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3 Q&As on the ECB as a Saviour

Three questions for you that are lingering in my head with my proposed answers.

1.  Can the euro area be saved by the  Eurobond issuer or by the ESFS (European Stability Fund)?

No. For 3 main reasons.  1) It takes time to build them, these are administrative tools/bodies. 2)  Compared to direct ECB (European Central Bank)  intervention, both require essentially funding from the markets at market rates  and are less capable to have the same quantitative impact. So, to make a long  story short, better do it directly with the ECB, the famous proposal of the Lender of Last Resort (LLR). But here are two more questions for you.

2.  What is it that we are asking the  ECB to do by becoming an LLR?

Good question Piga. Totally unclear. Everyone has his/her opinion. Some (call them As) think that  what is sufficient is a mere announcement by the ECB that it will stand ready to buy any amount of governments bonds in the secondary market. Some others (Bs) think  instead that ECB should buy any level of public debt in any country that is in  excess of 60% of GDP. Some (Cs) say that banks that receive money from the ECB  in exchange for their bonds should funnel it only to the private sector to  boost credit to (rationed) firms. Some others (Ds) that we should have the ECB  recapitalize banks that are currently engaged in a dangerous game of selling those bonds before their price goes further down in an attempt to scale down  their liabilities and avoid sinking once and for all. Finally, someone (Es) says  that the ECB should target specifically those holders of bonds with high spreads so as to make monetary policy uniform across countries while injecting  liquidity in the economy.

What a mess, right. Well how can we understand the true differences across these schemes? First of all notice that almost all of them require the ECB providing money to banks: only guy B’s proposal may imply that such money could to families holding bonds, so let’s get rid of guy B for simplicity. Second, notice the differences between the 4 remaining schemes; they pertain to 1) the type of help the bank receives from the ECB and 2) the type of allocation that one is asking the bank to do  with this help.

In particular,  proposal D is unique in that it directs the ECB  funding to rebuild the equity of banks. What would they do with this added  money? Well they could either 1) buy more government bonds or 2) lend it to  firms. In option 1) we are back to square one, in that we have no certainty that fragile banks will not keep on selling those bonds to improve their  balance sheet, setting the stage for a continuation of the type crisis that  justified the intervention. In option 2), are we really sure that loans to firms in this current cycle will not also be considered risky and lead to further downsizing of the balance sheet accounts by repaying debt and not helping the economy?

Said in one word: funding with equity banks might be a serious idea in the current environment and we  should discuss which policy is best able to do it but it cannot be used to capture 2 birds with one stone, i.e. solve the bank and  the government problem. So let’s stay only with  the remaining 3 options for an ECB Lender of Last Resort, A, C and E, which all have in common the fact that the ECB buys (or commits to buy) in the  secondary market (large, very large) quantities of government bonds. And let us ask the final third question for today.

3)  What do we gain with an ECB as LLR?

So. So far we have established that the best  thing to do if we want to operate via ECB (and we have seen that ECB support is  a potential tool among the few we have) is for it to exchange bonds for cash  with the banks. Ok, now, for what purpose?

Well, here again proposers differ. Some (A) for  lowering the spreads on government bonds and initiate a virtuous circle where  government borrowing needs decline and so do budget deficits. Others instead  argue (C) that this money should be used by banks to lend to the economy and  starting a virtuous circle where growth picks up and governments improve their situation and spreads decline. Others again (E), a mix of the two. Well let me start with proposal A. Are we really sure that if the ECB buys up government bonds will decline? Well, since spreads are due to risk, the answer might be related to the source of risk we  are dealing with. I could well imagine a type of risk eliminated by an  aggressive ECB program of the kind we are studying. For example, imagine  spreads are high in Italy because banks fear that when large chunks of debt they are holding will reach maturity and reimbursement  time comes, no one will want to refinance it,  preferring to invest in China instead. Well that’s a good reason, refinancing risk due to liquidity shortages, to keep spreads high. But what if now I know the ECB is there to buy up any bond I might have in my portfolio? Sure enough, that asset will not be risky anymore and spreads could collapse at the news of  an LLR called ECB.

Now suppose that the risk is due to the potential break-up of the euro, or to a belief that the Government will never restore  growth in that country. How would the knowledge that at any point in time the  ECB buy bonds on demand help in any way eliminating that risk? It is a risk that is not controlled by the ECB and thus no insurance is certain here. Spreads would remain high.

What about proposal C? Could the provision of ECB cash to banks reignite credit in the economy? Would interest rates go down and firms be willing to ration less? Would growth start and spreads collapse? Not sure at all. But this is for the next time. We are all tired. My turn to collapse.

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