- By Phil Levy<p> Phil Levy teaches international economics at Columbia University's School of International and Public Affairs. </p>
Ah, the emotional roller-coaster ride that is modern central banking; the way our collective hopes and mutual funds soar and plunge with the advent of each new acronym from Europe – EFSF, SMP, and LTRO. Yesterday, a new bout of global financial euphoria erupted with the ECB announcement of OMT. The Financial Times lead headline proclaims: "ECB signals resolve to save euro."
To set the scene, the troubled nations along the periphery of the eurozone have recently been plagued by high and rising interest rates when they try to borrow. For countries that have racked up a substantial amount of debt, high interest rates translate pretty quickly into spending obligations they cannot meet. Greece, Ireland, and Portugal all had problems of this sort, but were small enough to be bailed out by their eurozone brethren. Spain and Italy are too big for that, so when their interest rates began to climb, it looked like a mortal threat to the euro project.
Traditionally, when a sovereign nation has bills it cannot pay, it can resort to printing money. The central bank will buy up the sovereign’s unloved bonds, thus injecting newly-printed money into the economy, driving up the price of the bonds, and, in turn, driving down interest rates. But Spain and Italy cannot do that. A key facet of having a common currency is that only the European Central Bank (ECB) has this power. Yesterday, the ECB came up with yet another plan to do so.
Why so many plans? Why not just print money until the pain goes away? There’s a downside to the printing. When countries satisfy insatiable spending desires by printing money, ever-increasing piles of currency chase after a limited number of goods and inflation ensues. There are cautionary tales seared into national memories, like the scenes from Weimar Germany in which people carried wheelbarrows full of cash to make their daily purchases.
With such memories in mind, Germany demanded some conditions when it gave up its Deutsche Mark for the euro: No bailouts and no central bank financing of sovereign borrowing. The ECB would have a mandate even simpler than that of the Fed in the United States — it would just seek to avoid inflation. These strictures have proven an obstacle for the modern ECB, as it has sought to engage in bailouts and central bank financing of sovereign borrowing.
So how did the ECB end up choosing between its founding principles and the salvation of the euro project? For much of the last decade, lenders perceived sovereign bonds around the eurozone as equally safe, more or less. Spain could borrow at rates close to those that Germany faced, all of which were low. Then, in the wake of the financial crisis, these "spreads" — the difference in borrowing rates — began to grow. Germany still paid very little, but Greece, Spain, Italy and others began to pay a lot. There are a couple different explanations for why, and which one you pick should largely determine whether you think yesterday’s ECB action will work.
Explanation #1: While Greece had real trouble, markets panicked and fled from otherwise viable economies. This looked like a classic bank run, in which a healthy institution could be run into the ground under a public stampede. Just as in a bank run, if a lender of last resort steps in and reassures the twitchy masses that everything is fine, that reassurance will be self-fulfilling. In the case of Spain and Italy, the argument would go, if people were not so worried about the countries’ ability to finance their debts, they would charge lower interest rates and the countries would have no trouble financing their debts. In this scenario, the ECB’s move yesterday was its boldest attempt yet to quell the panic.
Explanation #2: When Greece got into trouble, it roused investors from their slumber. Whereas they had previously just assumed that all euro zone sovereigns were equally risky, they now pored through the books more closely. They did not like what they saw. Countries were on unsustainable fiscal paths. The ratio of debt to GDP was high and climbing. There were attempts at government reform, but they were politically painful and looked in any case to be too little, too late. Better to get out while one could. Sell.
While the ECB is largely betting on the first explanation, it is worried about the second. Under its new plan for Outright Monetary Transactions (OMT), it will buy up the debt of troubled countries. It significantly relaxed two limitations it had earlier put on such measures: it is not demanding that it get repaid before everyone else (a clause that had scared away private investors) and it is lowering standards for the kind of collateral it will accept. At the same time, countries must formally ask for help and sign up to a reform program. Further, the ECB will only buy short-term debt.
A number of problems loom:
- Political dissent. The German representative to the ECB, Jens Weidmann, appears to have voted against the plan and said it was "tantamount to financing governments by printingbanknotes." German Chancellor Angela Merkel backed the ECB move, but has been criticized for doing so.
- Any takers? Past eurozone programs, such as the SMP, have not been fully utilized. In the case of OMT, the big question is whether Spain or Italy would be willing to seek a formal assistance program — a politically perilous humiliation.
- Will it work? Sovereign debt is ony part of Europe’s economic crisis. Short term rates are already low, but they are not being passed on to private borrowers in the afflicted countries. It is unclear how the OMT will change that.
- Moral hazard. It is difficult to see how the ECB would extricate itself from one of these programs, should a country fail to undertake successful reforms. In theory, of course, it could just stop. But if the ECB cannot tolerate the thought of a Spanish failure now, how much worse will it look down the road when the ECB’s balance sheet is stuffed with Spanish or Italian bonds and it has waived any rights to be paid before other investors?
If recent experience is a guide, there will be a period of elation on the belief that the ECB has solved the euro zone problem. Then people will begin to read the fine print and the roller coaster will begin its next descent.