Four myths about European Central Bank

1. Losses on Greek bonds will create inflation
        No. Imagine ECB becomes insolvent after Greek default. In this case ECB will lose control of inflation only if there is a run on ECB. During a run on ECB, EUR LIBOR will become lower than ECB deposit rate, meaning that ECB's contractionary policy rate increases would not be honored by the interbank market. Some commentators have raised the possibility of a run on ECB in the form of unilateral exit of Germany from the Eurozone. In my view this is highly unlikely. It is important to recognize that only member states can execute a run on ECB, but commercial banks cannot, as they are regulated by ECB.
        Canadian economist and mega-blogger Nick Rowe has raised the possibility that inflationary expectations will arise because ECB has overpaid for Greek junk bonds. However in the comments he has conceded that ECB can successfully operate with negative equity: "Paying interest on reserves is equivalent to the ECB issuing bonds. Issuing bonds doesn't change the net worth of the ECB. But nevertheless, you have a good criticism here. The NPV of a central bank is much greater than the assets on its balance sheet. It's the NPV of all future seigniorage. In other words, it might have to buy an awful lot of really junk bonds in order to trash its balance sheet sufficiently. Hmmm."

2. ECB is sterilising purchases of Greek bonds
        No. ECB will provide unlimited 3 month liquidity in a scheduled longer term refinancing intervention on 30 June 2010. This means that any sterilisation will be reversed according to the desires of commercial banks. Only when ECB will stop full allotment in longer term refinancing operations we will be able to talk about real sterilisation. So far the purchases of Greek bonds are de-facto unsterilised.
        The instrument of ECB's sterilisation operations is one week term deposits. These deposits are eligible as a collateral in ECB's refinancing operations. Short maturity of deposits and eligibility as a collateral means that these deposits are almost as liquid as overnight deposits at ECB. This is confirmed by the tiny premium on one week deposits required by commercial banks as compared to the ECB overnight deposit rate. We can safely conclude that ECB's sterilisation operations have only minor effect on removing the liquidity in Eurozone.

3. Sterilisation of purchases of Greek bonds is needed to prevent inflation
No. Even with the enormously huge monetary base ECB can control inflation by increasing policy rates. Sterilisation might be desirable for the fine-tuning of the yield curve, but is not necessary for the containment of inflation. Stephen Williamson, the guru of new monetarism, says that sterilisation is an inefficient way of controlling inflation (his models imply that even fine-tuning of the yield curve by sterilization won't work).

4. Current tensions in interbank markets are comparable to Lehman Brothers. For example, WSJ writes: "Euro-zone banks placed a record €316.4 billion ($387.1 billion) in the ECB's ultra-safe overnight deposit facility, ECB data showed Wednesday, bringing back memories of the days following the collapse of U.S. investment bank Lehman Brothers in 2008."
        No. The use of ECB's overnight deposit facility is just an indication of the bloated balance sheet of ECB. The balance sheet is bloated precisely because ECB is successfully preventing the repeat of Lehmanesque financial tensions by adding huge amounts of liquidity. In fact, during Lehman crisis, ECB has fought the financial tensions much more successfully than the Fed. ECB started providing unlimited liquidity on October 15 2008. If only Fed had copied the aggressive liquidity stance of ECB in 2008...