Opinion - The ECB's "Quantitative Easing"

This week the European Central Bank provided private European banks with unlimited access to funds at a low interest rate for a three-year term.  The banks responded by absorbing nearly 500 billion euros of these loans, pledging their worst assets (including sovereign debt of the southern European countries) as collateral to the ECB.  The ECB’s action staved off an imminent bank liquidity crisis in Europe, reducing one source of recessionary pressure on the European economies.  I could write a short book on the ramifications of this action, but I’ll limit this article to a few key points: first, this was an intervention of massive significance; second, it was a necessary step in the short term; and third, it does nothing to address the underlying issues and thus only pushes back the final day of reckoning.

The ECB is restricted by law from becoming the “lender of last resort” for the countries of the Eurozone, but can intervene to provide liquidity to the banking system.  By this action, however, the ECB has violated the spirit of the law by indirectly supporting the southern European sovereign debt markets, accepting their debt as collateral and providing private banks with cheap money in return.  This has transferred the risky sovereign debt from the private banks to the ECB, stabilizing the private banks’ capital situation and simultaneously driving down the interest rates on sovereign debt.  The prime directive of the ECB is to ensure that inflation does not get out of hand, but this action is a massive move toward an inflationary policy.  This is a significant change in policy as the ECB has acted to live within the letter of the law while violating its prime directive.

The private banks were brought to this crisis by the European bank regulators, who assigned sovereign debt assets a zero-risk rating.  As a result, private banks invested heavily in the debt issues of weaker Eurozone countries since their bonds offered higher returns.  (Note that the higher returns implied a market judgment that these bonds had higher risk!)  When the quality of the debt of countries such as Greece came into question, the French and German governments were suddenly faced with the possibility of domestic bank failures should Greece default on its loans.  In addition to the threat to the shared euro currency, a default would force the France and Germany to bail out their private banks.  Led by France and Germany, the European Community reacted with a series of bailouts for Greece.  Unfortunately, the imposition of strict austerity measures in Greece in return for bailouts did not address the key underlying issues that created the Greek government debt crisis.  Noting the ineffective (and counter-productive) response of the European Community to the Greek sovereign debt crisis, the bond market traders spread the crisis to the other troubled southern European countries of Italy, Spain, and Portugal.

As the debt crisis deepened, the European banks found their access to traditional refinancing (or wholesale debt) markets increasingly limited, because the banks held large amounts of Eurozone sovereign debt – the market recognized that one or more sovereign debt defaults could force many of the European banks into bankruptcy.  This withdrawal of wholesale debt providers from the European bank market forced the ECB’s extraordinary loan program to supply liquidity to the European banking system.  With the economies of Europe moving back into a recession, the loss of liquidity in the European banking system would intensify the recessionary pressures as funding for both private and public debt would contract.

One major consequence of the ECB action is the transfer of default risk on Eurozone sovereign debt from the private banks of Europe to the ECB.  Moreover, since the ECB is legally the first priority lender, this action has reduced the value of Eurozone debt held by other parties; in the event of a Eurozone government default, the ECB will be paid before other debt holders.  Thus the wholesale debt markets will now be even more unlikely to supply credit to European banks, forcing the banks to increase their future dependence on the ECB for funding.  Similarly, the private market for Eurozone government debt has become less attractive because private holders of troubled country bonds are now subordinate to the ECB.

Finally, the risk of default by the troubled Eurozone countries has not diminished; the risk has simply been transferred from the private banks to the ECB.  And the backstop for the ECB is the combined resources of the Eurozone countries; rather than bailing out their private banks, Germany and France could be forced to bail out the ECB.  Ultimately, the taxpayers of the Eurozone will have to pay the bill, either through increased taxes or increased inflation (or most likely both).

The ECB action was required to prevent the European banking system from freezing up over the next few weeks, (and the ECB will be forced to continue it in future months), but this Euro version of the Fed’s Quantitative Easing program will have many ramifications both for the debt markets and for the economies in Europe.  By printing money on this scale the risk of future inflation has risen, and the transfer of questionable assets from the private banking system to the ECB has not decreased the overall risk to the Eurozone system.  Mario Draghi chose the lesser of two evils in pursuing this course, but it’s clear that he is aware of the tradeoffs and is not pleased with having been put in this position by the incompetence of the Eurozone governments.  The ECB has kicked the can further down the street, but this has merely delayed the inevitable reckoning.