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Net Net: Promoting innovation and managing change

The Solution to European Debt Crisis Really Is More Debt

European Central Bank
Travelpix Ltd | Photographer's Choice | Getty Images

The European Central Bankopened up its new borrowing window on Wednesday and 523 banks showed up, hat and dodgy collateral in hand, to borrow $638 billion in three year loans.

The ECB is extending these loans at the extraordinary low interest rate of just 1 percent. This should provide a lot of relief to European banks that had seen their costs of funding soar due to fears of exposure to riskier sovereign debt.

One common reaction to all this borrowing is to ask whether the problems of too much debt in Europe can really be solved with more debt.

The surprising answer is that yes. In fact, more lending by the ECB is exactly what is needed right now.

A deadly trifecta struck the balance sheets of European banks this year: Sovereign bonds were downgraded, the market value of the bonds dropped, and counterparties began demanding much higher collateralization for transactions involving sovereign debt. In effect, the bonds lost their status as “cash equivalents” and became risk assets.

This meant that banks faced the prospect of having to reserve against the very assets they once used to reserve against other assets. To put it differently, in the past a bank making a corporate loan could reserve against losses on that loan by holding sovereign debt of Italy. The Italian bonds operated as good as cash in the banking system. These days, however, Italian bonds are viewed as riskier than many corporates.

This amounts to a giant monetary vacuum at the heart of the European financial system. Add to this the fact that U.S. financial institutions — from money market funds to banks — have cut their exposure to Europe, and you have a huge monetary shortage in Europe.

So what the ECB did was remonetize the asset base of European banks by allowing them to trade risk assets for cash. It moved to undo the effects of the demonetization of sovereign debt.

This might not go far enough to rescue countries like Spain and Italy.

So far, it looks as if banks are mainly engaged in balance sheet repair. They simply do not have the extra lending capacity to buy lots of new issue sovereign debt.

But even if this doesn’t end the problems of government issuers, it does stem the monetary contraction in European banks. A widespread financial collapse is now less likely than it was before the ECB undertook this lending.

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