"In every crisis there’s a point of no return — if you don’t do XYZ in time, it’s too late, and the crisis is certain to get out of anybody’s control. I’m increasingly convinced we’ve already passed that point of no return in Europe. The banks won’t lend to each other, the Germans won’t do Eurobonds, and the ECB won’t act as a lender of last resort. The confidence fairy has left the continent, and she isn’t about to return. Which means, as we used to say in 2008, that things are going to get worse before they get worse."
As the increasing bond yields and CDS spreads indicate, the European credit markets are pretty much freezing up. As reflected in the dismal response in recent auction, even the Teutonic credibility of the German bund has taken a dent. Governments are finding that debt refinancing has become very expensive. Banks, with heavy sovereign debt exposures, have become averse to lending anymore, not only to sovereigns but also to each other. Further, they also face rising margin calls due to heightened sovereign debt default risks. The risk of assets turning sour and demand for increased capital requirement (from margin calls), is turning an initial liquidity crisis into a solvency crisis for the banking sector.
In the circumstances, there are two options. The interventionists advocate aggressive measures to restore credit markets (through rate cuts, liquidity injections, credit guarantees, and asset purchases) and bank recapitalization with stringent conditions attached. This is effectively a call to the central bank to step in as a lender, buyer, and insurer of last resort. It would also involve governments taking stakes in banks. Felix Salmon too prefers intervention. His prognosis about the fate of Eurozone is based on this assumption. He believes that the ECB's intransigence and failure to act has driven away the confidence fairy.
The sceptics counter that such measures are likely to be futile. They oppose such bailouts as rewarding reckless and greedy bankers. They also argue that it would merely postpone the hard decisions and belt tightening that are necessary to remove the excesses and distortions created by the skewed pre-crisis growth. Finally, they associate it with trying to restore growth in the aftermath of an asset bubble by inflating another bubble. They point out that the extraordinary monetary easing and liquidity support has the potential to amplify distortions and destablize global financial markets. It would also come in the way of the much needed croeconomic rebalancing among economies of the developed and emerging world.
In this context, as Christina Romer points out, the nature of the response matters critically with any interventionist approach. She points to the contrasting experiences of Sweden in 1991 and Japan in 1992 after their respective banking crises. The former nationalized its banks, recapitalized with public funds, and then returned to private control, with the result that the country returned to its pre-crisis trend within three years. In contrast, Japan refused to clean up its banks, rolling over loans to failing companies, with the result that it continues to grapple with anemic growth and deflation for almost two decades.
It is difficult to make a satisfactory enough judgement call on either position from merely theoretical principles or historical experiences. Both sides could be right and wrong in different ways. In simple terms of a cost-benefit analysis, which option generates higher net benefits? Alternatively, which option would generate the least costs or the less worse set of distortions? Unfortunately, these questions do not have convincing enough answers.
But it is undoubtedly true that bailouts generate moral hazard by taking away the biggest disciplining factor of capitalism. And, as the recent evidence has shown, such bailouts, perversely enough, end up concentrating risk by making the TBTF institutions even bigger.
Update 1 (21/12/2011)
In its role as lender of last resort to banks, the ECB allocated 489.2 billion euros, or $644 billion, to 523 institutions through its longer-term refinancing operations, or LTROs. The loans are for three years and will be at the benchmark 1% interest rate. This is the largest amount ever allocated in a single ECB liquidity operation and first time ECB has extended loans for maturities beyond one year. ECB had started the liquidity operations in the aftermath of the Lehman collapse. It announced that another LTRO will be held in February 2012.
The three-year loans are designed to compensate for a dearth of longer-term market funding, at a time when banks are facing the need to roll over an extraordinarily high amount of their own debt. Banks in the euro zone must raise more than 200 billion euros in the first three months of 2012.
The cheap loans issued by the ECB may also indirectly help governments like Spain and Italy that have faced higher borrowing costs. Spain paid sharply lower interest on debt it auctioned early this week, as banks appeared to use cheap ECB money to buy the bonds, profiting from the difference in interest rates. However, the proceeds could also be used to re-finance existing assets as they become due in the months ahead.
The ECB, as part of its effort to prevent a credit crunch, also broadened the collateral it will accept in return for loans. It is even accepting outstanding loans as security, a measure designed to help smaller community banks that may lack conventional forms of collateral like bonds.
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