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Why Draghi Can't Be Bernanke

Author: Benn Steil, Senior Fellow and Director of International Economics
November 28, 2011
Financial News


The European Central Bank needs to say "we have a wall of money here and…we are going to keep buying Italian bonds and any other euro bonds that are threatened" – or so insists Irish finance minister Michael Noonan.

This won't happen, and the reasons go well beyond the legal shackles the ECB has already shed.

The ECB, it should be noted, is not an endemically hidebound institution. In the wake of the Lehman collapse in 2008 it boldly stepped into the liquidity breach with offers of unlimited low-interest collateralised loans. Yet while the Federal Reserve voraciously gobbled up $1.3 trillion in mortgage securities between September 2008 and July 2010, which few would have found imaginable before Lehman, the ECB's relatively dainty forays into the eurozone sovereign debt market have been grudging, to say the least.

No doubt, the eurozone political leadership, such as it is, has made the ECB's task more difficult since the Greek debt deal of October 27. Banks were told to boost their capital levels as a share of their assets. Giving them the choice of raising capital or dumping assets was a huge mistake. With demand for bank stock in Europe about as robust as demand for snow shoes in the Sahara, the banks naturally chose the alternative of liquidating their bond holdings – the Italian variety being the most plentiful.

Perversely, every downward tick in the value of government bonds now worsens the banks' capital positions.

The ECB then jumped in to buy just enough bonds to keep Italy hopeful, but still on the path to insolvency – sort of like a lifeguard who keeps a drowning man's head only just below the surface.

For its part, the Fed, under Ben Bernanke, has leveraged its balance sheet 55:1, such that a 33 basis point rise in long-term rates post Operation Twist would wipe out its reported capital of $52bn. Yet it turned a profit of $82bn on its interventions last year and, far more importantly, no one in the markets doubts that its balance sheet is fully underwritten by the Treasury and the American taxpayer. In a pinch, it could hand every dodgy asset on its balance sheet off to the Treasury in return for US sovereign debt, and thereby normalise the composition, if not the size, of its balance sheet almost at will. As long as the US sovereign is solvent (In God We Trust…), the Fed is free to continue behaving like a hedge fund.

Nothing of the sort can be said for the ECB. The Eurosystem's €81bn in capital could be the only thing standing between its status as the supplier of 27% of the world's monetary reserves and outright liquidation. A mere 25% markdown on its direct and indirect Greek, Portuguese, and Irish debt holdings would wipe out that capital.

Why does this matter? It is because using the ECB's balance sheet to intervene in the bond markets is, in the end, merely a political expedient to get around German resistance to boosting the eurozone bailout fund or issuing eurobonds. And the German taxpayer is the ultimate backstop for all three options, and any other that can be imagined.

Just as the German government is resisting further bailout funds or new eurobonds, it may ultimately be unwilling, or politically unable, to recapitalise the ECB were it to be hit with significant losses on its bond purchases. By absorbing more and more credit risk, the ECB puts its very existence at the mercy of hardening German public opinion. Unlike the Fed, the ECB has no nation behind it which considers it central to its nationhood.

But can't the ECB just print money, even if it has no capital? And aren't inflationary pressures modest at the moment? Yes and yes. But the problem is that the banks, and the public at large, will eventually want more interest-bearing assets and less cash. At that point, the ECB will have to sell assets to soak up the excess cash, or watch inflation soar. If the value of its assets is sufficiently eroded by defaults, it will need more of them.

Yet by this point, much more of the German public may have concluded that the whole project is a lost cause, making it impossible for the German government to provide the assets – at least on a timely basis. The market would then conclude that a return to Weimar is a real risk – not because of central bank stupidity or corruption, but because of endemic political lassitude. A run on the euro, like the current run on Italian bonds, would ensue.

On November 16, the reality of such a calamitous unfurling of events was made clear in a very public face-off between the Irish prime minister, Enda Kenny, and the German finance minister, Wolfgang Schäuble. "The ECB should be the ultimate firepower," Kenny said while Schäuble stood by shaking his head no.

The trouble for Kenny is that even if the ECB agreed with him, it is Schäuble and his chancellor who pay the piper and therefore call the tune. New ECB president Mario Draghi can realistically only hope to buy time, and a few more bonds, until Germany and the crisis-stricken eurozone periphery can somehow agree to take the gargantuan political steps needed to restore the latter's growth and reduce its unmanageable debt burden. And time is preciously short.

Benn Steil is director of international economics at the Council on Foreign Relations and co-winner of the 2010 Hayek Book Prize for Money, Markets and Sovereignty.

This article appears in full on CFR.org by permission of its original publisher. It was originally available here.

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