06 December 2011

Tornell/Westermann: Eurozone Crisis, Act Two - has the Bundesbank reached its limit?

Act Two in the unfolding eurozone drama begins this week as leaders at the European summit announce emergency measures to prevent further market turmoil. Why the sudden urgency? Because the German Bundesbank is about to exhaust its capacity to lend more funds to strapped governments.

In the wake of the 2008 crisis, some national central banks, especially those in Greece, Ireland, Italy, Portugal, and Spain (the GIIPS), have dramatically increased their loans to financial institutions. To fund these loans, GIIPS central banks borrowed mainly – via the ECB – from other central banks, in particular the Bundesbank. In order to fund these loans, the Bundesbank sold its holdings of German assets. Between December 2007 and September 2011, the central banks of the GIIPS increased their loans to domestic financial institutions by nearly €300 billion. In contrast, the stock of gross German assets in the Bundesbank balance sheet fell sharply to its lowest level in history.

The ominous sign – which might set the stage for Act Two in the unfolding eurozone drama – is the fact that the Bundesbank will soon exhaust the stock of securities that it can sell to fund further loans to the Eurosystem. At that point, the Bundesbank could sell its gold or increase the deposits it takes from the private sector. Most likely, however, the Bundesbank will face strong pressure from the German public against such action. Hence, it appears as if the eurozone crisis is entering a second phase in which policymakers feel the need for new measures to prevent market turmoil.

In principle, the limit on the amount of claims on the Eurosystem that the Bundesbank can accumulate equals the assets in its balance sheet plus the amount it can borrow in capital markets. Pressure from the German public, however, might prevent the Bundesbank from reaching the theoretical limit.

Up to now, Bundesbank loans have allowed GIIPS central banks to buy government bonds without a corresponding increase in the monetary base of the eurozone as a whole – i.e. without the ECB printing more money (after an expansion in 2008, the monetary base returned to trend growth). Before long, however, the Bundesbank’s stock of domestic assets is going to hit zero, and it is highly unlikely that it will agree to sell its gold or borrow more in private capital markets. At that point, the Bundesbank will not be able to lend more funds to the eurozone TARGET mechanism. As a result we are heading towards the multiple equilibria zone in which beliefs of a breakdown of the eurozone are self-fulfilling. In such a situation, market participants may transfer funds from financial institutions in fiscally weak countries to other ‘safe’ countries like Germany. In tranquil times, such transfers can be done seamlessly through the TARGET mechanism of the ECB. However, if a critical mass of agents were to engage in such capital flight away from fiscally weak countries, the TARGET system would be overwhelmed. In principle, a speculative attack could occur within a day, and the ECB would have to assume all of the marketable securities from countries that suffer the speculative attack. Since the ECB has a relatively small capital base, it would not be able to purchase a large amount of assets from countries that suffer the attack.

In Act Two of the unfolding eurozone drama, the new measures might include the ECB printing more money, the EU announcing the issuance of eurobonds, or the IMF extending credit lines to strapped governments. The motive of such a policy response is to prevent a speculative attack and induce a shift to the good equilibrium. These actions will buy some time for economic and fiscal reforms to take place. However, as previous experiences suggest, if reforms do not take place, these measures may be very costly to the taxpayer.

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