandonindependence in order to restore financial stability, as panic and contagion fromthe Greek sovereign debt crisis had severely undermined the transmission of mon-etary policy signals (ECB, 2010). To pre-empt legal challenges based on theMaastricht Treaty’s prohibition of monetizing government debt, the centralbank announced that it would purchase government bonds in secondarymarkets, and that it would sterilize the impact of those purchases.

The central bank showed little concern that its (in)action might have contrib-uted to the crisis, despite criticism to the contrary (De Grauwe & Ji, 2012). Yet itsrefusal to provide support to the Greek sovereign bond market in early 2010 sent aworrying signal that other Eurozone sovereigns with deteriorating fiscal positions(owing to large automatic stabilizers, for example) might suffer a similar fate.With this, banks’ perceptions of collateral liquidity worsened and generated col-lateral contagion (Bolton & Jeanne, 2010) because banks dependent on marketfunding turned away from what they expected to be increasingly expensive, in col-lateral terms, lower-rated sovereigns (Ireland, Portugal, Spain, Italy). The BIS(2011) subsequently documented a marked reduction in the use of the debtissued by periphery countries as collateral and higher risk premiums for banks’debt issuance.

Put differently, the hesitation of the ECB throughout the early stages of theGreek crisis fed a liquidity spiral. Paradoxically, the institution accepted thatmuch. Its analysis of crisis policies hints at the liquidity spiral developingthrough sovereign markets in early 2010:

While government bonds have traditionally been an important element in thetransmission process because they serve as a benchmark, or floor for thepricing of other financial contracts and fixed income securities, they have alsoemerged as a prime source of collateral in interbank lending over the past fewyears. Excessive or abrupt changes in the value or availability of these [govern-ment] securities can imply a sharp deterioration in banks’ funding conditions,

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with adverse effects on both the supply of bank loans to the real economy andtheir prices. (ECB, 2010, p. 5)

The ECB thus presented sovereign bond purchases as efforts to stabilize collateralmarkets (ECB, 2010), actions necessary to restore financial stability in a market-based financial system. Nonetheless, its policy actions remained inconsistentbecause of its continued preference for independence. Although it acceptedthat bank funding strategies could introduce volatility and pro-cyclicality insovereign bond markets (Bini Smaghi, 2011), it viewed its task of stabilizationas only a temporary abdication from independence. After sizeable purchases inMay and June 2010 (around E65 billion, which the press speculated weremostly Greek), the pace of outright purchase slowed markedly. No substantialinterventions preceded, or indeed accompanied, the Irish and Portuguese bailouts.The central bank only returned to sovereign bond markets to contain the tensionsfor the Spanish and Italian sovereigns in the second half of 2011, and even thenwith only limited impact on yields (Gabor, 2012). When the crisis threatened thebreak-up of the Eurozone in late 2011, it again chose three-year refinancing oper-ations. This deliberate neglect of the link between funding and market liquiditycontributed to the spread of sovereign debt pressures from Greece to otherEuropean countries.

What explains this inconsistency? Legal constraints may well have influ-enced policy choices (Featherstone, 2011), yet legal arguments seem less compel-ling since Draghi introduced Outright Monetary Transactions. Rather, it seemsthat the central bank continued to believe that the pre-crisis institutional architec-ture, which delegated responsibility for financial stability to individual govern-ments, was fundamentally sound, provided that the mechanisms for fiscaldiscipline could be improved.

Before 2008, scholars agreed that the Eurozone macroeconomic governanceperformed well, particularly in delivering price stability (Cecchetti & Schoen-holtz, 2008). In this account, the credibility of the central bank allowed statesrepeatedly to violate the Stability and Growth Pact without serious repercus-sions—Germany and France did so more often than either Spain or Ireland (Ender-lein & Verdun, 2009). Markets were fooled into disregarding the credit riskassociated with individual governments, generating a convergence in bondyields that perversely sanctioned fiscal indiscipline. The ECB hence viewed thesovereign debt crisis as a political failure to enforce a set of binding fiscal rulesgiven the lack of political will to move to a common fiscal policy.

Against this background, the ECB used sovereign bond purchases as a politi-cal instrument to impose its views regarding fiscal responsibility on memberstates. It only agreed to interventions after Greece agreed to fiscal austerity.With the creation of the European Financial Stability Fund in June 2010,12 thecentral bank sought immediately to terminate its extraordinary support to banks.In November 2010, it refused to extend further liquidity support to ailing Irish

12A bailout fund set to raise market funding and provide emergency support to crisis-ridden memberstates without mandate to purchase government debt.

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banks,13 instead urging governments to clean bank balance sheets. The ECB thencriticized the failure of the European Stability Mechanism to establish a set of firmrules to bind member states to fiscal responsibility. Moreover, it invoked inflation-ary pressures to raise policy interest rates in early 2011 and to (informally)suspend support to sovereign bond markets, despite pressures in the Portuguesesovereign debt market. In 2011, the central bank formulated detailed, albeitsecret, conditions for Spanish and Italian governments to fulfil in return formeasures that central banks in other market-based system routinely performedas part of their strategy to prevent liquidity spirals.14

With the Outright Monetary Transactions programme, the central bank madeit explicit that it would contain ‘adverse self-fulfilling equilibrium’ (read financialinstability sharpened by volatile collateral values) if governments committed to,and complied with, strict conditionality. In turn, the ECB ‘explicitly commitsitself to suspending the Outright Monetary Transactions in case of failure onthe part of the government to comply with conditionality’ (Cour-Thimann &Winkler, 2012, p. 779), thus strengthening its political power in the architectureof the Eurozone crisis management.

