Co-authored by Edward Fuller
“a repo is actually a temporary open market purchase” (Frederic Mishkin)
There is widespread belief that the purpose of the Long Term Refinancing Operation (LTRO) is to encourage European banks to borrow money so they can purchase new issues of European debt. While this might be a welcomed outcome of the LTRO, it is not the program’s primary purpose. The surest way to grasp the LTRO is to compare the program to Quantitative Easing (QE). Consider a hypothetical balance sheet for Bank of America. On the asset side, Bank of America has $10 of reserves and a $100 mortgage backed security (MBS). The $10 of reserves supports $100 of deposits on the right side of the balance sheet. This leaves $10 of equity.
Now suppose the housing bubble bursts. The value of Bank of America’s MBS falls from 0 to . This means their equity account is -. Bank of America is in serious trouble.
Here’s where QE1 comes in. The Fed buys Bank of America’s mortgage backed security for 0. The Fed exchanges 0 in reserves for BofA’s toxic mortgage backed security. The Fed’s open market purchase means Bank of America’s reserves increase from to 0. Their equity account increases from - to . The Fed’s open market purchase saves Bank of America by making their equity account positive again.
The 0 MBS is now on the left side of the Fed’s balance sheet. The Fed’s reserve account on the right side of the balance sheet increases by 0. In short, the open market purchase leads to a 0 increase in the size of the Fed’s balance sheet. It’s widely known that open market purchases are inflationary. Where does the Fed get the money to purchase Bank of America’s MBS? The Fed creates reserves out of thin air. The Fed’s balance sheet expands by 0 because they create 0 of reserves out of thin air. This is why the open market purchases associated with QE are inflationary. What does this have to do with the ECB’s Long Term Repurchase Operation? First consider the definition of a repurchase agreement.
A repurchase agreement (aka repo) involves the central bank purchasing securities with an agreement that the seller will repurchase those same securities in the future. Repos are known as temporary open market purchases; the central bank temporarily buys securities from banks. Many call this borrowing, but (as Mishkin states) a repo is actually a temporary open market purchase. T-accounts are the best way to illustrate the similarities between Quantitative Easing and Europe’s Long Term Refinancing Operation (LTRO).
Suppose BNP Paribas has the same balance sheet as Bank of America above. Rather than a MBS, BNP Paribas owns a €100 Italian bond. Here’s the balance sheet before the crisis.
Now the European sovereign debt crisis strikes. The value of the Italian bond falls to €50. BNP’s equity is now -€40. BNP Paribas is in serious trouble.
The LTRO is a temporary open market purchase. The ECB will purchase the €100 Italian bond from BNP Paribas. In exchange for the 0 Italian bond, the ECB gives BNP Paribas 0 in reserves.
BNP Paribas is saved as their equity account is positive again. The Italian bond is now on the ECB’s balance sheet and is matched by a €100 increase in reserves. The ECB’s balance sheet (and the monetary base) increases by €100. This illustrates that the Long Term Refinancing Operation is identical Quantitative Easing. The only difference between QE and the LTRO is “an agreement” that BNP Paribas will repurchase the Italian bond in 3 years. It’s possible (perhaps probable) that BNP Paribas will never repurchase this bond from the ECB. The LTRO is undercover QE. The ECB was able to expand its balance sheet by creating reserves out of thin air. The LTRO will be even more inflationary if European banks use their new reserves to purchase new issues of sovereign debt. The purpose of QE1 in the U.S. was not to encourage U.S. banks to sell assets so they could purchase new issues of mortgage backed securities. Similarly, the purpose of the LTRO is not to encourage European banks to borrow money so they can purchase new issues of European debt. The purpose of the LTRO is to recapitalize European banks by removing toxic assets from their balance sheets via inflation. The LTRO is QE in disguise. The LTRO affects bank balance sheets in the same way as Quantitative Easing. Look for the ECB’s balance sheet to expand by at least €200 billion in the weeks ahead. Of course, only inflation can make such an expansion possible.
