In response to the sovereign funding crisis sweeping across the Eurozone, the ECB decided to “conduct two longer-term refinancing operations (LTROs) with a maturity of 36 months”. Combined with the commitment of the members of the Eurozone excluding the possibility of any more haircuts on private sector holders of Euro sovereign bonds, the aim of the current exercise is clear. As Nicholas Sarkozy put it rather bluntly,

Italian banks will be able to borrow [from the ECB] at 1 per cent, while the Italian state is borrowing at 6–7 per cent. It doesn’t take a finance specialist to see that the Italian state will be able to ask Italian banks to finance part of the government debt at a much lower rate.

In other words, the ECB will not finance fiscal deficits directly but will be more than happy to do so via the Eurozone banking system. But this plan still has a few critical flaws:

  • As Sony Kapoor notes, “By doing this, you are strengthening the link between banks and sovereigns, which has proven so dangerous in this crisis. Even if useful in the short term, it would seriously increase the vulnerability of both banks and sovereigns to future shocks.” In other words, if the promise to exclude the possibility of inflicting losses on sovereign debt-holders is broken at any point of time in the future, then sovereign default will coincide with a complete decimation of the incumbent banks in Europe.
  • European banks are desperately capital-constrained as the latest EBA estimates on the capital shortfall faced by European banks shows. In such a condition, banks will almost certainly take on increased sovereign debt exposures only at the expense of lending to the private sector and households. This can only exacerbate the recession in the Eurozone.
  • Sarkozy’s comment also hints at the deep unfairness of the current proposal. If default and haircuts are not on the table, then allowing banks to finance their sovereign debt holdings at a lower rate than the yield they earn on the sovereign bonds (at the same tenor) is simply a transfer of wealth from the Eurozone taxpayer to the banks. Such a privilege may only be extended to the banks if banking is a “perfectly competitive” sector which it is far from being even in a boom economy. In the midst of an economic crisis when so many banks are tottering, it is even further away from the ideal of perfect competition.

There is a simple solution that tackles all three of the above problems - extend the generous terms of refinancing sovereign debt to the entire populace of the Eurozone such that the market for the “support of sovereign debt” is transformed into something close to perfectly competitive. In practise, this simply requires undertaking a program of fast-track banking licenses to new banks with low minimum size requirements on the condition that they restrict their activities to a narrow mandate of buying sovereign debt. This plan can correct all the flaws of the current proposal:

  • Instead of being concentrated within the incumbent failing banks, the sovereign debt exposure of the Eurozone would be spread in a diversified manner within the population. This will also help in making the “no more haircuts” commitment more time-consistent. The wider base of sovereign debt holders will reduce the possibility that the commitment will be reversed by democratic means. The only argument against this plan is that such a concentrated new bank is too risky but that assumes that there is still default risk on Eurozone sovereign debt and that the commitment is not credible.
  • The plan effectively injects new capital into the banking sector allowing incumbent bank capital to be deployed towards lending to the private sector and households. If sovereign debt spreads collapse, then the plan will also shore up the financial position of the incumbent banks thus injecting further capital available to be deployed.
  • The plan is fair. If the current crisis is indeed just a problem of high interest rates fuelling an increased risk of default, then interest rates will rapidly fall to a level much closer to the refinancing rate. To the extent that rates stay elevated and spreads do not converge, it will provide a much more accurate reflection of the real risk of default. No one will earn a supra-normal rate of return.

On this blog, I have criticised the indiscriminate provision of “liquidity” backstops by central banks on many occasions. I have also asserted that key economic functions must be preserved, not the incumbent entities that provide such functions. In times of crisis, central banking interventions are only fair when they are effectively accessible to the masses. At this critical juncture, the socially just policy may also be the only option that can save the single currency project.


