The ECB’s proportionate response to the Eurozone crisis

When the Eurozone crisis worsened during the summer of last year, a number of experts proposed to appoint the ECB as a lender of last resort in the government bond markets to make these markets less prone to liquidity crises and contagion, and to prevent the weakest Eurozone countries from being pushed into a self-fulfilling debt crisis (see De Grauwe 2011 and Wyplosz 2011).

Direct ECB Intervention versus the LTRO Programme

There is little doubt that these experts contributed to convincing the ECB to take its responsibilities to prevent a potential breakup of the Eurozone. However, instead of committing to becoming the buyer of last resort for government bonds, the ECB decided to intervene by offering Eurozone banks the possibility of borrowing an unlimited amount of money for a three-year period at very low interest rates. The banking sector welcomed this offer and borrowed more than €1 trillion in the two longer-term refinancing operations (LTROs) in December and February.

It is widely recognised that these operations have been instrumental in triggering a sharp decline in interest rate premiums, along with other important factors including the arrival of a government led by Prime Minister Mario Monti in Italy, the positive feedback effect on Spain (until recently), the adoption of the new Eurozone fiscal rules (the fiscal compact), and Greece’s second bailout deal.

Despite these positive developments, three main criticisms have been made of the LTROs (see De Grauwe 2012):   

• Moral hazard: The liquidity injections in the banking system created moral hazard problems that are more dangerous than those resulting from direct ECB intervention.

• Excessive liquidity provision: Because banks channelled only a fraction of the liquidity they obtained from the ECB into the government bond markets, the ECB had to pour much more liquidity into the system than if it had decided to intervene itself.

• Limited chance of success: The austerity programmes imposed by the European Commission are pushing the peripheral Eurozone countries into a deep recession that will exacerbate their fiscal problems and will create renewed distrust in financial markets. As a result, the sovereign-debt crisis will explode again.

Moral hazard

The massive infusion of ECB liquidity has mitigated the risk that the banks’ large funding needs create self-fulfilling runs in the coming months. However, it has not removed the fact that banks need to reduce the size of their balance sheets.

The LTROs confirm that the ECB was not insensitive to the banks’ potential liquidity problems, and the risk of mounting market pressures on banks leading to large real-economy feedback effects. From this perspective, the ECB had good reason to act as a lender of last resort to the banking system. Its operations were fully in line with the principle that the lender-of-last-resort function should only be used when banks experience liquidity problems. In line with this principle, the governance of moral hazard should be performed by an institution other than the central bank, ie by the supervisor (see De Grauwe 2011).

Therefore to address the risk that banks deleverage too slowly, it is essential that the supervisory authorities closely monitor banks and put in place proper incentives to ensure that they strengthen their balance sheets so as to be able to reimburse the trillion-euro liquidity borrowed from the ECB, without too much stress.

To reduce the risk of national supervisors being too complacent towards their national institutions, it would also be useful to give the ECB a greater role in coordinating and overseeing supervision of the Eurozone banking system, as proposed by Lorenzo Bini Smaghi (see Bini Smaghi 2012).

Excessive liquidity provision

The LTROs have had a major impact on the ECB’s balance sheet and the money base, and it is likely that the ECB would have injected less liquidity into the system if it had agreed to intervene directly in the sovereign bond markets. Indeed, the main argument in favour of direct ECB intervention is that such a move would have the potential of immediately stopping tensions in the markets by operating on expectations. In practice, however, it is unclear that a sudden ECB commitment would have the ability to stabilise yields immediately. While shifts in investor expectations and market equilibrium can occur quite suddenly, the exact timing of an equilibrium shift is notoriously difficult to predict (see El-Erian and Spence 2012).

The likelihood of bringing the yields down towards a good equilibrium would depend on the credibility of the ECB’s commitment to buy unlimited amounts of sovereign bonds to stabilise yields. Given the opposition of Germany to an active role of the ECB as a buyer of last resort for government bonds, markets would certainly test the ECB’s determination to intervene whatever the amount of the liquidity injection.

These remarks highlight the overall limits to the proposal of mandating the ECB to serve as a buyer of last resort for government bonds in a similar way as most central banks assume the responsibility of lender of last resort to the banking system. The challenge is threefold:

• Not only would making unconditional commitments to intervene directly in the sovereign-debt markets be contrary to the Maastricht Treaty, but also it could give the perception that the ECB is willing to monetise public debt, which could make it difficult for the ECB to control inflation in the future (see Mishkin 2011).

• It is agreed that a central bank should not bail out banks or governments that are insolvent. The problem with this principle is that it is very difficult to establish whether a country in difficulty is suffering from liquidity or solvency problems.

• In general, central banks don’t guarantee to the bondholders that they will always pay off the sovereign bonds issued in their own currencies. For instance in the US, the Federal Reserve has gone far beyond the traditional lender-of-last-resort function, notably by extending assistance to insolvent too-big-to-fail insolvent firms and purchasing US government bonds. However, these actions have nothing to do with backstopping US government debt.

Limited chance of success

It is doubtful that the ECB’s direct interventions in the government bond markets would have triggered more significant falls in yields than the LTROs. Italy’s borrowing costs are back to the levels observed in May 2011. The ECB has therefore found a way of breaking the self-fulfilling downward spiral in which mounting doubt about the future of the Eurozone translated into mounting pressures on interest rates.

Still the fiscal and economic problems of the peripheral Eurozone countries have not disappeared, and it is possible that the austerity programmes pursued by these countries will be pushed them into a deep recession that will exacerbate their fiscal problems and will create renewed distrust in sovereign-debt markets.

Such a scenario would undoubtedly put the Eurozone again in difficulty. The question we must ask ourselves is whether this scenario should be assigned a lower probability of occurrence if the ECB had decided to intervene directly in the sovereign-debt markets instead of following the indirect LTRO approach. It is not possible to answer that question with any level of certainty.

If Italy and Spain take long time to come back to the growth path, it is probable that slow improvement in these countries’ fiscal and economic situation would reduce the commitment for reform and push investors to reassess both default and exit risks. This could lead to the return of volatility in sovereign-debt markets and rising yields.

In theory, the risk that these developments again send the Eurozone along a dangerous downward spiral would be more limited if the ECB had offered an explicit and fully credible guarantee of public debts. In practice, however, things may not be quite that simple, as a weakening in fiscal consolidation efforts could also worry investors and force the ECB to intervene in government-bond markets. This development would contribute to growing tensions within the ECB and between Eurozone leaders, which could raise doubt about the ECB’s commitment to intervene when the reform process in a member country slows down.

It is therefore not certain that direct ECB interventions would be much more effective in preventing runs in a situation where a member country is not delivering. As long as the European authorities don’t have supranational powers to impose measures on problem countries, a situation might arise where a government’s inability to take adjustment measures could threaten the Eurozone (see Delbecque 2012).1

Conclusion

The ECB’s banking liquidity operations have been instrumental in breaking the negative spiral, averting a credit crunch, restoring confidence and bringing risk premiums back down. This does not mean that the exit from the crisis has been reached (see Wyplosz 2012). The ECB has just bought time for the weakest countries to carry on their adjustment efforts. In this context, it would be good if these countries would make best use of the window of opportunity to strengthen their economies.

In parallel, the Eurozone leaders should be concerned about the warnings that too little efforts will be made by banks to become less dependent from ECB financing and that the austerity programmes could push the peripheral Eurozone countries into a deep recession. They should also agree to boost the funding of the European Stability Mechanism – the successor of the European Financial Stability Facility – to make sure that the Eurozone rescue fund is big enough to help countries like Spain or Italy, if need be.

References

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