{"id":59547,"date":"2012-02-23T11:34:15","date_gmt":"2012-02-23T00:34:15","guid":{"rendered":"http:\/\/www.fnarena.com\/index.php\/2012\/02\/23\/the-ecbs-trillion-euro-bet\/"},"modified":"2012-02-23T11:34:15","modified_gmt":"2012-02-23T00:34:15","slug":"the-ecbs-trillion-euro-bet","status":"publish","type":"post","link":"https:\/\/staging.fnarena.com\/index.php\/2012\/02\/23\/the-ecbs-trillion-euro-bet\/","title":{"rendered":"The ECB&#8217;s Trillion Euro Bet"},"content":{"rendered":"<p>\n\t&nbsp;By Charles <span class=\"scayt-misspell\">Wyplosz<\/span><\/p>\n<p>\n\t<em>Spreads on public debts in the <span class=\"scayt-misspell\">Eurozone<\/span> &ndash; with the exception of Greece &ndash; are falling hard and fast. This column argues that this is in large part because the <span class=\"scayt-misspell\">ECB<\/span> is now effectively guaranteeing <span class=\"scayt-misspell\">Eurozone<\/span> government debts. But it cautions that in doing so, the central bank is taking enormous risks.<\/em><\/p>\n<p>\n\tWith immense modesty, the President of the <span class=\"scayt-misspell\">ECB<\/span> Mario <span class=\"scayt-misspell\">Draghi<\/span> is giving the credit for falling spreads on <span class=\"scayt-misspell\">Eurozone<\/span> 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 <span class=\"scayt-misspell\">Draghi&rsquo;s<\/span> interpretation! While simultaneity is not causality, it is hard not to see a link between the impressive decline in bond spreads and the <span class=\"scayt-misspell\">ECB&rsquo;s<\/span> long-term refinancing operations (<span class=\"scayt-misspell\">LTROs<\/span>).<\/p>\n<p>\n\tThe story is that banks borrow from the <span class=\"scayt-misspell\">ECB<\/span> at very low rates (about 1%) and buy public bonds whose yields are much higher. The amounts are considerable &ndash; by the end of December <span class=\"scayt-misspell\">LTROs<\/span> had injected &euro;250 billion of fresh cash. <span class=\"scayt-misspell\">Rumours<\/span> are that the next round will see an injection many times that amount. When one <span class=\"scayt-misspell\">realises<\/span> that the total lending capacity of the <span class=\"scayt-misspell\">EFSF<\/span> is &euro;250 billion, it is not difficult to see why the <span class=\"scayt-misspell\">LTROs<\/span> have turned around market sentiment.<\/p>\n<p>\n\tFor 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 <span class=\"scayt-misspell\">ECB<\/span> (see for example <a href=\"http:\/\/www.voxeu.org\/index.php?q=node\/6884\">de <span class=\"scayt-misspell\">Grauwe<\/span> 2011 <\/a>and <a href=\"http:\/\/voxeu.org\/index.php?q=node\/6845\"><span class=\"scayt-misspell\">Wyplosz<\/span> 2011 <\/a>on this site). Under its previous management, the <span class=\"scayt-misspell\">ECB<\/span> had rejected this approach on dubious grounds. They had argued:<\/p>\n<ul>\n<li>\n\t\tIt&rsquo;s not in the mission (wrong, financial stability is in the mission);<\/li>\n<li>\n\t\tIt would create massive moral hazard (wrong, the moral hazard can and should be treated separately);<\/li>\n<li>\n\t\tIt would expose the <span class=\"scayt-misspell\">ECB<\/span> to financial risks (true, that is why a central bank is not a commercial operation); or<\/li>\n<li>\n\t\tIt is for governments to sort out their own mess (wrong, they plainly cannot).<\/li>\n<\/ul>\n<p>\n\tWith a seriously trained economist at the helm for a change, the new <span class=\"scayt-misspell\">ECB<\/span> management has clearly seen the light. It has still been held up by the moral hazard issue and by Germany&rsquo;s unreasoned opposition, but it has found ways around both blocking points. President <span class=\"scayt-misspell\">Draghi<\/span> 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 &ndash; also known as the fiscal compact. If things go well &ndash; a big &lsquo;if&rsquo;, as national arrangements can fall far short of what is needed to achieve lasting discipline &ndash; this treaty will establish a <span class=\"scayt-misspell\">decentralisation<\/span> of fiscal discipline through the adoption in national constitutions of the German &lsquo;debt brake&rsquo; balanced-budget rule. <span class=\"scayt-misspell\">Decentralisation<\/span>, instead of European Commission supervision and control (as was the case with the Stability and Growth Pact), would be a major, long-desired step (see von Hagen and <span class=\"scayt-misspell\">Wyplosz<\/span> 2008).