“The European Central Bank’s second and final 3-year, long-term refinancing operation is coming tomorrow and while analysts are finalizing their bets on the take-up, they generally agree on one thing: The optimism is over.
The ECB’s massive liquidity operation has effectively removed the possibility of a banking crisis in the short term by averting a liquidity crisis and giving banks tons of cheap cash. Consequently, Spanish and Italian banks in particular purchased vast amounts of Italian and Spanish debt, as those bonds can be used as collateral against borrowing from the central bank.
That’s all been positive in the short run. In fact some optimists even suggested that this could bring an end to the crisis by relieving so much pressure off the banks.
But by now, everyone’s recognized that there are major flaws in this argument.
Italy and Spain
Italian and Spanish banks have borrowed from the ECB in record quantities and appear to have made sizable investments in domestic sovereign debt because they can make a profit off the difference between the interest rate on that debt and the one percent interest charged by the ECB.
This makes a lot of sense; if one of the countries were allowed to default, domestic banks would be dealing with complete economic collapse. Default on sovereign bonds would prove just a trivial piece of a much greater catastrophe.
In a closed economy, increasing domestic bank exposure to sovereign debt in order to pull an economy out of a trouble spot makes sense. So long as banks are there to buy up government debt, the government can issue as much debt as it wants and always find buyers. It can even give money to fund people and businesses and that excess money will eventually find its way back through the system as it’s pumped through the financial system via saving and lending.
Even in an economy with a single currency, currency risk will discourage (though not completely deter) investors (people, businesses, and banks) from putting money abroad.
The structure of the eurozone, however, completely eliminates this currency risk, and in fact encourages investors in one country to keep their money in another if its economic prospects are better. And despite currency risk, the prognosis for the euro area—and thus the euro—is so uncertain in the long term that many investors are willing to overlook the currency risk of holding American or Japanese assets because of the assurance that those investments will be worth something someday.
This chart illustrates what’s going on.
Simone Foxman for Business Insider
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