Föhrenbergkreis Finanzwirtschaft

Unkonventionelle Lösungen für eine zukunftsfähige Gesellschaft

Danger Ahead for the Eurozone

Posted by hkarner - 8. März 2018

Date: 07-03-2018
Source: The Wall Street Journal

Policy makers needs to think carefully about what discretion the central bank should retain in a crisis.

Mario Draghi, head of the European Central Bank.

A recent flurry of activity between Paris and Berlin has raised hopes that the eurozone may be on the verge of a much-needed overhaul. The policy tools available to the European Central Bank are, however, receiving surprisingly little attention in this debate. This is worrisome, since experience has shown that when crisis shakes the eurozone, the central bank is the first line of defense.

Various reform proposals could de facto deny the ECB the discretion it has used to good effect in the past. In 2011, the bank was able to accept sovereign bonds as collateral for three-year loans to cash-squeezed banks (the LTRO program). In 2012, ECB President Mario Draghi developed a program to buy government bonds in the secondary market if necessary (the OMT program). In 2015, the ECB started buying government bonds as it proved the eurozone could engage in unorthodox monetary policies such as quantitative easing.None of these programs were envisioned when the ECB was created, but they all proved important. When combined with the €500 billion European Stability Mechanism political leaders created during the crisis, the ECB’s use of discretion has allowed it to reassure markets that an unlimited lender of last resort exists for both eurozone banks and governments.

Now this discretion is in danger of being eroded. Consider the various proposals to limit commercial banks’ exposure to their national governments. Reformers worry about a “doom loop” between governments and banks. If, say, an Italian bank holds a disproportionate share of Italian government bonds, a crisis that undermined market confidence in the Italian government’s ability to repay would threaten the bank by reducing the value of its assets. A sovereign crisis could morph into a banking crisis.

Yet breaking the doom loop could also cut off a safety valve. Today, a Spanish or Italian bank can buy its national government’s bonds if necessary to alleviate a credit squeeze. The ECB can ease this task by offering banks liquidity support through its refinancing operations, as it did under the LTRO program. If banks were no longer allowed to do this, governments would be left only with the politically difficult option of requesting support from the European Stability Mechanism, potentially with automatic debt restructuring that might not sit well with investors.

Proponents of such a reform might say this is the point. Reducing the ability of banks to buy sovereign bonds and rendering sovereign debt restructuring explicit would create market discipline to encourage governments to run sound fiscal policies. Experience shows, however, that market discipline is not reliable. The market is prone at times to both exuberant overshooting and terrifying undershooting of fair values, muting disciplinary signals.

A similar problem emerges with several proposals for eurobonds. The basic idea would be to split sovereign debt in two, with the senior part becoming very safe even in a crisis, while the junior part would be liable to restructuring in a crisis and therefore a mechanism of market discipline.

A genuine eurobond with joint and several liability across eurozone member states would be a welcome risk-sharing mechanism, as would a genuine and sizable eurozone budget funded by such bonds. The proposals for so-called eurozone safe bonds currently on the table, however, focus on risk-repackaging rather than risk-sharing.

The division of sovereign debt into senior and junior also raises the important question of what this entails for the ECB’s quantitative easing program. If the ECB is effectively permitted only to buy the safest set of bonds, this would have significant implications. The ECB would no longer be able to conduct quantitative easing in the national-government bond markets, which could see spreads widen significantly. And, if such restrictions were also to apply to the OMT, then the eurozone would no longer have an unlimited lender of last resort to national governments.

None of this is to say that the monetary tools of past crises would be best suited to the next one. But policy makers needs to think carefully about what discretion the ECB should retain in a crisis. If the ECB effectively loses its capacity to engage in programs like OMT and LTRO, what will it do instead? To be a credible central bank and protect the integrity of the eurozone, it must have the flexibility to adopt the tools that can stem contagion in a crisis, calm markets if investors fear a eurozone member may leave the bloc, and ensure proper transmission of monetary policy.

One solution could be permanent liquidity lines provided by the ESM for countries to draw on in a liquidity crisis. Not only is this suggestion likely to prove politically unpalatable but if the crisis strikes the entire region, the ECB would be the only viable lender of last resort to the sovereign, as is the case for all other major central banks. Policy makers should ensure the ECB can continue to serve this important function.

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