Today the talk is all about the ECB stepping in to help the banks, rather than buying more sovereign debt. This is in line with my expectations, although I should say I don’t have any expectations about the detail. I wrote to a correspondent a couple of days ago: “Why has the market suddenly decided that the ECB is ready and willing to provide a monetary solution to the problem, when only a month ago it was paranoid that the ECB was completely inflexible and would prefer to allow the euro to break up than to do anything about it? And all because European countries are going to write into law the kind of austerity programmes they were already pursuing! This just doesn’t make any sense to me… What is it that people expect the ECB to do? I suppose it is a massive bond-buying programme. But that would require a major change in its philosophy — from a horror of inflation to a cheery willingness to inflate away the whole debt problem… I think the ECB is going to continue to try to force a fiscal solution and that the market has misinterpreted the comments of a new central bank chairman — as so often happens.” Nonetheless, it did seem that the ECB was revving up for some kind of action — but what? Yesterday I watched Perry Mehrling’s explanation (http://j.mp/sSovPR) which suggested that the ECB will take on the loans that national central banks have so far been making to each other (which have allowed peripheral central banks to lend to their domestic commercial banks). This would be a welcome embrace of its lender-of-last-resort function, but I wonder how much practical difference it will make — it does not imply any extra lending to the banking system. The ECB is already conducting unlimited one-year lending operations to the European banking system. There is talk of 2-year and 3-year operations, which I suppose would make banks’ funding somewhat more stable. But that seems a marginal change.

Will commercial banks suddenly become enthusiastic buyers of peripheral debt because of any of the measures that are presently under discussion? I am not sure of the answer to this. On one hand, the present crisis began to kick off when the ECB withdrew from its emergency funding programmes in 2010. If similar programmes are not put in place, perhaps banks will start buying peripheral bonds again. On the other hand, peripheral banks are deleveraging in response to an ongoing flight of deposits, and it has become increasingly clear to the banks over the past two years that imbalances within Europe are the real problem and that there is no easy solution. I really do not know which hand is going to win out. Experience suggests it will be the second one — i.e. that a vicious cycle is now in operation in the peripheral bond markets and consequently private-sector lenders will not return to them. In either case, further ECB funding of Eurozone banks will not remove the vulnerability of peripheral bonds to self-fulfilling runs.

A problem with the above account of the situation is that it does not make sense for the ECB to hold off from lending to the banking system just in order to force politicians to get set on the path to fiscal integration. The ECB ought to act as lender of last resort to the banking system and did so in 2008-09. Is it really prepared to hold back from the kind of lending it things is necessary in order to hold national politicians hostage? In order to promote European integration? If this really is what is happening, then it is worrying.
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