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many thanks for this post. AS you mention in your post "The only argument against this plan is that such a concentrated new bank is too risky but that assumes that there is still default risk on Eurozone sovereign debt and that the commitment is not credible." Isn't it precisely a strong argument against this plan the fact that in the current context it is quite likely that Portugal for instance (given its public debt levels in Portugal combined with low growth prospects) will restructure its debt at some point? In other words, don't you think that sustainability prospects in many euro area countries are so dire that the commitment is hardly credibe?


Francisco - if we've already signed up to "as much austerity is needed", then atleast the interest rate needs to be much lower. And making access to the repo window "open access" will ensure that rates are hot high because of insolvent banks or market speculation. If rates are then high, then it will be purely because the market believes that the needed austerity is not politically doable and there is real default risk. Even if default occurs, the losses would not be concentrated in just a few incumbent banks.

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John David Galt

If I had a bank account anywhere in the Eurozone, I'd be moving it to Japan right about now.


I agree with your reply. However the point I wanted to make is that simultaneous austerity accross the eu is unlikely to work in the absence of some support to aggregated demand in the line of your 'helicopter drop' proposal based on the Waldman/Mosler idea. Do you therefore consider that the 'simple solution to the eurozone sovereign funding crisis' is a second best solution under constraint of the current bad choice tu of austerity accross the board?


John - Switzerland is a lot closer! Francisco - It is absolutely "second best" but simply makes the best of the situation within the parameters that we need to save the Euro and that fiscal union is unacceptable to the EU electorate. IMO the "best" solution involves having your own currency that can devalue in such circumstances. The UK economy with a 20% devaluation post the crisis is still struggling - if it was in the Euro, things would have been much harder. Even stimulus in the current environment will simply flow back to asset markets in the core. Just like EU easy money in 2005 triggered asset bubbles in the periphery when it was meant to stimulate the core, stimulus meant to help the periphery now will trigger asset bubbles in the core.


Don't you think it could be possible at least to a certain extent to avoid that any monetary stimulus would flow back to assetr markets via regulatory measures that would channel funds to SMEs for instance?


Francisco - the only way to make stimulus flow into the periphery is to institute capital controls as Steve Waldman has correctly noted. On your example of SMEs, if you were an investor who got better financing terms today you'd likely put your money in SMEs in northern Europe. just like you would put your money in Spanish/Irish real estate in 2005. Same thing happened in 1998 - rate cuts intended to save LTCM and the banks ended up fuelling the dot com bubble. Btw, the ECB has also made loans to SMEs acceptable as collateral for the first time which is a long overdue step and something that central banks are usually very averse to doing for reasons I described here


If I understand well you are highly circumspect on the potential positive outcome of any monetary stimulus going beyond repo-to-maturity facilities for new banks being granted fast-track banking licenses. But after having re/financed euro area Member States in such a way would't the flows in the end go anyway 'North' without capital controls? Moreover, does it mean that you do not adhere anymore to your 'helicopter drop' idea even as a purely theoretical benchamrk?


"If I understand well you are highly circumspect on the potential positive outcome of any monetary stimulus going beyond repo-to-maturity facilities for new banks being granted fast-track banking licenses." Yes. "But after having re/financed euro area Member States in such a way would’t the flows in the end go anyway ‘North’ without capital controls?" Hopefully some of the benefit from lower rates on peripheral govt bonds goes on less austerity, govt job cuts etc in the periphery i.e. direct fiscal effects on household and corporate balance sheets in the periphery. Leakage would occur in fiscal actions but nowhere as much as in monetary actions. "Moreover, does it mean that you do not adhere anymore to your ‘helicopter drop’ idea even as a purely theoretical benchmark?" The helicopter drop idea is really only feasible for countries where the monetary and fiscal authority are the same. The UK deputy governor even discussed this option in a speech and operationally it is very easy. But in Europe, it is not even legal from what I understand. If it is made legal, then it is still a worthwhile idea because it has a direct impact on household balance sheets in the periphery. Moreover, if you are an average German taxpayer wouldn't you rather sign up to a scheme in which the ECB prints money and sends a check for EUR 500 to each citizen within the Eurozone than the current scheme?

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