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?

About Marshall Auerback 37 Articles

Marshall Auerback has 28 years of experience in the investment management business, serving as a global portfolio strategist for RAB Capital Plc, a UK-based fund management group with $2 billion under management, since 2003. He is also co-manager of the RAB Gold Fund. He serves as an economic consultant to PIMCO, the world’s largest bond fund management group, and as a fellow of the Economists for Peace and Security.

From 1983-1987, he was an investment manager at GT Management (Asia) Limited in Hong Kong, where he focused on the markets of Hong Kong, the ASEAN countries (Singapore, Malaysia, the Philippines, Indonesia, and Thailand), New Zealand and Australia. From 1988-91, Mr. Auerback was based in Tokyo, where his Pacific Rim expertise was broadened to include the Japanese stock market. From 1992-95, Mr. Auerback worked in New York for the Tiedemann Investment Group, where he ran an emerging markets hedge fund. From 1996-99, he worked as an international economics strategist for Veneroso Associates, which provided macroeconomic strategy to a number of leading institutional investors. From 1999-2002, he managed the Prudent Global Fixed Income Fund for David W. Tice & Associates, an investment management firm, and assisted with the management of the Prudent Bear Fund.

Mr. Auerback graduated magna cum laude in English and philosophy from Queen’s University in 1981 and received a law degree from Corpus Christi College, Oxford University, in 1983.

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