‘Whatever it Takes’ – How Far is the ECB Really Prepared to go to Save the Euro?

Re-reading Mr Draghi’s market-moving remarks last Thursday, one gains a sense that the European Central Bank chief recognizes that the ECB has a banking run on their hand. Most market participants have understandably focused on Mr Draghi’s pledge that the ECB was “ready to do whatever it takes” to preserve the single currency. “Believe me, it will be enough,” he told a conference in London.

We prefer to focus on other aspects of the speech. It is particularly salient that Mr. Draghi highlights the fatal flaw of the euro zone noted by Professor Peter Garber some 14 years ago: As long as there was no perceived probability of euro exit by any euro nation, the established transfer system coupling private markets with European system of Central Bank support (Target 2, ELA, ECB repos) would function like any other monetary system in a single nation state. However, Garber recognized that if there arose the prospect of a euro exit and, therefore, a devaluation risk for holders of deposits in the banks domiciled in the country slated for exit (e.g. Greece or Spain), the European monetary system would be exposed to a bank run. Under the EU treaty capital mobility was guaranteed. Under the common currency deposit transfers from domestically domiciled banks in countries at risk of euro exit (e.g. Greece, Spain) to banks domiciled in other euro nation states (e.g. Germany, Netherlands) was costless. Faced with any non-negligible perceived risk of a euro exit and thereby a devaluation loss, rational market participants should move all their deposit funds from the banks domiciled in the country at risk of euro exit to banks domiciled in nations at the Eurozone’s unassailable core.

In the United States we have 50 states and one central bank. There are fund transfers across states. But there cannot be any prospect of a secession of a state that will bring with it its own devalued currency. Hence, there is no incentive for deposit flights from banks in one state or region to another. Therefore, private markets, with a little help from the Fed, will close the financial circuit to the extent there are such fund transfers. The European Monetary System was supposed to work that way. And as long as no one worried about any country leaving the euro, it did. But once the risk of euro exit on Europe’s periphery raised its ugly head, the euro system became completely different. Peter Garber argued that, given such a perceived prospect, the euro system was a perfect mechanism for a deposit run. And once doubts arose in 2009 about a possible euro exit by Greece and Ireland, a deposit run began – and in earnest.

And Draghi’s speech also seems to recognize this flaw implicitly:

“There are some short-term challenges, to say the least. The short-term challenges in our view relate mostly to the financial fragmentation that has taken place in the euro area. Investors retreated within their national boundaries. The interbank market is not functioning….The interbank market is not functioning, because for any bank in the world the current liquidity regulations make – to lend to other banks or borrow from other banks – a money losing proposition. So the first reason is that regulation has to be recalibrated completely.

The second point is in a sense a collective action problem: because national supervisors, looking at the crisis, have asked their banks, the banks under their supervision, to withdraw their activities within national boundaries. And they ring fenced liquidity positions so liquidity can’t flow, even across the same holding group because the financial sector supervisors are saying “no”.

So even though each one of them may be right, collectively they have been wrong. And this situation will have to be overcome of course.

And then there is a risk aversion factor. Risk aversion has to do with counterparty risk. Now to the extent that I think my counterparty is going to default, I am not going to lend to this counterparty. But it can be because it is short of funding. And I think we took care of that with the two big LTROs where we injected half a trillion of net liquidity into the euro area banks. We took care of that.

Then you have the counterparty recess related to the perception that my counterparty can fail because of lack of capital. We can do little about that.

Then there’s another dimension to this that has to do with the premia that are being charged on sovereign states borrowings. These premia have to [do], as I said, with default, with liquidity, but they also have to do more and more with convertibility, with the risk of convertibility.

The truth is that “whatever it takes” (to use Mr. Draghi’s phrase that got the markets so excited late last week) has to deal with this issue of convertibility that Professor Garber highlighted years ago.  Furthermore, dealing with this issue means an unconditional backing of all of the national sovereigns including, yes, Greece. Because failing to stand behind ALL of the members of the eurozone contradicts the currency union’s central premise: namely, that it is permanent and indissoluble.

Openly discussing the possibility of a “Grexit”, then, simply exacerbates the current problem and sets up another round of speculative attacks as the vampire squids guess which is the next member to go. The problem is that it is unclear that all of the member states recognize the inherent logic behind this.

