Sunday, August 19, 2012
ECB limited and conditional lending is not 'what it takes'
August 19, 2012
The ECB president, Mario Draghi, said he’d do “whatever it takes to save the euro”. This column asks what 'whatever it takes', means and whether the ECB is prepared to go that far. It argues that limited and conditional lending improves the odds of success but it is not the game changer needed.
There is broad agreement that the ECB is going to be the main actor in the potential resolution of the peripheral debt crisis. In principle, there are two avenues that the ECB could pursue in its efforts to avoid a full-blown crisis. First, it could ease monetary policy sufficiently to weaken the euro and generate inflation to facilitate growth. We think this route would not be sufficient in the near term and the ECB may perceive it as a breach of its mandate. As a result, it is not the focus of the market or the ECB. A second, more immediate task is to break down the vicious dynamics of higher yields and worsening debt dynamics that is affecting the systemically important peripheral European economies. Can the ECB achieve this objective?
As De Grauwe (2011) and Kopf (2011) have indicated, one of the main problems for the Eurozone is that, unlike the US, UK, or Japan, individual Eurozone countries effectively have 'foreign currency' debt in the sense that their own central banks cannot print the currency in which their debt is denominated. In that sense, the sovereigns lack a lender of last resort. The absence of a lender of last resort means that Eurozone governments are exposed to bouts of fear and distrust in the bond markets. These fears can trigger a liquidity crisis, which can easily turn into a solvency crisis, as higher interest rates and worsening debt dynamics can be self-fulfilling and effectively end up in default. Moreover, the Eurozone’s fixed exchange rate implies that the sudden stops (or reversal) of flows that are currently playing a key role in the European periphery will have a much bigger (negative) impact on economic activity.