(Sorry for blogging silence – I’ve been asked to write a book on the eurocrisis and European integration, so have been deep in research working out if I understand the current situation enough to do so.)
It’s been a bit over a week since the European Council’s shock announcement of some kind of deal – which means it’s been just about long enough to work out what the hell it all means in practice.
One of the best articles I’ve seen in the last few days is the following from VoxEU (an increasingly indispensible resource).
The key issue, the argument (which I’ve seen elsewhere) runs, is the vicious cycle of bank debts being linked to the finances of the state in which the bank is based. Multi-national financial organisations, running into problems worldwide, being supported by the single nations in which they are based.
Banks get in trouble, and under the current system states are expected to bail them out, increasing risk in government bonds, weakening the state’s ability to pay, which weakens the banks yet further, and so on ad infinitum (or, at least, until bankruptcy/default for either bank or state or both – which would in turn trigger fresh crises elsewhere).
The European Council’s decision to bypass governments and bail out banks direct via the European Stability Mechanism, then, is designed to break this cycle. However, as always there’s a problem…
“The ESM has financial resources amounting to €500 billion. Compare this with the total government bonds outstanding of close to €2,000 billion in Italy and of about €800 billion in Spain and it is immediately evident that the ESM will be unable to stem a crisis involving one of these two countries, let alone the two countries together.
“In fact it is worse. As soon as the ESM starts intervening, it will quickly destabilise the government bond markets in these two countries.”
Why? Because as soon as it’s used, the argument runs, the European Stability Mechanisms’s already inadequate funds will become even less adequate to bail out additional bank liabilities, making those liabilities instantly less attractive and prompting investors to flee to safer harbours.
The answer, according to the article, is simple: the European Central Bank needs to come into play, with an last-ditch ability to print more euros to pay off bank liabilities:
“The ECB is the only institution that can prevent panic in the sovereign bond markets from pushing countries into a bad equilibrium, because as a money-creating institution it has an infinite capacity to buy government bonds. The fact that resources are infinite is key to be able to stabilise bond rates. It is the only way to gain credibility in the market.”
Both the ECB and Germany, however, are unwilling to go down this route. Partially, as far as I can tell, due to German fears of a repeat of the hyperinflation of the 1930s (print more euros to pay off bad debts, will this push down the value of the euro? No one seems sure…), partially – the argument in the article runs – because the ECB is acting like a regular bank, not a central bank:
“It is surprising that the ECB attaches such an importance to having sufficient equity. In fact, this insistence is based on a fundamental misunderstanding of the nature of central banking. The central bank creates its own IOUs. As a result it does not need equity at all to support its activities. Central banks can live without equity because they cannot default. The only support a central bank needs is the political support of the sovereign that guarantees the legal tender nature of the money issued by the central bank. This political support does not need any equity stake of the sovereign. In fact it is quite ludicrous to believe that governments that can, and sometimes do, default are needed to provide the capital of an institution that cannot default. Yet, this is what the ECB seems to have convinced the outside world.
“All this would not be a problem were it not that the ECB’s insistence on having positive equity is in conflict with its responsibility to maintain financial stability. Worse, this insistence has become a source of financial instability.”
And so the only institution that can solve the eurocrisis is the least reluctant to act. No change there, then…
(Of course, the way the crisis has been unfolding of late, there’s probably been an announcement since I started typing this post that’s rendered all the above obsolete…)
By the way: If you want to dig deeper on this, I strongly recommend this from Edward Hugh at A Fistful of Euros, which digs into much more detail on this whole issue – including the intriguing recent suggestions that the ESM “direct bank bailout” concept may actually be nothing of the sort.