The European Central Bank has put its ultimate weapon in place: Under the new Outright Monetary Transactions (OMT) program, the ECB will buy bonds of distressed member states without predetermined limits, provided they have applied for assistance from the ESM. ECB-President Mario Draghi has repeatedly declared that the ECB will do “whatever it takes to preserve the euro as a stable currency”. He has kept his word. The new tool was welcomed by financial markets as “the great bazooka”, and criticised by Bundesbank President Weidmann as endangering the euro. So far, it has stabilised markets, but we do not know yet how it will work out over the long run.
Nevertheless, the Bundesbank has asked important questions: will the direct intervention by the central bank stabilise or destabilise the economy? Is it justified that the ECB buys government bonds outright from member states under distress?
The answer depends on how one explains the Euro crisis. Fundamentalists believe that excessive public or private borrowing have led to the unsustainable accumulation of public debt and macroeconomic imbalances, which need to be brought back under control by harsh austerity policies. By contrast, monetarists emphasise the role of financial shocks, which have generated liquidity crises and destabilised banks’ and companies’ balance sheets. The two explanations have different policy implications.
Fundamentalists have argued for many years, even decades, that European monetary union did not need a centralised fiscal authority, other than the rules of the Stability and Growth Pact, because markets would discipline governments. They relied on the no- bailout clause in the European Treaty, which says “the Union shall not be liable for or assume the commitments of central governments, regional, local or other public authorities, other bodies governed by public law, or public undertakings of any Member State” (TFEU. Art 125). Fundamentalists hoped that financial markets would surveil governments, monitor their creditworthiness and “punish” excessive borrowing by raising interest rates and thereby force them to consolidate and ensure fiscal discipline. We now know that this view was excessively naïve, and not only because markets were short-sighted before the crisis: before the Global Financial Crisis, spreads for Euro Area government debt were minimal, but after the Lehman collapse they exploded, overshooting reasonable levels by far. Hence, they did not avoid excessive borrowing, if that is what caused the crisis, although they clearly made things worse. Nevertheless, many fundamentalists still argue that one has to enforce the No-bailout principle to prevent future misbehaviour, for otherwise governments have supposedly no reason to balance their budgets. The ECB’s OMT would be inviting moral hazard and only destabilise the economy.
For monetarists, there is a different logic at work. A small local liquidity shock can generate huge crises if it is not actively countered by the central bank. In their view, a sudden deterioration in a specific class of asset values can spill over into the real economy when the fall in the value of banks’ asset portfolio puts their balance sheets into difficulties and reduces their net worth. Banks will then deleverage, i.e. sell assets and stop lending. The resulting credit crunch will cause a recession, increase unemployment and push up the debt burden. Such a crisis can be stopped by a buyer of last resort that provides the necessary liquidity and buys up the excess supply of securities that causes the asset prices to drop. This buyer of last resort can be the central bank, or other member states of the Euro Area. Of course, fiscal profligacy needs to be checked and this needs appropriate institutions at the European level – which we do not have – but in the short run the most important thing is to stop the crisis from turning into a default avalanche.
There is a lot of evidence that the Euro debt crisis is a liquidity crisis. Even in Greece public debt was sustainable before the credit crunch and fundamentalist austerity policies converted the global financial crisis into a 5-year depression. However, a particular feature of the Euro crisis is due to the home bias in banks’ asset portfolios. Home bias means that local banks hold excessive shares of “their” government’s debt in their portfolio. The reason is that often national governments use local banks like house-banks to meet their funding requirements. The drawback is that banks with home bias in their asset portfolio are excessively vulnerable when yields on the national debt increase and prices collapse because it weakens their balance sheets. With home bias, local banks will suffer disproportionately from the deterioration of local economic conditions.
Hence, if markets punish excessive borrowers by pushing up rates, bond prices will fall. This is exactly what the market discipline theory seeks to achieve. But as a consequence, the assets of banks and other private investors will depreciate. This fact turns the No-bailout clause into a dangerous policy principle, especially when it is combined with home bias. To restore their balance sheets, local banks will reduce leverage, sell the depreciating governments bonds, and stop lending. In short, they will cause a credit crunch; alternatively, they will lend aggressively to high-yielding risky projects, thereby increasing financial fragility. Either way, the principle of No-bailout will destabilise the Euro Area and damage growth and employment.
Unfortunately, the No-bailout principle overlooked this logic because it ignored external effects. If it had been valid, a rise in government bond yields would not have affected the borrowing conditions for other debtors within a given member state. But this is not what we have observed. In fact, a salient feature of the Euro Area crisis is the strong interdependence between the banking and sovereign crisis.
Hence, the theory of creating market discipline by the No-bailout commitment is bankrupt, and the European Central Bank has now become its receiver. The ECB has to pump liquidity into financial markets and buy up securities from extremely fragile sovereign debtors, because governments refused to stabilise the Euro-economy in the early stage of the crisis. The OMT pose potential risks for the ECB’s balance sheet in the medium term, because the bank disproportionally accumulates risky securities.
These risks could have been avoided had governments cooperated instead of dogmatically insisting on a mistaken concept, namely the No-bailout principle. The EMS would have been the proper vehicle to generate a stabilising bailout under democratic control. A proper banking union and the swap of national debt into Eurobonds could have reduced the effects of home bias. But governments have blocked this route. Thus, while the ECB does whatever it takes to save the euro, sovereign nation states are the root of all evil.