Better in their words…

And who is talking about this?
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By BENN STEIL AND PAUL SWARTZ

Week after week, market watchers hang on the German chancellor’s every pronouncement about the euro-zone’s debt travails, so one might be forgiven for thinking that Germany has been propping up the whole troubled enterprise. In fact, the European Central Bank has for the past 15 months been manning the front line. That’s been politically expedient, but it’s also an even bigger threat to the survival of the euro than is the restructuring of euro-zone bank and sovereign debt that the ECB has been so determined to avoid.

Europe has been playing a destructive game of pass-the-dodgy-debt for two years now. Much of this debt ultimately winds up at the ECB, though the schemes that get it there are often so disgracefully disguised that they would attract high-profile government crackdowns were they to occur in the private sector. The Irish National Asset Management Agency, for example, buys bad bank debt with newly conjured government IOUs, which the banks then pass on to the ECB for cash, making it look like a run-of-the-mill central bank liquidity operation.

With attention on the €116 billion in sovereign bonds the ECB has gobbled up since May 2010 (a third of which it acquired in the past three weeks), little notice has been paid to the €525 billion that the ECB has lent to banks, often against highly suspect collateral.

If the ECB winds up duplicating its share of the Portuguese, Irish and Greek (PIG) bond markets in Spain and Italy, it will soon find itself with €400 billion of sovereign IOUs, bringing its total market exposure to almost €1 trillion. To put this in context, total lending from all other high-profile European facilities adds up to less than €75 billion.

With only €81 billion in capital, the ECB has naturally been “talking its book” in railing against the horrors of sovereign debt restructurings. A 25% haircut on its direct and indirect PIG holdings could render it technically insolvent. That would oblige it either to abandon any pretext of inflation-targeting and print its way through a shortfall, or to join the queue for bailout funding from Germany and other solvent northern European countries.

The first option, rolling the dice with future inflation, is not as far-fetched as the ECB would like the market to believe. The central bank has many times over the past 15 months failed to sterilize its bond purchases, meaning that it has been unwilling to allow interest rates to rise to the level that would be required to ensure a neutral effect on the money supply.

The ECB has in any case been steadily losing control of its monetary policy levers over the past year. In 2000, the bank’s first president, Wim Duisenberg, explained that its framework for implementing monetary policy was working well because it was successfully “steering short-term market interest rates” where the bank wanted them to go. That was indeed the case prior to the financial crisis: The ECB’s policy rate was tightly connected to important short-term interest rates, such as the three-month government borrowing rate.

In a growing swath of the euro zone, however, this is no longer the case. The correlation between the ECB’s policy rate and actual government borrowing rates in Spain, Greece, Italy, Ireland and Portugal has plummeted since the ECB began its debt-buying program. In Spain the correlation has fallen from nearly 100% to nearly zero. The market’s view of default risk on euro-zone government debt has increasingly come to dominate these rates, which strongly influence borrowing rates in the private sector. By Duisenberg’s criterion, monetary policy in the euro zone is becoming less and less effective as the ECB wades deeper and deeper into the political quicksand of fiscal policy and discretionary credit allocation.

If Germany is not going to countenance the inflation option, however, a bailout of an undercapitalized ECB will be necessary. Yet if Germany is going to wind up backstopping much of the bad peripheral debt that winds up with the ECB in any case, its resistance to eurobond issuance is irrational. Germany could demand strict fiscal conditionality from peripheral governments as the price for their borrowing with German guarantees, but Germany has no leverage if the ECB simply continues buying up PIG debt and then sticks Berlin with the default bill.

Mr. Steil, a co-winner of the 2010 Hayek Book Prize, is director of international economics at the Council on Foreign Relations, where Mr. Swartz is an analyst.
Benn Steil and Paul Swartz: Who Would Bail Out the European Central Bank? – WSJ.com.