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. Buying Gold today...?