In particular, Germany and The Netherlands have made persistent and less-than-subtle threats to boot out Athens if the latter seeks to amend the terms of its bailout package. They and others, such as the Finns, are moving in the opposite direction from Draghi  These countries aren’t prepared to do “whatever it takes”, but instead are setting out firm limits as to how far they are prepared to go.

Specifically, one cannot just assume that the German Constitutional Court will keep rubber stamping the ECB, and that the Bundesbank will simply let the ECB go ahead and do “whatever it takes”. Lastly, it has become increasingly apparentthat, as a result of the bank run, the ECB’s exposure to the PIIGS is now larger than many in the markets now recognise. The Germans and other northern countries now know the extent of the involvement and that is what is causing them to withhold support of open ended bailouts.

But without securing German support, how do you stop the bank run?  Let’s reiterate:  these are POLITICAL and LEGAL problems, not economic ones.  The ECB can, as many of my fellow NEP bloggers have argued, always “write the check”.    But there are clearly political factors at work here which are preventing the ECB from taking on what should be a natural institutional role.  That it is not doing so is creating a situation whereby the deposits are leaving the banks on the periphery and going to banks in the core. The banks in the core lend to the System of European Central Banks (with basically the ECB “on the hook”) which then provide lender of last resort financing to the banks on the periphery.

It may be that by April the banks in Greece, Ireland and Portugal had lost half their deposits and the banks in Italy and Spain had lost a quarter of their deposits.   Interbank lending is plunging, as are the net foreign assets of the ECB.

To understand the eventual significance of this process, let us assume the bank run continues and the banks on the periphery overall lose the majority of their deposits, the banks in the core have corresponding huge claims on the ECB, and the lender of last resort position of the ECB is now equal to a majority of what was the outstanding deposits in the banks on the periphery.

What kind of a banking system is this? A dysfunctional and a highly unstable one. One would have a set of banks on the periphery that are massively dependent on ECB lender of last resort financing. What if the Germany court now rules that the ECB’s lender of last resort activities is illegal?  That would accelerate the run and created an even more dysfunctional banking system, as Eurozone banks would be disinclined to lend to their normal client base.

Add to that the proposed additional fiscal austerity which the Troika is proposing as a quid pro quo to help Spain’s impaired banking system (confirmed over the weekend by German Finance Minister Wolfgang Schauble) and you have a major problem on your hands. So what is the nature of the problem?

What is wrong is the distorted role of the ECB and the unstable nature of the euro banking system overall. If we simply trend the recent deposit run forward, within perhaps six months the majority of the original deposits in the peripheral countries will have departed. That would basically leave the ECB with a lender of last resort exposure to the periphery on the order of several trillion euros. That would represent a loss exposure equal to almost 40 times ECB capital (before revaluation of gold reserves). I do not believe central banks, as basically government entities, need to have a positive capital. But I think a loss exposure from possible euro exits by these peripheral countries would almost certainly create a huge crisis of confidence in the euro. What will Mr Draghi and the ECB do then?

What does “whatever it takes” really mean? It’s a paradox. To make his “whatever it takes” pledge credible, Mr. Draghi has to go well beyond the traditional boundaries of economic and central banking orthodoxy. But in going well beyond these boundaries, does Mr. Draghi risk creating another crisis of confidence in the euro?

This post originally appeared at New Economic Perspectives and is posted with permission.

12 Responses to "‘Whatever it Takes’ – How Far is the ECB Really Prepared to go to Save the Euro?"

  1. Elephant   July 30, 2012 at 6:33 pm

    Capital control may be imposed.

  2. Sonny   July 30, 2012 at 8:23 pm

    The Greeks will exploit this as long as the others(Germany), continue to pump funds in. It will fail, but when is the question. World markets are getting tired of all the BS. When the effect of the BS fails to move world markets, the party will be over.

  3. JohnD   July 31, 2012 at 12:06 am

    It is silly to talk about Greece "failing" when it is "the System" that has proven to have been a failure. The morons that set up the Euro system asked that, overnight, Greece become Germany.

    Wealth is created by applied ideas and labor of Humans. In every Nation. Financial systems must be set up to create the volume of money needed by every Human necessary to their activities that create wealth.

