How Europe’s central banks are staving off catastrophe

By Felix Salmon
June 1, 2011
Martin Wolf, who has an important column on the way that Europe's central banks have been staving off a full-scale eurozone crisis.

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The chart of the day comes from Martin Wolf, who has an important column on the way that Europe’s central banks have been staving off a full-scale eurozone crisis.

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What you see here is the amount of money that various individual European central banks — not the ECB — owe each other. From the creation of the eurozone in 1999 up until late 2007, such lending between European central banks was modest — but then, when the financial crisis hit, the Bundesbank in particular went on a lending spree, while the PIGS central banks all started borrowing up a storm. Since then, the Bundesbank has essentially been singlehandedly financing the PIGS central banks: it’s now owed a whopping €325 billion, and rising. (That’s about $470 billion, at today’s exchange rate; we’ll surely hit the half-trillion-dollar level soon.)

What’s being done with all this money? “Let us call a spade a spade,” says Wolf: “This is central bank finance of the state.” It’s indirect, to be sure, but this graph is a finger in the eye of Article 123 of the Lisbon Treaty, which bans monetary financing. And it means that there’s a whole new set of dominoes which could, catastrophically fall:

Government insolvencies would now also threaten the solvency of debtor country central banks. This would then impose large losses on creditor country central banks, which national taxpayers would have to make good. This would be a fiscal transfer by the back door.

Needless to say, no one envisaged, when the eurozone was created, that individual countries’ central banks could become insolvent. But that’s a real possibility, now, and no one has a clue how to address that kind of problem. What we do know, if our memories stretch back as far as September 2008, is that such an event could have enormous consequences. Here’s the ECB’s Lorenzo Bini Smaghi, in conversation with Ralph Atkins:

FT Some argue that a Greek default would be the least worst-option for the euro area. The impact on the euro area would be containable and it would reinforce euro area principles long term. Why are they wrong?

LBS It would not be the least worst option – as we can see from the reaction of financial markets, not only within the euro area but also outside. The destabilizing effect could be quite dramatic. Those who say that the impact would be contained simply do not look at the data. It reminds me of those who in mid-September 2008 were saying that the markets had been fully prepared for the failure of Lehman Brothers.

All sophisticated indicators of systemic risk, cross correlations of CDS and yield spreads show a high sensitivity to restructuring moves and are at levels higher than in September 2008. Suggesting that there are no contagion risks is naïve and entails taking a risk that no responsible policy maker can afford, if he or she has any interest in the well being of its citizens.

Tracy Alloway, today, picks up on much the same theme, quoting a research report from Merrill Lynch: while volatility is low, correlations are still very high. And that’s a combination which tends to presage nasty price crashes across many asset classes. In other words, markets are exhibiting a lot of fragility right now, and something drastic like a Greek restructuring could easily send them into a Lehman-style downward spiral, as Wolf spells out:

Debt restructuring looks inevitable. Yet it is also easy to see why it would be a nightmare, particularly if, as Mr Bini Smaghi insists, the ECB would refuse to lend against the debt of defaulting states. In the absence of ECB support, banks would collapse. Governments would surely have to freeze bank accounts and redenominate debt in a new currency. A run from the public and private debts of every other fragile country would ensue. That would drive these countries towards a similar catastrophe.

The only other choice, says Wolf, is equally intolerable: Europe’s richest governments aiming a firehose of their taxpayers’ euros, in open-ended and unlimited quantities, at any country facing massive outflows.

Given these choices, it’s easy to see how Europe’s politicians and central bankers are doing everything they can to kick the can down the road and put off the moment that they have to make a big decision. But the longer they wait, of course, the more momentous and more difficult any such decision is going to be. Just how much risk are Europe’s central banks going to take on, before they draw the line and say no mas?

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