Suppose you suddenly needed a new car, so you rush right out to the showroom, and your eyes fall upon this shiny new luxury sedan loaded with extras. The engine roars, the stereo sings, the seats envelop you like your mother’s arms, and the tires squeal delightfully as you drive home to explain to your spouse why you needed this dream machine. Oh, you forgot to ask about the price?
This is probably the easiest way to understand the consequences and context of European Central Bank (ECB) actions over the past few months. Facing a liquidity crisis and a banking crisis and a sovereign debt crisis all wrapped into one on top of a currency crisis, the ECB went into action.
Through the Long-Term Refinancing Operation (LTRO) the ECB pumped about 1 trillion Euros into the European banking system at a rate of just 1 percent interest. The banks then used the funds largely to buy the dodgy bonds of Europe’s periphery. Voila, sovereign bond rates go down, bank profits got a quick sugar high, and Europe’s banks lived to see another day.
Like almost all of official Europe’s responses to the crises surrounding and following from the Euro, the ECB’s actions addressed the immediate crises while buying time to solve the underlying problems of unsustainable government debt and unsustainable balance-of-payments imbalances among Euroland members. The ECB bought time. Most of the focus has been on whether that time will be put to good use. So far, not so much.
Apparently, nobody asked about the price. Europe’s collective mailbox is filling with statements detailing the price. For example, the banks that bought the dodgy sovereigns (often at the firm behest of their governments) have enjoyed earning around 4 percent on money for which they paid the ECB 1 percent. Spanish banks are reported to have bought sovereigns worth 67 billion euros in December and January, while Italian banks bought 54 billion.
But now the interest rates on those bonds are rising again and threaten to rise much higher much faster, creating paper losses that will someday become realized losses far larger than the extra bit of profit earned earlier. This can only get ugly.
Modern central banks are adamantly opposed to monetizing the debt of countries running large deficits. There are few more sure paths to ultimate inflationary ruin. Official Europe has long shared this aversion, most especially the Germans, repeating again and again that this would never happen. But, of course, that’s exactly what they have done, but with a paper-thin twist. Rather than have the ECB simply soak up the debt of Italy, Greece, et al directly, they gave the banks the cash and encouraged the banks to buy the bonds.
This is actually part of a subtext to the Euro crisis. One can generally predict what the Europeans are going to do by the force of their denials that they won’t. Markets notice these sorts of things, so when German Chancellor Angela Merkel insists there is no need for a bigger bailout fund, one knows it’s coming. Spanish Premier Mariano Rajoy says, “To talk about a bailout for Spain at this moment makes no sense.… Spain is not going to be rescued. It’s not possible to rescue Spain. There’s no intention to. It’s not necessary, and therefore it’s not going to be rescued.” So many denials in so little time. He must believe Spain’s next crisis is on the doorstep.
The biggest price to be paid for the ECB’s actions may yet lie in the future. It’s akin to simple physics: Actions produce reactions. One possible reaction is that inflation will really and finally take hold in the stronger countries like Germany. Alternatively, to avoid the surge of inflation, the ECB may reverse itself if only by allowing the LTRO to unwind. Having pushed interest rates down when they were little responsive, the ECB will then be pushing interest rates up just as credit markets tighten.
One might think of this as buying the fully loaded shiny new luxury sedan on credit. Drive now, pay later. And oh, what a price it will be.