Seamus Coffey: Only the unlimited balance sheet of the ECB has the necessary firepower to solve this crisis
THE eurozone dominoes are lined up and seem set to fall. Greece has been hopelessly propped up for nearly two years now and the latest EU summit in Brussels tried to let it fall gently without harming other countries that looked like they could topple with it. This has failed.
In the past week Italy has come under enormous pressure and its ten-year government bonds yields have finished above 7pc on two occasions. Yesterday saw these doubts spread further with rises in the yields of Spain, Belgium and also France. Over the past six weeks the French ten-year yield has increased from 2.5pc to 3.7pc.
This is still well clear of the danger zone but the trend is heading in that direction. Similarly, Belgium has also seen a rise from 3.6pc to 4.9pc. More worryingly, Spanish yields have gone from from 4.0pc to 6.3pc since the start of October and are once again approaching the 7pc level. German ten-year yields are 1.8pc, just as they were six weeks ago.
There are two countries bucking the trend which have seen their yields fall in the midst of the market turmoil: Ireland and Portugal. On the 25th October, Portuguese yields were 12.5pc; yesterday they finished at 11.3pc. A month ago, the nine-year yield on Irish government bonds was 8.6pc and yesterday it was down to 8.0pc. Ireland has junk status with one ratings agency but the yield on its bonds are less than one percentage point higher than those of A-rated Italy.
Of course, Ireland and Portugal are in EU/IMF rescue programmes and are not issuing new debt in bond markets. Any new finance that they need is sourced from EU/IMF loans. It is noteworthy that as doubts have spread throughout the eurozone over the past month that two of the weakest countries should have the strongest performing bond yields. Of course, they were at distressed levels to begin with but they are moving in the right direction.
One reason for this is that Ireland and Portugal have secure access to funding and although the rescue deals were not initially designed to serve the purpose they do show the value of having even a temporary lender of last resort. As long as Ireland and Portugal continue to meet the targets of their programmes they will be able to draw down the necessary funding to meet their borrowing requirements and rollover existing debt.
Italy, Spain, Belgium and the rest of the eurozone do not have this security. Market participants can target these countries with little fear as the countries have no option but to stay in these markets to raise new finance. On Monday Italy had to pay 6.3 PC interest when issuing a new five-year bond.
Italy can only sustain borrowing at these rates for a few months. With no where to turn to but bond markets there is no reason for the yield to fall. In a short time those who are now selling Italian government bonds will earn a return by buying them back at a lower price.
The ECB has bought some existing sovereign bonds on the secondary market but has no mandate to purchase new issues. Italy has no choice but to issue new bonds in the markets and holders of these can then choose to sell them on to the ECB if they wish. The ECB can step in to try and moderate the bond yield in secondary markets but cannot step in to offer direct support to Italy as it tries to issue new debt.
In order to prevent a run on sovereign bonds a country needs to have access to a credible lender of last resort. This is somewhere governments can turn if the yields required by bond markets get “too high”. However, it may not even be necessary that a government use the lender of last resort. The mere fact that such a facility exists means that an attack on a country’s bonds by traders would be futile which would prevent the attack happening in the first place.
The United States has a total debt that, in relative terms, is just below that of Italy and has an annual deficit that is almost three times as large, yet US ten-year yields are 2.0 PC. The US debt situation is worse than that of Italy but its yield is nearly four times lower. This is because there are few who doubt that the US will be able to rollover its debts.
If yields for US government bonds rose, the US Treasury would simply turn to the Federal Reserve to allow the government to borrow at “affordable” rates. There is no gain in shorting US government bonds as the US will always be in a position to repay. Hence, the US Treasury can nearly always raise sufficient funds from the markets and rarely requires the Federal Reserve to support it. The mere presence of a lender of last resort keeps yields low.
That is not to say that a lender of last resort is the cure to all the current ills in the eurozone. The problem the eurozone faces now is structural but it has been surfaced because of fiscal profligacy; eurozone countries have been spending too much money and accumulating too much debt. Eurozone countries must increase taxation or reduce expenditure.
A lender of last resort is useful to control borrowing costs but it becomes a problem if countries become too dependent on it and force their central banks to print too much money. The US addresses this problem with the Congress-controlled debt ceiling, an upper limit on the size of the government debt.
This came to the fore in August this summer when US government debt approached the $14.3 trillion limit. The US Treasury could easily have raised new debt via the Federal Reserve but was legally restrained from doing so because of the ceiling. Of course, the ceiling was increased (to €16.4 trillion) but the debate did bring to the fore the spending that was causing the debt to rise and the costs of carrying such a huge amount of debt.
In Europe, the ECB could act as a lender of last resort like the Federal Reserve. It is currently legally prevented from doing so. Europe also does not have the architecture to impose fiscal discipline that is necessary to ensure that such a facility is not abused. The cost of the ECB printing money would be increased inflation which Germany in particular wants to avoid.
In Ireland’s case we have seen the discipline that can be introduced as part of an EU/IMF rescue. This approach can be used for relatively small countries such as Greece, Ireland and Portugal. The EU and IMF simply do not have the resources to undertake similar programmes for even one or Spain or Italy. Only the unlimited balance sheet of the ECB has the necessary firepower.
Even without a lender of last resort eurozone countries have managed to accumulate too much debt. A lender of last resort is a solution to the short-term problems faced by the eurozone but much more is needed to address the structural changes that need to be introduced to preserve the euro in the long term.
This will involve greater regulation of banking systems and control of national finances at European level. For many this would appear to be a large cost, but that is the cost that must be paid if the benefits of a common currency are to be realised.
Seamus Coffey is a lecturer in economics at UCC and a blogger at http://economic-incentives.blogspot.com
