Only the ECB can Stabilise the Eurozone

Government bond markets in Europe remain volatile, with Spanish and Italian bond rates at near unsustainable levels. Paul De Grauwe argues that the only institution that can stabilize these markets by buying government bonds is the European Central Bank (ECB). The ECB must now overcome its risk averse nature and take advantage of its virtually infinite resources to help to successfully restore financial stability.

It is becoming increasingly obvious that the European Central Bank is the only institution that can stabilise the government bond markets in the Eurozone. These bond markets have been gripped again by fear and panic, leading to unsustainable increases in the government bond rates in Spain and Italy. If this is left unchecked, these countries will be pushed into default.

The self-fulfilling nature of these developments is key to understanding the crisis. Spain and Italy are solvent nations. However, fear and panic does two things. First it drives the interest rates on the government bonds of these countries to unsustainable levels. Second, it leads to sudden stops in liquidity making it impossible for the governments of these countries to continue to service their debt. To avoid this they are forced to start excessive austerity programs that lead to deep recessions and a collapse of government tax revenues. As a result the budgetary situation is worsened, not improved. The fear of default creates the conditions where default becomes inevitable. Countries are pushed into a bad equilibrium.

The ECB is the only institution that can prevent panic in the sovereign bond markets from pushing countries into a bad equilibrium, because as a money creating institution it has an infinite capacity to buy government bonds. The fact that resources are infinite is key to be able to stabilize bond rates.

The ECB is unwilling to stabilize financial markets this way. Many arguments have been given why the ECB should not be a lender of last resort in the government bond markets. Many of them are phony.  Some are serious like the moral hazard risk. The latter, however, should be taken care of by separate institutions aimed at controlling excessive government debts and deficits. These are in the process of being set up (European Semester, Fiscal Pact, automatic sanctions, etc.). This disciplining and sanctioning mechanism then should relieve the ECB from its fears for moral hazard (a fear it did not have when it provided €1,000 billion to banks at a low interest rate).

The deeper reason for the ECB’s reluctance to be a lender of last resort in the government bond market has to with its business model. This is a model whereby the ECB has as a main concern the defense of the quality of its balance sheet, i.e. a concern to avoid losses and to show positive equity, even if that leads to financial instability.

It is surprising that the ECB attaches such an importance to having sufficient equity.  In fact, this insistence is based on a fundamental misunderstanding of the nature of central banking. The central bank creates its own IOUs. As a result it does not need equity at all to support its activities. Central banks can live without equity because they cannot default. The only support a central bank needs is the political support of the sovereign that guarantees the legal tender nature of the money issued by the central bank. This political support does not need any equity stake of the sovereign. It is quite ludicrous to believe that governments that can, and sometimes do, default are needed to provide the capital of an institution that cannot default.

All this would not be a problem were it not for the fact that the ECB’s insistence on having positive equity is in conflict with its responsibility to maintain financial stability. Worse, this insistence has become a source of financial instability. For example, in order to protect its equity, the ECB has insisted on obtaining seniority on its government bond holdings. In doing so, it has made these bonds more risky for the private holders, who have reacted by selling the bonds. This also implies that if the ECB were to take up its responsibility of lender of last resort, it will have to abandon its seniority claim on the government bonds it buys in the market.

The correct business model of the ECB is to pursue financial stability as its primary objective (together with price stability), even if that leads to losses. There is no limit to the size of the losses a central bank can bear, except the one that is imposed by its commitment to maintain price stability. In the present situation the ECB is far from this limit.

A central bank should be willing to take such losses if in doing so it stabilises financial markets. In fact when it successfully stabilises financial markets losses may not even appear. Today, the fear of making losses paralyzes the ECB. The ECB should set aside these fears.

