A Bridge, but Leading Where?
The Weekly Standard, February 4, 2012
Purity has no place in a crisis. The 2008 TARP bailout was a clumsy, ugly, and rather shameful creation, but by signaling that Uncle Sam was in the room (with his printing press not far behind), it headed off the final descent into a panic that would have brought the banks, and, with them, the economy, and, with that, who knows what else, tumbling down. Three years later, another four-lettered program has been launched, this time in Europe, but once again designed to calm fears that were threatening to metastasize into catastrophe.
It was no coincidence that the European Central Bank (ECB) launched its first LTRO (long-term refinancing operation) on December 8, the first day of a two-day Brussels summit in which the EU’s leaders planned to show that they were really, really in control of a currency union on the edge of chaos. The central bank’s billions were intended to sugar the bitter pills that the Brussels summiteers were bound to prescribe—and did. The eventual, uh, “Treaty on Stability, Coordination and Governance in the Economic and Monetary Union” that was hacked out of those talks (and a second summit last week) combines the big-heartedness of Scrooge with the vision of Magoo and the credibility of Madoff. Its significance lies more in what it won’t do than what it will. Few were impressed.
The LTRO, by contrast, got off to a tremendous start. In the months prior to the new program’s debut the central bank had been criticized (not always fairly) for not doing enough to support the eurozone’s stumblebum banks. Its rescues were too ad hoc, too brief, and too grudging. Not any more: Just in time for Christmas, the ECB repackaged itself as Santa, offering out longer-term (three year) funding at highly attractive rates and, as an added bonus, not being too fussy about how it was collateralized.
The combination of one generous lender and many anxious takers produced a spectacular result. From across the eurozone, 523 banks borrowed a total of 489 billion euros ($641 billion), a far larger haul than financial markets had anticipated. This was a measure both of the easy terms being offered and the difficult straits in which so many European banks had found themselves. Lehman’s unquiet ghost was on the move. Trust in the banks was eroding, as was trust between them. Interbank lending was slowing, crimping the banks’ ability and willingness to lend money out into the “real” economy.
By December, credit to the eurozone’s businesses and consumer clients was falling at a rate that conjured up memories of the nightmare of 2008. With the currency union’s extended ordeal driving Europe into recession, the last thing anybody needed was credit crunch part deux to make matters even worse. Yet that is what the continent was getting. And the deeper the recession, the harder it would be for the PIIGS (Portugal, Italy, Ireland, Greece, Spain) to escape their budgetary hell, and, crucially, for their lenders’ faith in them to return. And so the vicious circle turns.
Initially, the market was unsure how to respond to the LTRO. Was the program’s size a reason for celebration or concern? But then sentiment changed for the better. Italy completed a number of successful bond auctions. Yields on French and Spanish government debt fell—while those of Germany’s safe haven bunds rose. The Rodney Dangerfield euro even made up some lost ground against the dollar. And this was despite the flow of dreary news that just would not go away. The impasse over the “voluntary” restructuring of Greek debt continued, Portugal slid closer, again, into bailout territory, there was a further round of ratings agencies downgrades (this time from Fitch), and hideous fresh reminders of the plight of the eurozone’s periphery continued to slouch into view. In late January statistics were released showing that Spain’s unemployment rate had hit 22.8 percent in the last quarter of 2011. For the under-25s the rate is nearly 50 percent.
But for now the glass was half full. The old TARP trick had worked again. The European Central Bank had not only supplied the banks with nearly 500 billion euros ($650 billion) in badly needed liquidity, but it had also signaled that it was there on the ramparts alongside them. The cash was important, the boost to confidence no less so, and the message will be rammed home with an LTRO 2.0 scheduled to take place later this month. Another gusher? Maybe. The standard guess is that this second round will amount to 350 billion euros or so, but some have speculated that the total could swell to as much as 1 trillion euros.
