There are several problems in the details of how the European Central Bank plans to intervene in the continent’s government bond markets.
In the first place, it requires that a country ask for assistance and agree to a fiscal austerity program. There’s a very strong possibility that no country will want to admit that it is so crippled that it needs central bank assistance—at least, not before circumstances become epically dire.
The Federal Reserve ran into this sort of problem in 2007. Banks that needed to borrow were willing to pay elevated levels in the interbank market rather than go to the Fed’s discount window. Banks apparently believed that heavy borrowing at the discount window would be viewed as a sign of financial distress—so they just stayed away from it.
In order to inject more reserves into the banking system, the Fed wound up creating an anonymous auction facility that allowed banks to borrow without going to the discount window.
A very similar dynamic could keep countries away from the ECB bond window. Think about it politically: How long would a ruling party that goes begging for a bailout and hands its fiscal sovereignty over to the ECB stay the ruling party? This is the sort of thing that brings governments down.
Another possible stumbling point is the need for an agreement on the terms of fiscal austerity between European financial regulators and a government of a country requesting assistance. What seems reasonable to, say, Spain might not seem reasonable to the European regulators, and vice versa.
I’m not convinced the ECB is very credible when it says it will cut off a country from the bond program if the country defects from its fiscal commitments. This would certainly trigger gigantic political and economic crisis—it could even destroy the euro altogether. The most likely result would be a series of renegotiations of the fiscal terms. The beneficiary countries will know that the ECB cannot really terminate the bond buying programs, which all but guarantees that they will not stick to the fiscal commitments.
The most serious problem with the plan is that having the ECB buy bonds would instantly serve to subordinate loans held by private creditors. As we saw in Greece, this means that losses suffered by private creditors during a default will be deeper because the ECB will be paid in full.
Officially, the ECB says that it will buy the loans on a pari passu basis—meaning, that it won’t be senior to private creditors. But this promise lacks credibility. In a fiscal crisis or default situation, the ECB will be in a much better position to negotiate than private creditors. When the haircuts are going around, the ECB will be the last in line.
Investors may charge a premium for this subordination—if they are willing to buy the bonds at all. So the ECB bond program could have the perverse result of raising the rates charged by private creditors or even shutting the beneficiary out of the market all together.
Remember that the possibility of getting forced out of the market is one of the main penalties for defaulting on debt. So participating in the ECB’s bond program could be the financial equivalent of defaulting on debt.
I’m not saying the program won’t work. Just that there are serious risks that it won’t work as advertised.
But what do I know? The markets seem to love the ECB plan.
by CNBC.com senior editor John Carney
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