Draghi turns up the risk dial

Long-term refinancing operations by the ECB have sent bond yields down, but the truth is that LTROs are making things in the eurozone much more dangerous.


With immense modesty, the President of the ECB Mario Draghi is giving the credit for falling spreads on eurozone government debt to the courageous reforms announced in a number of countries, especially those where former academic economists act as prime ministers. Oh, how we would love to buy Mario Draghi’s interpretation! While simultaneity is not causality, it is hard not to see a link between the impressive decline in bond spreads and the ECB’s long-term refinancing operations.

The story is that banks borrow from the ECB at very low rates (about 1 per cent) and buy public bonds whose yields are much higher. The amounts are considerable – by the end of December LTROs had injected €250 billion of fresh cash. Rumours are that the next round will see an injection many times that amount. When one realises that the total lending capacity of the EFSF is €250 billion, it is not difficult to see why the LTROs have turned around market sentiment.

For months, many observers have argued that one of the necessary conditions to stop the crisis is an explicit guarantee of public debts to be offered by the ECB. Under its previous management, the ECB had rejected this approach on dubious grounds. They had argued:

- It’s not in the mission (wrong, financial stability is in the mission);
- It would create massive moral hazard (wrong, the moral hazard can and should be treated separately);
- It would expose the ECB to financial risks (true, that is why a central bank is not a commercial operation); or
- It is for governments to sort out their own mess (wrong, they plainly cannot).

With a seriously trained economist at the helm for a change, the new ECB management has clearly seen the light. It has still been held up by the moral hazard issue and by Germany’s unreasoned opposition, but it has found ways around both blocking points. President Draghi has let it be known that the moral hazard must be treated first and convincingly. Politicians have responded and produced, at the end of January 2012, the draft treaty on stability, coordination, and governance in the Economic and Monetary Union – also known as the fiscal compact. If things go well – a big ‘if’, as national arrangements can fall far short of what is needed to achieve lasting discipline – this treaty will establish a decentralisation of fiscal discipline through the adoption in national constitutions of the German ‘debt brake’ balanced-budget rule. Decentralisation, instead of European Commission supervision and control (as was the case with the Stability and Growth Pact), would be a major, long-desired step.

Then the ECB has bypassed the German resistance against backstopping public debt, which explains President Draghi’s false modesty. By providing commercial banks with vast amounts of cheap and stable cash, the ECB officially means to avert fatal liquidity shortages that could take one or more Eurozone banks along the Lehman Brothers path to ruin. The other interpretation – which is not incompatible with the first one – is that the ECB is indirectly backstopping public bonds. As noted above, it works, so well in fact that many observers and policymakers have called it a definitive victory.

Unfortunately, this clever move falls short of bringing the crisis to an end. Much more remains to be done. Greece and Portugal will be unable to grow with their existing debt burden – and this may also be the case for Italy and other countries as contagion takes hold. Current efforts to achieve an orderly debt restructuring of the Greek debt are far too modest. They aim to bring the debt-to-GDP ratio to 120 per cent, which is higher than its pre-crisis level of 110 per cent. Given that a deep enough default will lead to a banking crisis in Greece, the government’s first post-default move will have to be to bail out its banks. This means that the debt must be reduced to, at most, 60 per cent of GDP.

We must then face the fact that many of Europe’s largest commercial banks are in a precarious situation. Serious estimates by NYU economists, constantly updated on V-Lab’s website, suggest that Europe’s largest banks face a risk of $US1000 billion to $US1500 billion. A contagious wave of sovereign debt defaults would undoubtedly raise this amount. This gives us a vague but realistic peek into what governments must be readying themselves to inject into their banking systems. On this count, Germany, France, and Spain are next in line for the sovereign debt crisis. This is the result of three years of Japanese-style forbearance. By guaranteeing bank access to liquidity, the LTROs effectively eliminate the risk of illiquidity, but they do not address the risk of insolvency. The devil here is in two big, ominous details.

In fact, the LTROs make things massively more dangerous. Banks borrow cash from the ECB to acquire sovereign bonds. A plausible wave of sovereign defaults will turn these bonds into toxic assets. The more that banks accumulate these bonds, the riskier the situation is becoming. The ECB seems to be making a trillion euro bet. To see that, we should recognise that the sovereign debt crisis is a case of multiple equilibria. With a bit of luck, markets could be swayed by the ECB action; most public debts will be once again seen as safe and the ECB will have saved the euro at virtually no cost. But a reversion to a good equilibrium is by no means guaranteed. Should markets conclude that crucial public policy actions are missing, as argued above, a bad equilibrium will prevail, debt defaults will spread and eurozone banks will fold, imposing such a massive cost to taxpayers that the euro might collapse. The nature of multiple equilibria is that they are truly un-forecastable. So no one can assess whether this is a bet worth taking, especially since other central banks like the Fed or the Bank of England have directly bought sovereign bonds, taking the risk of default upon themselves rather than pushing it into bank balance sheets.

But maybe, given German intransigence, there was no other politically possible choice for the ECB. If the bet fails, we will blame the German authorities, not the ECB. That, too, is smart, but maybe a tad too smart.

This article first appeared on www.VoxEU.org. Republished with permission.

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