The Problem with ECB Lending

The other day Floyd Norris deftly explained the delicate situation with the Euro and the debt crises facing Italy, Spain, and other European nations, and how the ECB is now, finally, taking concrete steps to deal with the problem.  But I'm worried that what the ECB is doing won't be enough.  I haven't seen much about this, perhaps because I've been looking in the wrong places, so I thought I'd throw this out there.

The situation is fragile and markets are volatile mainly because the outcome is expectations dependent.  If financial markets believe countries like Italy and France will surely honor their debts, interest rates will fall and the debt burden will be manageable.  But if financial markets believe these countries will not honor their debts, interest rates will rise to a point that their debts will become impossible to pay back, thereby forcing default. In other words, expectations, good or bad, will be self-fulfilling.  Global markets are volatile because it's not clear where this expectations game will land.

It's very much like an impending traditional bank run: If depositors are confident no other depositor will withdraw their funds, no one will withdraw; but if depositors believe a critical number of depositors will withdraw, it will collapse the bank, and everyone should rush to withdraw as soon as possible.

So, how do we deal with bank runs?  In the US bank runs of the traditional variety hardly ever occur, mainly because deposits are guaranteed by the government (FDIC).  Banks can also deal with short-run liquidity problems by borrowing from the Fed at the discount rate.  Both mechanisms are probably helpful, but the FDIC guarantee is the critical feature.  The discount window does not guarantee deposits or bank survival in the event everyone withdraws, so it doesn't solve the expectations problem.

And this brings me to the problem with the ECB's lending program. 

One clear solution would be to have the ECB print Euros and buy bonds from these frgile countries.  If purchases were vigorous, this would be almost like FDIC insurance and push expectations and the ultimate outcome to the positive side.  But the ECB refuses to do this, claiming it is beyond their mandate.  And because Germany and other countries strenuously object to ECB bond purchases, it's a political non-starter, at least for now.

Instead, the ECB is lending liberally to European banks at low interest rates, much like banks in the US using the Fed's discount window.  The idea is that banks will then buy their own country's bonds, pushing rates down, much as if the ECB were buying the bonds directly.

I fear the problem with this approach is that it doesn't necessarily solve the expectations problem.  The banks may borrow cheaply from the ECB, but unless all the banks believe all the other banks will also buy domestic bonds, it's not in their interest to buy them either.  Indeed, they may find it safer to buy German bunds, or maybe even US treasuries.  Or maybe they'll do like our banks and just hold the cash as reserves.

It's a bit like trying to stop a bank run by printing money and giving it to depositors, hoping that, having cash in hand, they'll be less interested in withdrawing their deposits from the bank.  But people weren't tempted to withdraw funds because they needed the cash; they were tempted to withdraw because they were worried others would withdraw, thereby causing the bank to collapse.

Similarly, I fear the ECB's latest efforts, though significant and a step in the right direction, will not be enough.


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