Tuesday, November 29, 2011

Analysing The ECB: The Costs And Benefits Of Inaction

Watching the slow-motion train wreck that is the Eurozone debt crisis, it’s hard for anybody trained in finance or economics to grasp just why the ECB is refusing to act more decisively.

As the Eurozone’s central bank and the only one with the authority to print Euros, only the ECB has the ability to offer unlimited support for indebted governments. Granted that there is a huge pitfall in engendering future moral hazard, but that’s already being handled on the political front via stronger debt rules. The tail risk of inaction is a collapse of the Euro itself.

But the ECB appears to discount that risk:

ECB stance on bond buys to pay off

TOKYO: The European Central Bank's (ECB) refusal to engage in large-scale purchases of the region's sovereign debt will eventually be rewarded as this will preserve price stability and protect the value of the euro over the long term, governing council member Christian Noyer said yesterday.

It was up to European governments to provide a lasting backstop for liquidity, Noyer said, as a two-year-old sovereign debt crisis now threatens Germany and France, Europe's two largest economies...

...“I believe that virtue will eventually be rewarded,” Noyer said in a speech.

“In the next decade, markets and lenders will trust those currencies that, whatever the circumstances, are managed with one overriding priority: preserving price stability and the intrinsic value of the currency unit.”

Part of the reason for this attitude is legal – the ECB only has a mandate for price stability and not for economic growth, unlike virtually every other central bank out there. It’s also prohibited from lending directly to the Euro system’s member governments (the current bond purchase program involves the secondary market, not the primary).

Yet even then, there have been historical precedents in other jurisdictions for ignoring legal niceties under crisis conditions. In this case, since the survival of the Euro itself (and by extension the ECB) is at stake, one would think the ECB would be more proactive.

But Paul de Grauwe helps explain why they aren’t:

Why the ECB refuses to be a Lender of Last Resort
Paul De Grauwe

…A number of analysts are calling for the ECB to act as the lender of last resort in the Eurozone government bond market (see for example Wyplosz 2011 on this site). Up to now it has resisted. But why should the ECB refuse to take up the role of last-resort buyer?...

...When a central bank is called upon to be the lender of last resort it has to evaluate costs and benefits of its actions...

...When banks are close to collapsing, the cost of not providing the lender-of-last-resort service is almost instantaneous. This has to do with the fact that the banks’ liabilities typically have very short maturities (demand deposits, interbank deposits)...

...This asymmetry in the timing of the realisation of costs and benefits goes a long way towards explaining why even the most conservative central bank is likely to wish to avoid the immediate cost (collapse of the banking system) even at the cost of foregone future benefits, even if these benefits are very large. This asymmetry explains why the ECB did not hesitate for a moment to provide last-resort buyer support to Eurozone banks in 2008, despite the fact that in doing so it created moral hazard risk in the future.

We can now apply this cost/benefit analysis to the government bond market. Here we have a striking difference with the banking sector. The sovereign debt crisis occurs at a snail’s pace compared to banking crises. When investors sell government bonds and push the interest rate upwards, they affect the cost of borrowing of governments with some delay because the maturity of the bonds is typically of the order of five to seven years. As a result, there is not the imminent threat of a rapid collapse as there is with a banking crisis...

…The previous analysis leads me to the following forecast.

  • The ECB will only act when the cost of inaction is immediate and clear.

As a result, the ECB is likely to wait until the sovereign debt crisis has degenerated into a full-scale banking crisis.

  • There can be little doubt that the sovereign debt crisis will lead to a banking crisis.

The reason is that the continuing decline in the price of sovereign bonds will hammer the banks’ balance sheets to such an extent that the losses become unbearable.

…Thus there is a moment when the sovereign debt crisis inevitably triggers a banking crisis. This will be the moment when the timing asymmetry between costs and benefits is such that the ECB will see the merits of being a lender of last resort. Only then will the ECB come to action.

But as Paul mentions, the costs of providing lender-of-last-resort support now is considerably lower than it would be in the future. By the time the ECB may be willing to act, it would in all likelihood be already too late. Europe’s sovereign debts are large, but the Eurozone’s banking system’s liabilities are far larger – three times bigger in fact.

Standing on principle is all very good, but not at the kind of human and financial cost a collapse of the Eurozone would entail.

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