In November 2011, the Eurozone crisis reached a climax with interest rates on sovereign debt of Eurozone problem debtors soaring. Fear of sovereign defaults spilled over into the interbank markets as Eurozone banks, especially in problem countries (Greece, Ireland, Italy, Portugal, Spain), where the home bias of banks in sovereign bond holdings is particularly severe.
It became evident that the crisis strategy of the Eurozone countries focusing on a combination of a partly self-defeating, imposed austerity policies and a too low “firewall” of European rescue funds was not sustainable. At that time the ECB still intervened – reluctantly and against the convictions of the German government, the Bundesbank and many German economists – in the sovereign bond markets to keep the risk premia at bay. A drastic change in strategy was needed and many economists demanded that the ECB should become a lender of last resort to sovereign debtors, conditional on strict medium-run budget deficit and debt limits. With Germany being the biggest opponent of this idea, there has been no chance to move into this direction – yet.
However, on 8 December 2011, the ECB found a different way to overcome the serious deadlock in the interbank market and to become – at least indirectly – a lender of last resort. It introduced its longer-term refinancing operations (LTROs), which gives European banks an unprecedented opportunity to refinance themselves with a maturity of three years. In two major operations in December 2011 and February 2012, the ECB injected €1019 billion though LTROs into European banks.
The LTRO strategy has worked well - until recently. The acute liquidity problems of banks have been relieved, and banks used at least a fraction of the injected liquidity to buy sovereign bonds, thus contributing to a fall of interest rates for problem debtor countries like Spain and Italy (but not for Portugal and Greece). As a result, the ECB was able to terminate its direct interventions in the sovereign bond market.
But now, the Euro crisis has returned as interest rates on Spanish and Italian sovereign debt have started rising again. Should the ECB go for a third LTRO?
Interestingly, the LTROs caused much less controversy in the public than the direct interventions in sovereign bond markets. However, many economists have been sceptical. While some fear that LTROs may ultimately lead to more inflation, others are more concerned with the potential risk of failure which would burden the ECB with very high losses.
Some have cited the risk of inflation as a consequence of the LTROs. The sheer numbers create the impression of a massively created liquidity, but this is misleading.
First, according to ECB president Mario Draghi, LTRO’s created “only” €520 billion of new lending. The rest came from a shift from short-run to long-run borrowing. Second, by March 23, lending to financial institutions through LTROs was €1095 billion, while banks simultaneously hold €785 billion in the ECB’s deposit facility. Thus the ECB has not created much new liquidity, but effectively assumed the role of a financial intermediary for the banks.
Third, developments of monetary aggregates and credit volumes to the private sector are still far below the increases in the past, with the money supply (M3) - which includes deposits with an agreed maturity up to 2 years; deposits redeemable at a period of notice up to 3 months; repurchase agreements; money market fund (MMF) shares/units; and debt securities up to 2 years - even decreasing in late 2011.
While the present risks of inflation are low, would the ECB still be able to reduce the liquidity fast enough once inflationary processes get started? To start with, most forecasts as well as all measures of inflation expectations see no risk of serious inflation in the next 2-3 year. Moreover, the ECB has retained a number of instruments for monetary tightening if need be, including raising the charged interest rates on LTROs, thus making it less attractive to hold them.
Although such a policy turn may be more difficult to engineer than reversing the quantitative easing policy of the US Federal Reserve, the inflation risks coming with LTROs are very low at present.
The LTROs are a trillion-euro bet. If things go well and trust returns to the sovereign bond markets, the ECBs strategy could eventually induce a virtuous circle. Banks can now borrow at 1% and obtain much higher returns by investing in sovereign bonds. The bond markets would calm down, bank balances could improve and when reform policies will finally show positive results in a couple of years, a self-validating optimism could eventually restore a healthy Eurozone.
But the risks of failure and self-validating pessimism remain high. Austerity policies in Spain, Portugal and Italy are far from producing good news anytime soon. The recent bad news from Spain shows how fragile the situation is. A vicious circle with more intense sovereign debt crises and subsequent banking crises (especially if banks have used LTRO credits to invest in home country sovereign bonds) can easily lead to a worst case scenario, with subsequent losses also for the ECB, which has now taken credit risks into its balance sheet by lending to banks which are vulnerable to sovereign debt default.
In sum, the ECB has done as much as she could under the present political constraints to avoid a breakdown of the Eurozone. While the risk of inflation with LTROs is low, the risk of failure is still acute. It would have been much better to allow the ECB to act as a lender of last resort in conjunction with a realistic and workable fiscal compact that provides a growth perspective and a unified European banking market regulation, supervision and crisis resolution mechanism. Eurozone politicians are not prepared to accept this yet. The ECB has bought them time. If, however, the strategy fails - it will be time to act.