The ECB, eternal and infinite

By G.I. | WASHINGTON

THE European Central Bank has come under criticism for its failure to act as lender of last resort to embattled sovereigns. Yet when it comes to banks, the traditional recipients of central bank support, the ECB is lender of last resort on steroids. Today, it lent €489 billion to 523 banks at 1%, at its first three-year refinancing operation. It was its largest refinancing ever.

Banks used some of that to pay off shorter term loans from the ECB. Even so, net lending of €235 billion brought the ECB's total loans to banks to almost €1 trillion. Mario Draghi, the ECB president has repeatedly insisted the ECB's purchases of government bonds were neither “eternal nor infinite”, but that clearly doesn't apply to its lending to banks. As banks' private sector funding dries up, the ECB has supplied not just all the short-term funds they need, but all the dollar funds they need (via the revamped swap lines from the Federal Reserve) and now long-term funds as well.

This operation is crucial to understanding the ECB's strategy during the crisis. I recently returned from Europe with, I think, a better feel for the different points of view there. Both the ECB and its critics agree on the ultimate solution to the crisis: some form of joint liability for the region's debts coupled with a political compact that enforces fiscal responsibility on member states. Where they differ is the responsibility of the ECB in making that happen. The ECB's critics note it will take an agonizingly long time for the politicians to deliver. In the meantime the ECB must be lender of last resort and so keep sovereign insolvency from becoming a self-fulfilling prophecy. In refusing to do so, it is allowing a vicious cycle of austerity, bank runs and deleveraging to choke the economy and destroy public support for the euro; the ECB may end up the central bank of a non-existent currency.

The ECB's critics, however, may underestimate the potency of its tools and its willingness to use them. While it doesn't dispute that the crisis and austerity are taking a toll, it also believes it can soften the economic fallout if it is willing to be a lender of last resort to its banks without limit. If the day comes when retail depositors follow wholesale lenders and pull all their cash out of every bank in Greece, Spain and Italy, the ECB can replace it, euro for euro. If the ECB ends up the sole source of funding for half the region's banks, so be it.

When the Financial Times asked Mr Draghi if the ECB was really undertaking quantitative easing by a different name, Mr Draghi coyly answered:

Each jurisdiction has not only its own rules, but also its own vocabulary. We call them non-standard measures. They are certainly unprecedented. But the reliance on the banking channel falls squarely in our mandate.

Indeed, total ECB lending is now almost as large, in absolute terms, as the Fed's first, and largest, round of QE. Some analysts say banks may simply use the money to put on a carry trade by buying back their own debt or higher-yielding corporate or government debt. But does it matter? If they do, the ECB has taken long-term risk assets out of the market, raising private demand for the stuff that remains. That's precisely what the Fed is trying to achieve through QE.

This raises two questions: economically, does it work? And politically, does it make sense? On the first, it might stand a better chance than you think. In America credit is priced off the risk-free rate, so if a Treasury yielded 6%, mortgages would cost 8%. But the essence of Europe's debt crisis is that sovereigns are being reclassified from risk-free to credit. It is conceivable, then, that sovereign yields may decouple from the interest rates charged to households and companies.

Between the end of May and the end of October, the 10-year Italian government bond yield rose 140 basis points, to 6.19%. In the same period, the average rate on new household mortgage rates rose only 45 basis points, to 3.54% (based on Bank of Italy data which is only available through October) and the average new business loan rate rose about 75 basis points, to 3.74% (part of this was due to a rise in the ECB's policy rate which has since reversed). Ignazio Visco, the bank's new governor, said on December 9th, that higher bond yields were “being passed through to the cost of finance to the private sector and the spending plans of households and firms, thereby diminishing the domestic component of aggregate demand”. Still, between May and October, total loans to households and businesses rose, albeit by only 1% each. Yes, Italian GDP did contract 0.2% in Q3, and while tightening credit may have played a part, austerity may be the bigger culprit: public consumption declined 0.6%.

November and December data may be worse, and it is probably too late for Italy and the euro region as a whole to escape recession. But if the ECB is successful at alleviating banks' funding concerns, the supply of private credit may ease in the new year, and the deep recession and euro collapse so many feared a few weeks ago may be staved off. That would give politicians more time to either to hammer out a sustainable fiscal solution, or, unfortunately, to muddle through.

That then raises the next question: even if the ECB's strategy makes sense economically, does it make sense politically? In its willingness to lend to banks without limit (to be sure, against collateral), but not to sovereigns, the banks' ultimate guarantors, the ECB has rejected the more effective solution in favour of the more legal one. It is a bit like someone who won't lend to a deadbeat father but will lend to his teenaged son. Ultimately, if the father can't pay his bills, neither can the son.

Here again, the ECB may have been underestimated. While it believes politicians have certainly made matters worse, first in their initial insistence (since recanted) on private-sector haircuts and regulatory pressure on banks to deleverage, the ECB still believes the ultimate solution is political: the commitment by sovereign governments to fiscal balance. One of the more interesting things I heard in Europe was the assessment by a French observer that the problem today is France, not Germany: it continues to hold out for monetary union while surrendering as little sovereignty as possible, a position incompatible with a successful fiscal compact. If the ECB bent to France's wishes and became a more aggressive buyer of sovereign debt, it would simply let French (and other) politicians escape the tough decisions necessary for fiscal balance to work. It would bring near-term relief but no lasting solution.

I'm a bit more sympathetic to the ECB's strategy than I used to be, but still not convinced it will work. Even with the threat of economic collapse at their doorsteps, European leaders still seem incapable of unified, decisive action. As our leader this week argues, the new fiscal compact makes no provision for Eurobonds or any other form of joint funding of member state debts and dwells too much on austerity and not enough on growth. The longer Europe muddles through, the more banks' demands on the ECB will grow. Even if the ECB can, legally, become the sole source of funding for peripheral euro-zone banks, is that sustainable politically? At some point won't the leaders realise that lacking all private-sector confidence, their banks can no longer finance a growing economy? At that point, they will conclude the euro is not sustainable and prepare to exit, and the ECB's limits will have been reached.