Put differently, today investors have become very risk averse, fearing being caught in a crisis that could wipe out their wealth. In such an environment it is important that the central bank is willing to take some risk, thereby offsetting extreme risk aversion in the market. If instead the ECB is equally, if not more risk averse, the financial markets cannot be stabilized. Because of its deep pockets it is the central bank that in times of fear has to stand up fearless.  That’s the central bank we need. Not one that runs away.

This column was first published by EUROPP @ LSE


  1. Gray says

    “The ECB must now overcome its risk averse nature and take advantage of its virtually infinite resources to help to successfully restore financial stability.”
    No, it can’t. It hasn’t “infinite resources”, it only has the ability to create a virtually infinite amount of money. But let’s not forget that the value of money comes from the economic output backing it. And that output hasn’t increased that much at all. So, to increase the monetary base only creates a fata morgana of wealth, but the purchasing power doesn’t increase at all. It’s simply that inflation will increase (if that money actually “trickles down” to the real economy) and that will lead to many side effects, many of them unwanted. To put 330 million people in the Eurozone under the burden of such a giant monetary experiment, that will weaken the Euro and thus most probably not increase investor’s confidence is imho a dangerously risky way of making life easier for 120 million people in GIPSI nations. If those countries want to use devaluation for increasing their competitiveness, they should do so with their own currency, not with that of other people! When they joined the Euro, they did know that it would be a stable currency, and they have no right to demand from the majority to turn it into a Drachma now.

    Btw, it wasn’t the ECB which made bonds more risky for private investors, it were irreponsible and/or shortsighted economic and financial policies of bad governments, which pushed those nations close to becoming bankrupt and thus made them a bad credit risk!

    • Bert Nijhof says

      There is nothing wrong with the average situation of the Eurozone, its debt to GDP ratio is better then that of the USA and the UK. As long as we are in a depression there is no chance, that inflation will create any problem. Buying bonds is not a giant monetary experiment, it has been done by the UK and the FED e.g. two times the the last years without any effect on inflation and the investor confidence is so high that the investors are willing to pay the USA and the UK to keep their money safe. Your opinion has not been supported any facts.

      Btw, Before 2008 Ireland and Spain had surpluses and a debt to GDP ratio better then Germany or the Netherlands. Their problem has been caused by a housing bubble fueled by their banks and financed by the huge export surplus money from the North, desperately looking for investment opportunities. Even Italy had a primary surplus and had been reducing debt between 2001 and 2007.

      • Gray says

        We all know the problem isn’t the average situation, but the very special situations in the GIPSI nations. Their debt/GDP ratio is rightly reason for concerns. The big question is, will the ECB stepping in as a subsitute for weary investors lead to any positive developments? It’s hard to see how that shall be so, since that help isn’t coupled with any conditions. It simply allows the governments to take up even more debt, without forcing them to implement necessary but politically unpopular reforms. There’s a very real and substantial danger that this regular inflow of fresh central bank money will lead to inflation. Sure, so far this money only circulates in the banks, but this only further inflates the fina ncial sector (which isn’t helpful at alll, probably the opposite would be good) while doing nothing to creatre jobs in the real economy, because the money doesn’t trickle down. What HAS to be done is to rev up the economies of the GIPSI nations, but this pseudo-solution of the ECB playing bond investor only kicks the can down the road without accomplishing anny turnaround. The risk doesn’t stand in a reasonable relation to the meager reward of buying some time. Looks like those who advocate it are waiting for a miracle.

        Btw, I’m not one of those guys who ignorantly pretend that all GIPSI’s are the same. Very obviously, every single one of these nations had its own unique set of bad decisions that led into the crisis. In Ireland, it wasn’t so much irresponsible government spending, like in Greece, but rather a misguided “laissez faire” policy towards the financial sector. In Spain, it was the unsustainable growth in the construction sector, ignoring the fact that that bubble had to burst at one point, leading to a huge loss of jobs. And Italy never seriously brought down its disturbingly high debt/GDP ratio (always >100%) when it had the opportunity during the good Euro years. Of course, other government policies played a role, too, I’m simplifying things here. But fact is, those problems could have been avoided if the governments had reacted on the misdevelopments.

