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Stephen Fidler: ECB LTRO Seen Doomed to Fail


by WSJ

Paul de Grauwe, now at the London School of Economics, wrote a short and influential paper in May last year on the frailties of the euro zone–and the reason that financial markets attached a much greater default risk to Spain that they did to the U.K, despite the latter’s higher debt burden.

The British government, he explained, could always be sure of funds to roll over its debt in important part because of the Bank of England could as a last resort be prevailed upon to buy that debt; by contrast, the Spanish government cannot force the Bank of Spain or the European Central Bank to buy its debt.

“Members of a monetary union issue debt in a currency over which they have no control. It follows that financial markets acquire the power to force default on these countries. This is not the case in countries that are not part of a monetary union, and have kept control over the currency in which they issue debt. These countries cannot easily be forced into default by financial markets.”

Today, Mr. De Grauwe follows up this paper with another, entitled “How Not To Be a Lender of Last Resort, in which he argues that the ECB’s Long-Term Refinancing Operations–in which the central bank provided cheap three-year loans to banks–won’t succeed for long and that the “sovereign debt crisis will explode again.”

Direct intervention in the sovereign bond markets, he says, “is the only way to save the euro zone.”

There are three unfortunate consequences, he says, of using the LTRO indirectly to calm the government debt turmoil instead of intervening directly in troubled sovereign bond markets, which is strongly opposed by Germany because it implies direct central-bank financing of government budgets.

  1. Banks channel only a fraction of the liquidity they receive into the sovereign bond markets, forcing the ECB to pour in much more liquidity than if they had intervened directly in the government bonds.
  2. New waves of panic may grip the bankers again, leading them to sell off government bonds–undermining the credibility of the operation.
  3. Massive injections of liquidity create wider moral hazard problems than direct sovereign-bond market interventions. “Banks are now given unlimited sources of funding to make easy profits. This reduces their incentives to restructure their balance sheets that will make them more resilient in the future,” he writes.

He concludes:

“It is often said that Germany will never accept such direct interventions. Today this German opposition is difficult to overcome, and explains why the ECB reverted to the indirect LTRO program. But what is politically impossible today may in the end be accepted when it becomes obvious that direct intervention is the only way to save the euro zone. It would help if the German opponents liberate themselves from the dogma that it is a sin to create liquidity to buy government bonds when these bonds appear on the ECB’s balance sheet, while the same operation is viewed as virtuous when these bonds appear on the balance sheets of banks.”

Original Source

Paul de Grauwe, now at the London School of Economics, wrote a short and influential paper in May last year on the frailties of the euro zone–and the reason that financial markets attached a much greater default risk to Spain that they did to the U.K, despite the latter’s higher debt burden.

The British government, he explained, could always be sure of funds to roll over its debt in important part because of the Bank of England could as a last resort be prevailed upon to buy that debt; by contrast, the Spanish government cannot force the Bank of Spain or the European Central Bank to buy its debt.

“Members of a monetary union issue debt in a currency over which they have no control. It follows that financial markets acquire the power to force default on these countries. This is not the case in countries that are not part of a monetary union, and have kept control over the currency in which they issue debt. These countries cannot easily be forced into default by financial markets.”

Today, Mr. De Grauwe follows up this paper with another, entitled “How Not To Be a Lender of Last Resort, in which he argues that the ECB’s Long-Term Refinancing Operations–in which the central bank provided cheap three-year loans to banks–won’t succeed for long and that the “sovereign debt crisis will explode again.”

Direct intervention in the sovereign bond markets, he says, “is the only way to save the euro zone.”

There are three unfortunate consequences, he says, of using the LTRO indirectly to calm the government debt turmoil instead of intervening directly in troubled sovereign bond markets, which is strongly opposed by Germany because it implies direct central-bank financing of government budgets.

  1. Banks channel only a fraction of the liquidity they receive into the sovereign bond markets, forcing the ECB to pour in much more liquidity than if they had intervened directly in the government bonds.
  2. New waves of panic may grip the bankers again, leading them to sell off government bonds–undermining the credibility of the operation.
  3. Massive injections of liquidity create wider moral hazard problems than direct sovereign-bond market interventions. “Banks are now given unlimited sources of funding to make easy profits. This reduces their incentives to restructure their balance sheets that will make them more resilient in the future,” he writes.

He concludes:

“It is often said that Germany will never accept such direct interventions. Today this German opposition is difficult to overcome, and explains why the ECB reverted to the indirect LTRO program. But what is politically impossible today may in the end be accepted when it becomes obvious that direct intervention is the only way to save the euro zone. It would help if the German opponents liberate themselves from the dogma that it is a sin to create liquidity to buy government bonds when these bonds appear on the ECB’s balance sheet, while the same operation is viewed as virtuous when these bonds appear on the balance sheets of banks.”

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