ECB can halt contagion by acting as lender of last resort
COMMENT:Governments should be given strict rules to negate possibility of reckless debt issuing, writes PAUL De GRAUWE
THE FORCES of contagion in the euro zone appear unstoppable. Investors have driven yields on Italian and Spanish debt to new highs, as fears grew that the latest Greek rescue deal would prove insufficient to stop the financial rot. Without swift action from the ECB, this will prove a contagion process with a disastrous end.
Why do we face these problems?
Government bond markets in a monetary union are inherently fragile. Euro zone nations issue debt in a “foreign” currency, over which they have no real control. As a result, they cannot guarantee that they will always have the necessary liquidity to pay out the bond at maturity.
States which issue their own bonds, however, can guarantee the cash will always be available, because they can always force the central bank to create the money. And there is no limit to the amount of money a central bank can create.
This situation makes bond markets in a monetary union unusually prone to forces of contagion, very much like in banking systems. If one bank experiences a solvency problem, deposit-holders start doubting the solvency of their own bank, and run to convert their deposits into cash. When everybody does this at the same time the banks will not have enough cash.
This banking system instability was solved by mandating the central bank to be a lender of last resort – and the neat thing about this solution is that, when deposit holders are confident that it exists, it rarely has to be used.
The problem faced by the member countries of a monetary union such as the euro zone is exactly the same. Therefore, the solution is the same. Contagion between sovereign bond markets can only be stopped if there is a central bank willing to be lender of last resort. The only institution able to do this is the ECB.
The ECB initially performed the role in a timid way, while making it clear it was unwilling to continue doing so. Indeed, this reversal in the ECB’s policy is the most important factor explaining why the forces of contagion in the euro zone’s sovereign bond markets cannot be stopped.
Europe’s leaders tried to solve this problem by creating a surrogate institution, the European Financial Stability Facility. Yet the EFSF will never have the necessary credibility to stop the forces of contagion – because it cannot actually print money. It depends for its resources on the union’s member countries, and these are limited.
As a result, it cannot guarantee that the cash will always be available to pay out sovereign bond holders even if its resources are doubled or tripled.
The ECB argues that it can abandon its responsibility as lender of last resort, because to provide that guarantee gives wrong signals to politicians. It creates a temptation to add excessive government debt, because the ECB will eventually foot the bill. While this moral hazard risk is indeed a serious one, it is no different from the same risk in the banking system.
The way to deal with this is not to abolish the role of lender of last resort, but to create rules that will constrain governments.
Stopping Europe’s current crisis requires a fundamental overhaul of euro zone institutions. But the most important part of that overhaul is to ensure the ECB takes on full responsibility as a lender of last resort in the government bond markets of the euro zone. Without this, the markets cannot be stabilised and crises will remain endemic.
At the same time, further steps towards political unification must be taken, without which control on national government deficits and debts cannot be implemented.
Some steps in that direction were taken recently when the European Council strengthened control of national budgetary processes and on national macroeconomic policies.
These decisions, however, are insufficient, and more fundamental changes in the governance of the euro zone are needed. These should be such that the ECB can trust that its lender-of-last-resort responsibilities will not lead to a never-ending dynamic of debt creation.
Paul De Grauwe is professor of economics at the University of Leuven