7. Where Next?

The ECB used the crisis of market-based finance to cement its powerful position inthe European institutional configuration. This is a remarkable political achieve-ment that required two complementary strategies. The first was to bury deep inpolicy documents the acknowledgment that European finance suffered from thepredicaments of market-based finance, predicaments that the ECB’s traditionalcrisis interventions could not address. The second was to portray governmentsas incompetent economic actors, and use monetary policy interventions in orderto increase its power to shape national fiscal decisions.

The actions of the ECB over the course of the crisis demonstrate that bothpolitical and ideological constraints must be overcome to align central bankingwith the new reality of financial integration in Europe. Arestis & Sawyer (2010)argue that change should be radical, proposing a model of central banking thatrelies on various instruments and interventions in various markets in the pursuitof economic growth and employment. However, to date, the institution hasresisted even moderate institutional change. Its pre-crisis models, underpinnedby the efficient market hypothesis, served as anchors of intellectual identity andreinforced hierarchies of policy authority (Dymski, 2010). But the increasinglymarket-based European financial system confronts the central bank with an insti-tutional dilemma. Its position in the Eurozone institutional architecture lies in itsability to portray itself as a technocratic institution, guided in its policy decisions

13At that time, Irish banks had accumulated around E130 billion emergency liquidity loans from theEuropean Central Bank, around a quarter of the overall crisis liquidity support.14The Spanish and Italian press reported evidence that the European Central Bank sent officialletters to the respective governments with a detailed list of measures for structural reform andfiscal tightening it expected in exchange for direct intervention (El Pais, 2011; BBC, 2011). TheEuropean Central Bank refused to make the letters public (citing public interest).

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by the objectivity of the models it deploys. The task of (re)constructing techno-cratic legitimacy is more complex in financial systems that require the centralbank to abandon independence in order to preserve financial stability. The lateststrategy, Outright Monetary Transactions, seeks to navigate this paradox by com-mitting to preventing liquidity spirals if governments agree to fiscal austerity.Paradoxically, it also gives more power to an institution that no longer has theor-etical justifications for its claims to independence.

8. Conclusion

This paper highlighted an intriguing picture of central bank learning about crisispolicies. Dominant theories or political considerations may prevent central banksfrom recognizing and engaging with structural changes in financial intermedia-tion. Policy makers are not ‘disengaged spectators’ in the policy processes.Rather, they actively pursue policies that support their political interests, theirtheoretical allegiances, or both, even if such policies cannot effectively stabilizethe financial system.

The scholarship examining the Japanese quantitative program is a clear dem-onstration that the lessons to be drawn from policy experiments are far fromobvious, clear-cut or objective. When examining the Japanese crisis policies, scho-lars typically asked New Keynesian questions about risk spreads, even though theBank of Japan never intended to trigger such effects. The conflicting evidence onthe effectiveness of the portfolio-rebalancing channel convinced scholars that theNew Keynesian insistence on short-term money-market rates remained the appro-priate way to conduct monetary policy. In turn, scholars worried less about themotives that prompted private financial institutions to prefer that the Bank ofJapan bought government bonds. This, it has been argued here, reflected the increas-ing importance of market-based finance. Private financial institutions that rely oncollateralized wholesale funding must take into account market liquidity becausethis is closely intertwined with their ability to meet liabilities in a crisis. Centralbanks, and academic accounts of the Japanese crisis, chose to ignore the interdepen-dence between collateral market liquidity and funding liquidity because such inter-dependence is politically problematic and inconsistent with their theoreticalframeworks. To prevent a liquidity spiral, central banks have to provide supportto sovereign bond markets, the core collateral markets, yet this crisis strategy under-mines the separation between monetary and fiscal policy that underpins centralbank independence.

After Lehman Brothers’ collapse, central banks settled the trade-off betweenfinancial stability and independence by replacing the latter with weaker forms of‘pre-commitment technologies’. Most large central banks invoked the portfolio-rebalancing channel to engage in large outright purchases, initially of privatelyissued assets and then of government bonds. The measures provided effective,if unwitting, support to the key collateral markets, including the sovereign debtmarket. The ECB alone proved more reluctant to push the boundaries of its orig-inal mandate. Instead, it delegated financial stability to the private banking sector.

With the Securities Market Programme, the ECB recognized that sovereignbond markets had become a ‘special’ segment in financial markets. The rapid

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integration of wholesale markets in the Eurozone made sovereign bonds the keyform of collateral for European banks dependent on market funding. In such inte-grated markets, liquidity spirals can easily be triggered by extraordinary events(the Greek crisis) and worsened if the central bank refuses to support collateralvalues. Indeed, the threat of a liquidity spiral affecting other ‘peripheral’ sover-eigns eventually prompted policy action in response to the Greek crisis.

Nonetheless, interventions in sovereign debt markets did not mark a funda-mental shift in the ECB’s understanding of the appropriate institutional architec-ture to support the European common currency. Instead, the Bank used theseinterventions as a political instrument to extract fiscal commitments from nationalgovernments. Its admission that the European financial system had changedremained buried deep in its policy documents. In public discussions, the Bank con-tinues to blame the fiscal misbehaviour of individual governments. It never dis-cussed its refusal to update the crisis framework to encompass a new world ofEuropean banking that remains reliant on market funding. Instead, it has usedthe crisis to strengthen its political power.

Acknowledgments

The author is grateful to two anonymous referees, and to Steve Pressman, Engel-bert Stockhammer, Cornel Ban, Oddny Helgadottir, Tony Flegg, Corina Weidingerand participants at the Political Economy Research Group Workshop at KingstonUniversity (April 2012) for comments and suggestions.

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