Why the ECB refuses to be a Lender of Last Resort

The euro has a matter of weeks to save itself, with several institutions now preparing for its collapse. Given this, why does the ECB still refuse to bail out Europe’s heavily indebted countries? This column provides an explanation. It says that the ECB may well be behaving rationally but adds that such behaviour is also foolish – and dangerous.

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A forecast of action

The previous analysis leads me to the following forecast.

• The ECB will only act when the cost of inaction is immediate and clear.

As a result, the ECB is likely to wait until the sovereign debt crisis has degenerated into a full-scale banking crisis.

• There can be little doubt that the sovereign debt crisis will lead to a banking crisis.

The reason is that the continuing decline in the price of sovereign bonds will hammer the banks’ balance sheets to such an extent that the losses become unbearable.
In addition, sovereign debt crises lead to funding problems for banks and a risk of being shut out from the interbank market. Thus there is a moment when the sovereign debt crisis inevitably triggers a banking crisis. This will be the moment when the timing asymmetry between costs and benefits is such that the ECB will see the merits of being a lender of last resort. Only then will the ECB come to action.

Concluding remarks

All this is quite depressing for two reasons.

• First, the amount of liquidity the ECB will have to inject in the banking system is likely to be higher than the amount that is necessary to stabilise the government bond markets.

This assertion is based on a simple fact. Total liabilities of the Eurozone banks are more than three times the liabilities of Eurozone governments (De Grauwe 2011).

• Second, the banking crisis will also trigger a deep and long-lasting recession (see Reinhart and Rogoff 2009).

All this may in the end endanger the Eurozone itself.

http://www.voxeu.org/index.php?q=node/7352