        So, of course every one of those nations is a special case, requiring its own, individual way out of the crisis. Ireland’s fundamentals look good, with some help to kickstart the econnomy again it can make it. Italy is one of the leading industrial nations of the world and would be fine if only Monto would start to fight the shadow economy, improve tax collection, and use the proceeds to boost domestic demand among the lower and medium incomes. Hopefully, Spain, which had made impressive economic progress during the last decades, can be saved, too. But for Greece, crippled by a myriad of internal problems, and without the necessary popular support for thoroughly modernizing the state, most probably a return to the Drachme is inevitable. It’s has become obvious for everybody that that nation can’t cope with the conditions of the Eurozone, won’t manage to adjust in at least a decade, probably a generation, and that it would be better for the people to apply the proven receipe of the past, devaluation of the Drachma, now. No amount of wishful thinking can change reality, sorry.

    • says

      OK, personally, I think probably given the economic ideas in charge of the Eurozone, the world and certainly the countries involved would be best off if Greece, Spain, Ireland, and anyone else who finds themselves in similar straits just defaulted and got it over with, dumped the Euro, went back to their own currencies, and yes, devalued to increase competitiveness and allow a domestic growth and pump-priming agenda, putting people back to work.
      But assuming you want to keep the Euro, what Mr. De Grauwe says shouldn’t be controversial at all and your objections make little sense.
      There is no real agreement on where the value of money comes from; I’ve seen many ideas spun on the subject. If there’s any validity to your “from the economic output backing it” idea, it’s only in a very broad sense in a long-run time perspective. If there’s a financial crisis and people are suddenly thrown out of work and half the factories shut down, I would seriously doubt that anyone remotely worth listening to would claim that the value of money suddenly halved the next day.
      The fact is that depending on the circumstances, very often when central banks print money (or do functionally similar things) it does not cause inflation, certainly not in anything like a linear fashion. Take the US central bank over the past three years or so. These particular circumstances are that sort. Output is way below what it could be; printing money might cause some inflation, but not nearly enough to offset the advantages of stopping the senseless austerity and returning to a growth path by creating some jobs.

      • Gray says

        “But assuming you want to keep the Euro, what Mr. De Grauwe says shouldn’t be controversial at all and your objections make little sense”
        That sentence doesn’t make much sense to me, sorry. I want to keep the Euro, indeed, and as I see it, the way to do that is to stop wasting money on the hopeless case Greece, to force “to-big-to-fail” Italy into passing politically inconvenient fiscal reforms (instead of surrendering to their selfish calls for more easy money) and to help the others on their recovery course with a growth plan that creates jobs and boosts domestic demand. But the naive idea that everything will be fine if the ECB unconditionally flushes struggling nations with an increasing amount of money, which will actually remove incentives to reform, not only doesn’t lead to any real changes, it also puts all of the Eurozone under a severe risk. Imho that’s not a way towards saving the Euro, that’s the road to ruin.

      • Gray says

        Well, imho it’s beside the point to cite the quantitative easing in the US, all those trillions handed out to the banks, as evidence that the issuing of additional money by the central bank doesn’t lead to inflation. It’s a very special case. That money evidently didn’t trickle down into the real economy (afaics no data shows that the overwhelming majority of the people have more money to spend now), so why should it have any effect on the prices of goods for mass consumption? I suspect there is inflation, but it’s hiding in areas that aren’t covered by the index. A rather small share of that money would have had much more notable (and positive) effect if it had been handed out to the population for consumption. Alas, central banks don’t do stimulus, only governments do. And only healthy economies will come back on a sustainable path when fueled with fresh money, in failed systems, this will only lead to yet another short term bubble. Money isn’t a substitute for reforms, and short term patches can’t reasonably replace long term strategy. Ain’t that the obvious lesson from the Eurocrisis?