    Everyone knows that the money "given to Greece" goes directly to insolvent criminals running the major banks to cover their $Thousand Trillion derivative racket. Nations that have kept their banks out of their national treasuries are doing well regardless of whether their productive abilities compare with Germany.

    The Bankers must lose their banks which must be brought under national management, have the bad paper taken off the books and then be put in jail. Investment Banks can no longer be given keys to money printing presses. Nations must control the use of their own currency.

    The Euro System can only be a clearing house and a standard of value. Each country must be as smart as England, who kept their currency, and reintroduce their currency while staying in a Euro System that will properly value each nations currency, protecting currencies from speculative markets.

    I can't be the only person who understands this. I wish that all this light weight talk would just go away. I get so bored seeing it spread everywhere when the subject is so well understood by so many.

  4. R. van Ginderen   July 31, 2012 at 12:46 am

    It is important to remember that Draghi did not just proclaim the ECB would do whatever it takes, he said that it would do "whatever it takes", but "within the mandate of the ECB". This is a parable indeed: what the ECB can do within its current mandate, is not enough in the current environment to save the euro(zone). The financial markets have – for their own convenience – forgotten that Draghi attached the words "within our mandate". They only heard "and believe me, this will be enough". Actually… it won't….

    What is needed is a full-fletched banking, political and fiscal union in combination with a broader ECB mandate (stability of the financial system and viability of the euro, with less emphasis on the price stability mandate) and only then might the crisis possibly be solved – but only possibly still…

  5. Frances Coppola   July 31, 2012 at 5:16 am

    It's not really the ECB's decision, is it? It is Germany's. After all, they are funding this tragi-comedy. At some point they will say "es ist genug". Then the curtain will fall.

  6. Remco   July 31, 2012 at 6:55 am

    Eventually it will come down to the elections in the northern states (elections in the Netherlands September, Germany next year) and thus the voice of the public. If the politicians don't succeed in explaining the need and reason of fiscal balancing between north and south (writing a check for Southern Nations) the bomb will burst. There is a big difference between stating the intention of "doing everything we can" and pulling out the checkbook.

  7. JohnD   July 31, 2012 at 7:01 am

    Boring. Boring. More Boring…

    When Bernard Lietaer, former Belgium central banker who had as much to do as anyone with the present design of the Euro system, sat down for coffee with me at a Community Currency conference, Los Gatos, California, 1998, his main interest was currency solutions, ie, putting unlimited currency into the hands of every productive human being. http://www.lietaer.com/

    There is nothing more important than to do this. But, there is nothing less discussed when considering the present dead Euro financial system and US banking system.

    Why can't something substantive be talked about here. I constantly am being forced to check out the LaRouche's site for anything that is really going on. (Isn't that unforgivable?) But, He more and more is the only relevant source for real information.

    It is only a sign of the times that He is so out of bounds for everyone to talk about and I have to run across drivel like this.

    Sorry, just trying to wake up the troops. We must wrest back control over our nations and mass arrest the Bankers. There is no other solution.

    Nor, is there any other real problem I can think of not rooted in Banker's actions. Health is only one: http://www.youtube.com/watch?feature=player_embed

    Anyway. Boring, boring boring. But, I'm rambling…

  8. crouteaufromage   July 31, 2012 at 10:48 am

    well… the weak partners will start issuing tax receipts notes to pay their public servants. This receipts will be then "traded" on the street and or secondary market. Maybe… saving the Euro does not offer any other alternative. Local government might force public services companies to accept these tax receipts at face value. Recipients might decide to go on strike but… this might be the most effective way to diminish the largesse of the wealthfare state.

  9. John G   July 31, 2012 at 11:46 am

    Borrow 100,000 from the bank you've got a problem.

    Borrow 100,000,000 from the bank they have got a problem

    Not forgetting the Argentine, 10 years after default still largely shut out of international capital markets.

  10. Matt Dubuque   August 1, 2012 at 10:00 pm

    Draghi is going to consent to a banking license for the ESM, sextupling its firepower.

  11. napoli   October 5, 2012 at 1:27 pm

    Youre a mafia guy like every common sifilitic man! Go sell yourself to mafia, go!

  12. napoli   October 5, 2012 at 1:28 pm

    Marshall Auerback Youre a mafia guy like every common sifilitic man! Go sell yourself to mafia, go!