By Paul De Grauwe, Professor of international economics, University of Leuven, member of the Group of Economic Policy Analysis, advising the EU Commission President Manuel Barroso, and former member of the Belgian parliament. Cross posted from VoxEU
Among the questions still remaining since last week’s summit of European leaders is whether the new measures will stabilise government bond markets. This column’s answer is ‘no’.
This was the nth summit meeting of European leaders billed as finally solving the Eurozone crisis. Yet there were a number of important and useful decisions taken at last week’s summit:
A new banking union with a European supervisor that has some teeth; and
the possibility of organising recapitalisations of banks at the European level.
These are both positive steps. The last one in particular is important.
One of the main weaknesses of the Eurozone lies in the fact that banking problems have to be resolved by the national government where the banks are located. As a result, insolvency of local banks threatens the solvency of the national government, leading to a vicious circle of interacting solvency crises of local banks and the local sovereign. Cutting the link between the two is therefore key to creating a more stable financial environment in the Eurozone.
Banking union: Devil in the detail
While the principle of a European mechanism for resolving banking crises is now accepted, major practical problems of implementation of that principle lie before us.
• What will be the supervisory powers of the ECB?
• Who will run the recapitalised banks?
• What if a bank has to be nationalised?
These and many other practical questions will pop up on the road to implementing the new principle.
The European Stability Mechanism
The focus of this column, however, is on the new role that is given to the European Stability Mechanism (ESM), otherwise known as its bailout fund, that should start its operations very soon.
In addition to its conditional financial assistance to member countries, the ESM was given two new tasks.
• The first one (that I just discussed) is that it will be able to directly recapitalise troubled banks.
• The second one is that it will be allowed to buy government bonds in the secondary markets so as to prevent further destabilising surges in bond rates.
These are eminently important objectives.
Surely something must be done about the inexorable rise in the sovereign bond rates of a number of Southern European countries? These surges in the interest rates are only partly the result of bad fundamentals. For countries like Spain and Italy, a significant part of the increases in the spreads is the result of fear and panic in the markets that have the potential of driving countries into bankruptcy in a self-fulfilling way (De Grauwe and Ji 2012).
The question then is whether the ESM will be able to stabilise the government bond markets. My answer is ‘no’.
Why ESM will fail to stabilise government debt markets
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. The reason is the following.
Suppose a new movement of fear and panic, triggered for example by the deepening recession in Spain, pushes up the Spanish government bond rate again.
• To stem the tide the ESM starts buying Spanish bonds. Suppose it buys €200 billion worth of Spanish bonds.
At the end of the operation it will be clear for everybody that the ESM has seen its resources decline from €500 billion to €300 billion. Less will be left over to face new crises.
• Investors will start forecasting the moment when the ESM will run out of cash.
They will then do what one expects from clever people.
• They will sell bonds now rather than later.
The reason is not difficult to see. Anticipating the moment the ESM runs out of cash forcing it to stop its intervention, they expect bond prices to crash. To prevent making large losses, they will have an incentive to bring their bond sales forward to the present rather than wait until the losses are incurred. Thus the interventions by the ESM will trigger crises rather than avoid them.
This feature is well-known from the literature on foreign exchange crises. The classic Krugman model, for example, has the same features (Krugman 1969, see also Obstfeld 1994). A central bank that pegs the exchange rate and has a finite stock of international reserves to defend its currency against speculative attacks faces the same problem. At some point, the stock of reserves is depleted and the central bank has to stop defending the currency. Speculators do not wait for that moment to happen. They set in motion their speculative sales of the currency much before the moment of depletion, triggering a self-fulfilling crisis.
Only the ECB can stabilise bond markets
The only way to stabilise the government bond markets is to involve the ECB, either indirectly by giving a banking license to the ESM so that it can draw on the resources of the ECB (see Gros and Mayer 2010), or by direct interventions by the ECB. But the European leaders were unable (unwilling) to take that necessary step to stabilise the Eurozone.
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.
The SMP is the wrong precedent
The ECB did buy government bond markets last year in the framework of its Securities Markets Programme (SMP). However it structured this programme in the worst possible way. By announcing it would be limited in size and time, it mimicked the fatal problem of an institution that has limited resources. No wonder that strategy did not work.
The only strategy that can work is the one that puts the fact that the ECB has unlimited resources at the core of that strategy. Thus, the ECB should announce a cap on the spreads of the Spanish and Italian government bonds, say of 300 basis points. Such an announcement is fully credible if the ECB is committed to use all its firepower, which is infinite, to achieve this target.
If the ECB achieves this credibility it creates an interesting investment opportunity for investors. The latter obtain a premium on their Spanish and Italian government bond holdings, while the ECB guarantees that there is a floor below which the bond prices will not fall. (The floor price is the counterpart of the interest rate cap). In addition, the 300 basis points acts as a penalty rate for the Spanish and Italian governments giving them incentives to reduce their debt levels.
The ECB is unwilling to stabilise financial markets this way. Many arguments have been given why the ECB should not be a lender of last resort in the government bond markets. Many of them are phony (see De Grauwe 2011, Wyplosz 2011). Some are serious like the moral hazard risk. The latter, however, should be taken care of by separate institutions aimed at controlling excessive government debts and deficits. These are in the process of being set up (European Semester, Fiscal Pact, automatic sanctions, etc.). This disciplining and sanctioning mechanism should then relieve the ECB of its fears of moral hazard (a fear it did not have when it provided €1,000 billion to banks at a low interest rate).
Understanding the ECB’s reluctance
The deeper reason for the ECB’s reluctance to be a lender of last resort in the government bond market has to with its business model. This is a model whereby one of the ECB’s main concerns is the defence of its balance-sheet quality. That is, a concern about avoiding losses and showing positive equity – even if that leads to financial instability.
When the ECB was instituted, it was deemed necessary for that institution to issue equity to be held by the EU-governments. Thus the idea was created that in order to sustain its activities the ECB needed to obtain the capital of the member countries. This idea was reinforced in 2010 when a decision was taken by the Governing Council to raise the amount of capital by €5 billion. It is useful to read the justification of this decision: “Taking into account the increase of the ECB’s balance sheet total over the last years, it is considered necessary to increase the ECB’s capital by €5,000 million in order to sustain the adequacy of the capital base needed to support the operations of the ECB” (ECB 2010).
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. For example, in order to protect its equity, the ECB has insisted on obtaining seniority on its government bond holdings. In doing so, it has made these bonds more risky for the private holders, who have reacted by selling the bonds. This also implies that if the ECB were to take up its responsibility of lender of last resort, it will have to abandon its seniority claim on the government bonds it buys in the market.
What should be done?
The correct business model for the ECB is one that has it pursuing financial stability as its primary objective (together with price stability), even if that leads to losses. There is no limit to the size of the losses a central bank can bear, except the one that is imposed by its commitment to maintain price stability. In the present situation the ECB is far from this limit (Buiter 2008).
The creation of the European Financial Stability Facility (EFSF) and the ESM has been motivated by the overriding concern of the ECB to protect its balance sheet. This has been misguided. The enlarged responsibilities that are now given to the ESM are to be seen as a cover-up of the failure of the ECB to take up its responsibility of the guardian of financial stability in the Eurozone; a responsibility that only the ECB can fulfill.