According to the logic of a seminal paper published last year by Belgian economist Paul De Grauwe, the very structure of the eurozone (monetary union without fiscal union) was an invitation to financial panic. Fears that money would drain out of the zone’s weaker countries would be self-fulfilling. One consequence is that the possibility of bank runs cascading through the system has been among the most dangerous of the many threats swirling around the eurozone. By supplying that extra liquidity, by promising a second helping, and by implicitly suggesting that in a pinch there could be even more, the ECB is trying to deliver the message that there will always be cash in the banks’ tills. No need to panic, or even think about panicking, after all.
Theoretically (and for now in practice) that should make it easier—and cheaper—for those eurozone countries not yet in intensive care to borrow on the international markets. There’s something else that may be helping too. One of the devices used to reassure skeptical Germans that the new European Central Bank would be more Bundesbank than Weimar was a broad ban on direct purchases by the ECB of government bonds from the eurozone’s members. There’s no equivalent rule, however, that stops commercial banks from using the LTRO loot they have just received from the ECB to purchase the bonds that the central bank cannot. Indeed the banks appear to have been incentivized to do just that. Using cheap ECB funds to buy high-yielding eurozone government bonds looks, at first glance (if not necessarily the second), like a nicely profitable carry trade.
Pause for a moment, though, to think through this money-laundering: Banks that have been weakened by their exposure to dodgy European sovereign debt were being encouraged to use loans (secured by similar debt, and worse) from an already highly leveraged central bank (underwritten by increasingly restive taxpayers) that was itself heavily exposed to identical crumbling borrowers, to buy even more of the same poison. Ponzi himself would have blanched. Nicolas Sarkozy, however, thought it was a great idea. “Each state,” he said, “can turn to its banks” to buy its bonds. Because thanks to the LTRO, the banks “will have liquidity at their disposal.”
It remains uncertain how many banks followed the French president’s advice. Quite a few, in all probability: Nevertheless a good portion of the LTRO proceeds have been placed right back on deposit with the ECB. The banks are still building fortifications in preparation for the day of reckoning they obviously fear may be on the way. That they are has something to be said for it (healthy cash reserves represent a handy preemptive strike against panic), but it is also a sign of a system that no longer believes in itself. The wider slowdown in lending that comes with it carries, as Europe has seen, its own terrible cost.
The next few months will show how effective the LTROs are at calming these fears. Somewhat, I’d guess, but sorting out the eurozone’s predicament will take more than the European Central Bank’s billions. The fundamental flaw of the euro was, and is, that this one-size currency does not fit all. All the liquidity in the world will not change that. Europe’s monetary union was assembled on the basis of political fiat rather than economic reality, and the economics and politics have both turned sour. And not just sour: They have combined into a murderous cocktail. Understandably enough, the looted taxpayers of the north want to see budgetary discipline imposed on the dysfunctional south. German chancellor Angela Merkel has been leading the posse pushing for just that. But too much austerity too soon is draining the ability of the PIIGS to generate the growth that is the only way out of their burning sty. More dangerously still, it is reaching the limits of the politically possible. Shuttered businesses, soaring unemployment, and the prospect of years of stagnation to come are not the stuff of social stability. If insults like the recent draft German proposals that would have ground into dust the last shards of Greece’s economic sovereignty (and much of what remains of its self-respect) are then added to the mix, an explosion is unlikely to be far behind.
The next moves will not be straightforward, but, if they want the eurozone to survive in its current form, those who control its destiny will have to reshape it into a cut that will eventually (if they are very lucky) have a chance of fitting all. They will have to make a drastic change of course. They will have to acknowledge that austerity alone is failing and move instead to fiscal union (and a permanent transfer payment regime) buttressed with, to quote IMF managing director Christine Lagarde, a “clear, simple firewall.” This, I’d guess, would have to be a jointly underwritten financing mechanism of a size (2 trillion euros?) that recognizes how prolonged and tricky this process will be.
Whether the voters will go along with all this is an entirely different and very pointed question, but if the eurozone continues to be run as it is now, the LTROs will turn out to be brilliant, necessary bridge financings that lead, ultimately, to nowhere.