16 January 2012

Project Syndicate: Behind the ECB's 'wall of money'

Benedicta Marzinotto writes that throughout the crisis period, the European Central Bank's behaviour has been conditioned by the tension between what it can do and what it is allowed to do.

The ECB is the only institution in the European Union that is able to provide unlimited funding to governments, but its governing statute prohibits government bailouts. Nonetheless, the ECB has provided large amounts of liquidity to the financial system, indirectly softening the pressure on government debt refinancing. In his early December address to the European Parliament, ECB President, Mario Draghi, stressed his commitment to unlimited support of banks to avert the risk of a credit crunch. The wall of money unleashed by the ECB just before Christmas should be seen as a measure matching that commitment.

Draghi left it up to national banks to decide whether to use the liquidity to buy high-yield government bonds. The political logic behind such a plea is straightforward. If the banks proceed with purchases of their own government bonds, all public debt will be progressively renationalised, along with loans to the private sector, which undercapitalised banks have recently been providing only locally. Worryingly, the evidence so far is that banks have not used the cash, instead parking it at the ECB. That behaviour reflects banks’ uncertainty, but leaving the money with the ECB is a loss-making operation that cannot be sustained indefinitely. Sooner or later, the banks will use the cash. The question is how.

Banks’ immediate interest is to adjust to the new capital requirements and restore their balance sheets to financial health, which implies that they will use the ECB money in a way that enables them to meet this objective most cost effectively.

The ECB’s wall of money is likely to support the real economy only mildly. By contrast, if banks use the money now parked at the ECB to continue buying short-maturity government bonds, that wall of money would have a large impact on eurozone countries’ financial inter-linkages. Instead of falling on foreign banks in just a few exposed countries, a default would land mostly on the ECB’s balance sheet, whose losses are distributed to all eurozone central banks – a soft form of debt socialisation that may well prepare the ground for eurobond-type solutions.

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