“European Leaders Have Failed”

After countless crisis meetings at the European Council, it has to be admitted that the European leaders have failed to isolate the Greek crisis, and to stop the forces of contagion, professor of economics Paul de Grauwe states. Amen to that! But professor Grauwe also provides an exelente explanation to why the EU leaders have failed. This is an inportant analysis.

“The ECB has become the single most important reason why the Eurozone crisis cannot be stopped.”

Paul de Grauwe

“The biggest threat for the euro zone is the contagion of the Greek sovereign debt crisis to the rest of the system. If the Greek crisis could be isolated it would barely matter for the euro zone as a whole,” the Belgian professor writes. But that’s exactly the problem; it can’t be isolated.

Why has it been so difficult to stop the forces of contagion from Greece? (and Ireland?, and Portugal?, and Spain?, and Italy?, and so on..).

Well, if you know the “nature of money” the answer is pretty obvious.

However, it is not that obvious for many people, and (as pointed out in yesterday’s post) definitily not obvious for those who have taken upon themselfs to clean up this mess.

That’s why the following article, syndicated by www.eurointelligence.com, is one of the most important so far in 2011.

The author, Paul de Grauwe, is professor of economics at the Katholieke Universiteit Leuven in Belgium:

“Why Contagion Cannot Be Stopped In The Euro Zone”

The answer is that it has much to do with the vulnerability of government bond markets in a monetary union.

National governments in a monetary union issue debt in a “foreign” currency, i.e. one over which they have no control.

As a result, they cannot guarantee to the bondholders that they will always have the necessary liquidity to pay out the bond at maturity.

This contrasts with “stand alone” countries that issue sovereign bonds in their own currencies.

This feature allows these countries to guarantee that the cash will always be available to pay out the bondholders.

“The absence of a guarantee that cash will always be available makes the sovereign bond markets in a monetary union prone to forces of contagion, very much like banking systems that lack a lender of last resort are prone to contagion.”

In such banking systems, banks cannot guarantee that cash will
always be at hand to pay out deposit holders.

As a result, solvency problems in one bank quickly lead deposit holders of other banks to withdraw their deposits, setting in motion a generalized crisis.

The same risk exists in a monetary union when solvency problems in one country (Greece) lead bondholders to fear the worst in other bond markets and to sell the bonds there.

“We have learned from the history of banking that a necessary condition to stabilize the banking system consists in providing for a lender of last resort.

This gives a guarantee to deposit holders that the cash will always be available, and pacifies them most of the time.

The nice thing about this solution is that when deposit holders are confident that it will be used, it does not have to be used most of the time.

“The solution to the contagion problems of the banking system is exactly the same solution for a monetary union.”

Contagion between sovereign bond markets can only be stopped if there is a central bank willing to be lender of last resort, i.e. willing to guarantee that the cash will always be available to pay out the bondholders.

The only institution that can perform this role is the European Central Bank.

While the ECB has initially performed this role in a timid way, it has made it clear that it is unwilling to continue to do so.

“The refusal of the ECB to take up its responsibility as a lender of last resort is the single most important factor explaining why the forces of contagion in the Eurozone’s sovereign bond markets cannot be stopped.”

The ECB’s refusal to be the lender of last resort has forced the Euro zone members to create a surrogate institution (the EFSF and the future ESM).

The problem with that institution is that will never have the necessary credibility to stop the forces of contagion, because its resources are limited.

As a result, it cannot guarantee that the cash will always be available to pay out sovereign bond holders.

Only a central bank that can create unlimited amounts of cash can provide such a guarantee.

Why has the ECB refused to take up its responsibility of lender of last resort in the government bond markets (while it has dutifully taken up this responsibility during the banking crisis)?

A popular answer is that the ECB should not do this because it risks losing money.

This is certainly the wrong answer. When there is confidence that the central bank will operate as a lender of last resort in the sovereign bond markets, the central bank does not have to act as a lender of last resort most of the time.

And when it has to do so, we should not really worry about the fact that it loses money.

“What matters is financial stability, not the profit and loss account of the central bank. A central bank can always fill the holes by printing money.”

A more serious concern is moral hazard, i.e. the risk that if the ECB
guarantees that cash will always be available to pay out sovereign bond holders, this will lead governments to issue too much debt.

But this risk of moral hazard is no different from the risk of moral hazard in the banking system.

The way to deal with this risk is not to abolish the role of lender of last resort but to create rules that will constrain governments in issuing

“The ECB has been influenced too much by the one-dimensional theory of inflation targeting.”

According to that theory, all a central bank should do is to stabilize the price level. All the rest will then also be stable.

Historically, however, central banks have been invested with another equally important task, i.e. to ensure financial stability, which includes stabilizing the government bond market.

By refusing this role in the Eurozone, the ECB has become the single
most important reason why the Eurozone crisis cannot be stopped.

By Paul de Grauwe

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Filed under International Econnomic Politics, National Economic Politics