The forces of contagion in the eurozone appear unstoppable. On Thursday investors drove yields on both Italian and Spanish debt to new highs, as fears grew that last month’s Greek rescue deal would prove insufficient to stop Europe’s financial rot. Without swift action from the European Central Bank, this will prove to be a contagion process with a disastrous end.
Why do we face these problems? Government bond markets in a monetary union are inherently fragile. Eurozone nations issue debt in a “foreign” currency, over which they have no real control. As a result, they cannot guarantee to the bondholders that they will always have the necessary liquidity to pay out the bond at maturity. States which issue their own bonds, however, can guarantee that the cash will always be available, because they can always force the central bank to create the money. And there is no limit to the amount of money a central bank can create.
This situation makes bond markets in a monetary union unusually prone to forces of contagion, very much like in banking systems. If one bank experiences a solvency problem, deposit holders start doubting the solvency of their own bank, and run to convert their deposits into cash. When everybody does this at the same time the banks will not have enough cash. This banking system instability was solved by mandating the central bank to be a lender of last resort – and the neat thing about this solution is that, when deposit holders are confident that it exists, it rarely has to be used.
The problem faced by the member countries of a monetary union such as the eurozone is exactly the same. Therefore, the solution is the same. Contagion between sovereign bond markets can only be stopped if there is a central bank willing to be lender of last resort. The only institution able to perform this role is the ECB.
The ECB initially performed this role in a timid way, while making it clear that it was unwilling to continue doing so. Indeed, this reversal in the ECB’s policy is the most important factor explaining why the forces of contagion in the eurozone’s sovereign bond markets cannot be stopped.
Europe’s leaders have tried to solve this problem by creating a surrogate institution, the European financial stability facility. Yet the EFSF will never have the necessary credibility to stop the forces of contagion – precisely because it cannot actually print money. It depends for its resources on the member countries of the union, and these are limited. As a result, it cannot guarantee that the cash will always be available to pay out sovereign bond holders even if its resources are doubled or tripled. Only a central bank that can create unlimited amounts of cash can provide such a guarantee.
The ECB argues that it can abandon its responsibility as lender of last resort, because to provide that guarantee gives wrong signals to politicians. It creates a temptation to add excessive government debt, because the ECB will eventually foot the bill. While this moral hazard risk is indeed a serious one, it is no different from the same risk in the banking system. The way to deal with this is not to abolish the role of lender of last resort, but to create rules that will constrain governments in issuing debt.
Stopping Europe’s current crisis requires fundamental overhaul of the eurozone’s institutions. But the most important part of that overhaul is to ensure that the ECB takes on full responsibility as a lender of last resort in the government bond markets of the eurozone. Without this, the markets cannot be stabilised and crises will remain endemic.
At the same time, further steps towards political unification must be taken, without which control on national government deficits and debts cannot be implemented. Some steps in that direction were taken recently when the European Council strengthened control of national budgetary processes and on national macroeconomic policies. These decisions, however, are insufficient, and more fundamental changes in the governance of the eurozone are needed. These should be such that the ECB can trust that its lender of last resort responsibilities in the government bond markets will not lead to a never-ending dynamic of debt creation.
By Paul De Grauwe, The writer is professor of economics at the University of Leuven, August 3, 2011