The ECB, eternal and infinite

Economist
December 21, 2011

The European Central Bank has come under criticism for its failure to act as lender of last resort to embattled sovereigns. Yet when it comes to banks, the traditional recipients of central bank support, the ECB is lender of last resort on steroids. Today, it lent €489 billion to 523 banks at 1%, at its first three-year refinancing operation. It was its largest refinancing ever.

Banks used some of that to pay off shorter term loans from the ECB. Even so, net lending of €235 billion brought the ECB’s total loans to banks to almost €1 trillion. Mario Draghi, the ECB president has repeatedly insisted the ECB’s purchases of government bonds were neither “eternal nor infinite”, but that clearly doesn’t apply to its lending to banks. As banks’ private sector funding dries up, the ECB has supplied not just all the short-term funds they need, but all the dollar funds they need (via the revamped swap lines from the Federal Reserve) and now long-term funds as well.

This operation is crucial to understanding the ECB's strategy during the crisis. I recently returned from Europe with, I think, a better feel for the different points of view there. Both the ECB and its critics agree on the ultimate solution to the crisis: some form of joint liability for the region's debts coupled with a political compact that enforces fiscal responsibility on member states. Where they differ is the responsibility of the ECB in making that happen. The ECB's critics note it will take an agonizingly long time for the politicians to deliver. In the meantime the ECB must be lender of last resort and so keep sovereign insolvency from becoming a self-fulfilling prophecy. In refusing to do so, it is allowing a vicious cycle of austerity, bank runs and deleveraging to choke the economy and destroy public support for the euro; the ECB may end up the central bank of a non-existent currency.

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