<\/p>\n<p>\n\tThen the <span class=\"scayt-misspell\">ECB<\/span> has bypassed the German resistance against backstopping public debt, which explains President <span class=\"scayt-misspell\">Draghi&rsquo;s<\/span> <span class=\"scayt-misspell\">false<\/span> modesty. By providing commercial banks with vast amounts of cheap and stable cash, the <span class=\"scayt-misspell\">ECB<\/span> officially means to avert fatal liquidity shortages that could take one or more <span class=\"scayt-misspell\">Eurozone<\/span> banks along the Lehman Brothers path to ruin. The other interpretation &ndash; which is not incompatible with the first one &ndash; is that the <span class=\"scayt-misspell\">ECB<\/span> 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.<\/p>\n<p>\n\tUnfortunately, 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 &ndash; 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%, which is higher than its pre-crisis level of 110%. Given that a deep enough default will lead to a banking crisis in Greece, the government&rsquo;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% of GDP.<\/p>\n<p>\n\tWe must then face the fact that many of Europe&rsquo;s largest commercial banks are in a precarious situation. Serious estimates by NYU economists, constantly updated on V-Lab&rsquo;s website, suggest that Europe&rsquo;s largest banks face a risk of $1000 to $1500 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 <span class=\"scayt-misspell\">LTROs<\/span> effectively eliminate the risk of <span class=\"scayt-misspell\">illiquidity<\/span>, but they do not address the risk of insolvency. The devil here is in two big, ominous details.<\/p>\n<p>\n\tIn fact, the <span class=\"scayt-misspell\">LTROs<\/span> make things massively more dangerous. Banks borrow cash from the <span class=\"scayt-misspell\">ECB<\/span> 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 <span class=\"scayt-misspell\">ECB<\/span> seems to be making a trillion euro bet. To see that, we should <span class=\"scayt-misspell\">recognise<\/span> that the sovereign debt crisis is a case of multiple <span class=\"scayt-misspell\">equilibria<\/span> (<a href=\"http:\/\/voxeu.org\/index.php?q=node\/7475\">Blanchard 2011<\/a>, <a href=\"http:\/\/www.voxeu.org\/index.php?q=node\/4583\"><span class=\"scayt-misspell\">Wyplosz<\/span> 2010<\/a>). With a bit of luck, markets could be swayed by the <span class=\"scayt-misspell\">ECB<\/span> action; most public debts will be once again seen as safe and the <span class=\"scayt-misspell\">ECB<\/span> will have saved the euro at virtually no cost. But a reversion to a good equilibrium is by no mean guaranteed. Should markets conclude that crucial public policy actions are missing, as argued above, a bad equilibrium will prevail, debt defaults will spread and <span class=\"scayt-misspell\">Eurozone<\/span> banks will fold, imposing such a massive cost to taxpayers that the euro might collapse. The nature of multiple <span class=\"scayt-misspell\">equilibria<\/span> is that they are truly <span class=\"scayt-misspell\">un-forecastable<\/span>. 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.<\/p>\n<p>\n\tBut maybe, given German intransigence, there was no other politically possible choice for the <span class=\"scayt-misspell\">ECB<\/span>. If the bet fails, we will blame the German authorities, not the <span class=\"scayt-misspell\">ECB<\/span>. That, too, is smart, but maybe a tad too smart.