How the Greek crisis is the ECB’s fault
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.