Felix Salmon

How the Greek crisis is the ECB’s fault

By Felix Salmon
April 29, 2010

Peter Boone and Simon Johnson have a long and dense post on the eurocrisis today, which has a lot of different diagnoses and conclusions. I don’t agree with all of it, but I do think they touch on something important when they trace it all back to the way that the ECB became a quasi-fiscal agent:

The underlying problem is the rule for printing money: in the eurozone, any government can finance itself by issuing bonds directly (or indirectly) to commercial banks, and then having those banks “repo” them (i.e., borrow using these bonds as collateral) at the ECB in return for fresh euros. The commercial banks make a profit because the ECB charges them very little for those loans, while the governments get the money – and can thus finance larger budget deficits. The problem is that eventually that government has to pay back its debt or, more modestly, at least stabilize its public debt levels.

This same structure directly distorts the incentives of commercial banks: they have a backstop at the ECB, which is the “lender of last resort”; and the ECB and European Union (EU) put a great deal of pressure on each nation to bail out commercial banks in trouble. When a country joins the eurozone, its banks win access to a large amount of cheap financing, along with the expectation they will be bailed out when they make mistakes. This, in turn, enables the banks to greatly expand their balance sheets, ploughing into domestic real estate, overseas expansion, or crazy junk products issued by Goldman Sachs. Just think of Ireland and Spain, where the banks took on massive loans that are now sinking the country.

Given the eurozone provides easy access to cheap money, it is no wonder that many more nations want to join. No wonder also that it blew up.

The magnitude of the problem that Boone and Johnson describe here is of course directly related to the spread between the ECB repo rate, on the one hand, and any given nation’s funding cost, on the other. As that spread increases — and it’s been increasing wildly over the past few weeks in places like Greece — the moral hazard associated with this trade skyrockets.

And I think Boone and Johnson might also have touched on the important question of who’s buying PIIGS debt in general, and Greek debt in particular, at its current non-distressed levels. It’s not those emerging-market bond investors, crossing over into higher yields in Greece. They always price credit risk, and they don’t like what they see. (Remember that for many years Mohamed El-Erian was the most important and powerful emerging-market bond investor in the world.) Instead, it’s our old friends the banks, wallowing in the carry trade. They know, after all, that even if Greece isn’t bailed out, they will be.

8 comments so far | RSS Comments RSS

More like Mills and Boon, at the rate you are cranking out half-baked articles and appear on the front page of this magazine. Quite vogue.

Posted by Ghandiolfini | Report as abusive

I don’t have access to the article, so correct me if I’m wrong, but it seems that they are saying that the banks caused the governments to issue excessive debt. Maybe that’s part of the story, but politicians hardly need any urging on this. I’d also want to know exactly how the booty from the spread between Greek bond rates and ECB repos got divided between the banks and the politicians.

Posted by Eric_H | Report as abusive

So isn’t it finally the battle between those European banks who have bought these junk Greek bonds with associated lucrative rates (who want to get bailout from European Tax Payers now that bets turned out too bad) and the European Public?

In other words does Merkel need to get approval for European TARP? At least American TARP was for American Banks. Here seems like European TARP (that is what EU/IMF bailout of Greece is) for some German banks, some non-German banks while keeping intact spending habits of Greeks who in the first place were instrument of these games.

Posted by umeshgeeta | Report as abusive

Anyway, always moving along:

“any given nation’s funding cost” – now there is an interesting concept.

After all the GS insights, I am surprised they call it ‘crazy junk products issued by Goldman Sachs’. Europe got caught out on a deal, that’s what arbitrage is all about, thousands of traders live for that moment, fair and square.

Posted by Ghandiolfini | Report as abusive

I don’t understand the incentives here: “Given the eurozone provides easy access to cheap money, it is no wonder that many more nations want to join.”

Aren’t the real costs of joining now self-evident?

Let’s take Greece: joining the EU gave them access to “cheap” money to finance spending. But how is that cheaper than just spending drachmas? Drachmas were essentially costless. Isn’t costless better than cheap? The Greek government could create (by spending) as many drachmas as they wanted. They didn’t need to go out and find drachmas in the way they have to acquire (and pay back) Euros.

I really don’t understand why any European nation thought joining the EU was a good deal when compared to actual fiscal and monetary sovereignty.

Posted by Sensei | Report as abusive

Exactly Sensei, Britain the most obvious example. The US is a consistent culture/ethic, the Eurozone has too many different and varied detrimental personalities, it will never work.

Posted by Ghandiolfini | Report as abusive

Well i guess some governments were lured by the idea that joining a single currency union would prevent them from printing money and spending out of hand, but i guess the discipline part never came.
But dont forget also that EU is one of the largest if not the biggest trade zone which has its obvious benefits so that would be a reason to want to join the EU as well, Eurozone, thats a little different.

Posted by sedrak | Report as abusive

- To Bailout Greece or Not to bailout? Please weigh in! read more about Bailouts in a free market economy only postpone Doom’s day: http://economicsforliberty.wordpress.com

- Greek default: the winners and losers…: http://wp.me/pPdcm-3b

- Greece’s Debt Crisis: A Sign of Things to come to a Hugely Indebted America? Read on at http://wp.me/pPdcm-2P

Posted by Orphe_D | Report as abusive

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