<\/p>\n<p>\n\t<strong>References<\/strong><\/p>\n<p>\n\tBlanchard, Olivier (2011), &ldquo;<a href=\"http:\/\/voxeu.org\/index.php?q=node\/7475\">Blanchard on 2011&rsquo;s four hard truths<\/a>&rdquo;, VoxEU.org, 23 December.<br \/>\n\tde <span class=\"scayt-misspell\">Grauwe<\/span>, Paul (2011), &ldquo;<a href=\"http:\/\/www.voxeu.org\/index.php?q=node\/6884\">The European Central Bank as a lender of last resort<\/a>&rdquo;, VoxEU.org, 18 August.<br \/>\n\tvon Hagen, <span class=\"scayt-misspell\">Juergen<\/span> and Charles <span class=\"scayt-misspell\">Wyplosz<\/span> (2008), &ldquo;EMU&rsquo;s Decentralized System of Fiscal Policy&rdquo;, European Economy. Economic Papers 306.<br \/>\n\t<span class=\"scayt-misspell\">Wyplosz<\/span>, Charles (2010), &ldquo;<a href=\"http:\/\/www.voxeu.org\/index.php?q=node\/4583\">The <span class=\"scayt-misspell\">Eurozone<\/span> debt crisis; facts and myths<\/a>&rdquo;, VoxEU.org, 9 February.<br \/>\n\t<span class=\"scayt-misspell\">Wyplosz<\/span>, Charles (2011), &ldquo;<a href=\"http:\/\/voxeu.org\/index.php?q=node\/6845\">They still don&rsquo;t get it<\/a>&rdquo;, VoxEU.org, 22 August.<\/p>\n<p>\n\tCharles <span class=\"scayt-misspell\">Wyplosz<\/span> is Professor of International Economics at the Graduate Institute, Geneva; Director of the International Centre for Money and Banking Studies. CEPR Research Fellow<\/p>\n<p>\n\tCopyright VoxEU.org &#8211; the above story was originally published on www.VoxEU.org &#8211; readers reading this story through a third party channel may find that any graphs are not included (our apologies for this technical anomaly) &#8211; here&#039;s a link to the original story on the VoxEU website: click <a href=\"http:\/\/www.voxeu.org\/index.php?q=node\/7617\">HERE<\/a><\/p>\n<p>\n\t<strong>Technical limitations<\/strong><\/p>\n<p>\n\t<strong><span style=\"font-style: italic\">If you are reading this story through a third party distribution channel and you cannot see charts included<\/span>, <em>we <span>apologise<\/span>, but technical limitations are to blame.<\/em><\/strong><\/p>\n<p>\n\t<em>Find out why FNArena subscribers like the service so much: &quot;<a href=\"http:\/\/www.fnarena.com\/index4.cfm?type=dsp_newsitem&amp;n=29EB960D-9DFF-C00E-7F6B464E5D52E250\">Your Feedback (Thank You)<\/a>&quot; &#8211; Warning this story contains unashamedly positive feedback on the service provided.<\/em><\/p>\n","protected":false},"excerpt":{"rendered":"<p>Writing for VoxEU, Charles Wyplosz cautions the ECB is taking huge risks in effectively guaranteeing Eurozone government debts.<\/p>\n","protected":false},"author":3,"featured_media":0,"comment_status":"closed","ping_status":"closed","sticky":false,"template":"","format":"standard","meta":{"_acf_changed":false,"footnotes":""},"categories":[5],"tags":[21,41],"acf":[],"_links":{"self":[{"href":"https:\/\/staging.fnarena.com\/index.php\/wp-json\/wp\/v2\/posts\/59547"}],"collection":[{"href":"https:\/\/staging.fnarena.com\/index.php\/wp-json\/wp\/v2\/posts"}],"about":[{"href":"https:\/\/staging.fnarena.com\/index.php\/wp-json\/wp\/v2\/types\/post"}],"author":[{"embeddable":true,"href":"https:\/\/staging.fnarena.com\/index.php\/wp-json\/wp\/v2\/users\/3"}],"replies":[{"embeddable":true,"href":"https:\/\/staging.fnarena.com\/index.php\/wp-json\/wp\/v2\/comments?post=59547"}],"version-history":[{"count":0,"href":"https:\/\/staging.fnarena.com\/index.php\/wp-json\/wp\/v2\/posts\/59547\/revisions"}],"wp:attachment":[{"href":"https:\/\/staging.fnarena.com\/index.php\/wp-json\/wp\/v2\/media?parent=59547"}],"wp:term":[{"taxonomy":"category","embeddable":true,"href":"https:\/\/staging.fnarena.com\/index.php\/wp-json\/wp\/v2\/categories?post=59547"},{"taxonomy":"post_tag","embeddable":true,"href":"https:\/\/staging.fnarena.com\/index.php\/wp-json\/wp\/v2\/tags?post=59547"}],"curies":[{"name":"wp","href":"https:\/\/api.w.org\/{rel}","templated":true}]}}