Streetwise Professor

In the ongoing European crisis, everyone is looking at the European Central Bank to ride in to save the day.  The ECB is to serve as the lender of last resort (LOLR) for sovereign borrowers suffering liquidity problems.

There are two major problems with this.  First, lending to sovereigns is very different than lending to private institutions.  Second, there is a substantial probability that there are solvency problems for many European sovereigns.

The idea of an LOLR is that it can provide liquidity to financial institutions that cannot fund themselves on the market due to runs or the unwillingness of creditors to roll over debt.   These funding problems can arise due to a coordination problem among depositors/creditors.  The LOLR can prevent the coordination on an inefficient “run/don’t fund” equilibrium, meaning that just its existence can prevent the occurrence of runs, and if a run does indeed occur, it can mitigate its adverse effects.

In the 19th century Bagehot described the basic rules for the LOLR: lend against good collateral, at penalty rates.  This has been the mantra of central bankers ever since, although in the crisis both of these principles were pushed to their limit–and perhaps beyond.

The penalty rates aspect of the Bagehot formula is to ensure that healthy institutions do not attempt to get cheap funding at the central bank’s expense.  The collateral aspect is intended to increase the likelihood that the borrower is in fact solvent–it has assets sufficient to back the loan that is being extended to it.  Of course, valuing that collateral is a challenge, particularly in times of market stress when fire sale problems can cause the market values of assets used as collateral to plunge.

The Bagehot formula doesn’t work well with sovereigns.  What collateral will Italy pledge, for example?  The Uffizi Gallery?  The Coliseum?

But there is a more fundamental problem.  It has long been known that sovereign debt is different than private debt because of the higher cost of enforcing payment on sovereign debt.  Indeed, it is something as a puzzle as to how sovereign debt can exist in the first place: why would the sovereign ever repay?  One answer is that reputational concerns lead to repayment.  But it is prohibitively expensive to rely on reputation to enforce every debt contract in every state of the world: sometimes the benefits of avoiding existing debts exceeds the cost of not being able to borrow more in the future.

Since sovereign debt is different, and far more difficult to collect on–due to the lack of collateral and the high cost of enforcement of the debt contract–an LOLR to a sovereign is in an entirely different position than an LOLR to a private entity.   One should therefore be very cautious about extending the LOLR model from banks to countries.

This likely explains the ECB’s reluctance to commit to serving as the LOLR for Eurozone countries.

The European governments are trying to entice the ECB by providing political promises and ad hoc treaty changes to serve as a substitute for collateral, and as a way to enforce the payment of sovereign debts.  Last Friday’s “deal” was just the latest attempt at this–and the latest failure.  It is evident that the mechanisms advanced by Sarkozy and Merkel are inadequate.  First, they are just a variant on the pie crust promises made–and broken–in the past.  They will be, for instance, just another invitation to engage in Greek-style accounting and financial engineering.   Second, the mechanism of a “fine” for violation of deficit limits is something of a joke.

And consider the full game tree.  Let’s say that based on the promises of big borrowers to behave in the future, the ECB buys huge amounts of Greek, Italian, Portuguese, etc., debt today.  It now faces tremendous credit risk, and is at serious risk of holdup.  For example, if the ECB holds several hundred billions in Italian debt, and a year from now Italy has not made serious progress on restoring its fiscal balance and as a result is facing continued difficulty in rolling over its debt, what is the ECB going to do?  Will it say to Italy: you didn’t live up to your commitments, so you’re on your own?  Then Italy spins into the abyss and the ECB suffers a huge credit loss–and almost certainly becomes insolvent itself.  It can’t seize and sell collateral (see above).

No, instead, the ECB is likely to throw good money after bad.  Knowing this, Italy can play hardball with the ECB, and fade its commitments to fiscal probity.

It’s like the old joke.  If you owe the bank $1000 and you can’t pay, you have a problem.  If you owe the bank $1,000,000,000 and you can’t pay–the bank has a problem.  (Cf. Donald Trump’s bankers.)   And if you, sovereign borrower, owe the ECB on the order of 100 (or 500 or 1000) times that, the ECB has a big problem.  Lending today effectively commits it to lend more and more and more in the future.

Given this reality, the ECB’s response to the “deal” has been equivocal.  It understands the game tree.  It understands that the mechanism proposed by Sarkozy and Merkel does not overcome the fundamental problem with sovereign debt.  It understands that lending huge amounts to Italy or another European government today will put it in a position where it will feel compelled to lend even more in the future.

The markets’ response to the ECB’s equivocation has pretty brutal: European credit spreads widened, the equity markets have sold off, and the Euro is down about 1.5 percent.

Sarko in particular is panicking.  Here’s all the evidence you need: given that the ECB won’t lend to countries directly, he is proposing to launder the money through European banks:

At its monetary policy meeting on Thursday, the ECB offered ultra-long 3-year financing to banks and eased rules on the collateral it requires from them to tap its funds. It also cut its interest rates to a record low of 1.0 percent.

Euro zone leaders seized on the increased liquidity provision as a means to help fight the debt crisis, which has pushed up borrowing costs for countries on the periphery of the bloc – including G7 economy Italy – to unsustainable levels.

French President Nicolas Sarkozy said the ECB’s increased provision of funds meant governments in countries like Italy and Spain could look to their countries’ banks to buy their bonds.

“This means that each state can turn to its banks, which will have liquidity at their disposal,” Sarkozy told reporters at the summit in Brussels.

No problems with that plan. None whatsoever.

Well, other than the fact that European banks are hugely leveraged; have been under pressure to increase capital which they have done by shedding assets, including the debt of the riskier European countries; and are effectively backed by the very sovereigns whose debt they are supposed to buy.  Sarkozy’s “plan” that undercapitalized banks buy more government debt and then use it as collateral for ECB loans creates the very same problem for the ECB as it would face if it lent directly to Italy or Spain: a huge exposure to European sov debt credit risk that would effectively force it to continue to buy, buy, buy in the future even if the fiscal condition of these countries stays bad or gets worse.

And it is beyond satire that someone like Sarko, who has conniptions over banks taking on sovereign credit risk via CDS, thinks it’s perfectly copacetic to take it on by buying the actual bonds.

The basic problems with sovereign debt and the parlous condition of European sovereign borrowers means that if the ECB intervenes aggressively today, either directly or indirectly via the Sarko cutout plan, it will likely be doomed to monetize in the future.  A LOLR to sovereigns can’t do the same things that a LOLR to private debtors can.  Sovereign debt is different.  If reputational effects, or different mechanisms, don’t induce governments to do today what they need to do to get the markets to fund them, why would these mechanisms get them to do that in the future?  Indeed, the problem is all the worse once the LOLR provides the funding today because those that it lends to can threaten to bankrupt it in the future if it doesn’t.

The ECB may capitulate.  It is under tremendous pressure.  But that won’t make the problem go away: it will just defer it and likely make it worse. We’ll just proceed down the game tree until the ECB prints like crazy.

What are the alternatives?  Relatively flush governments agree to assume some of the debts of the weak sisters?: but the willingness and ability of Germany, etc., to do that is limited.  An agreement that credibly commits borrowers to perform, and take measures that ensure their ability to do so in the future?:  given all the problems with negotiating and enforcing such an agreement, this seems farfetched.

No, the fundamental problems with sovereign debt seem to put all the conventional solutions out of reach.  Sovereign debt contracts have to be self-enforcing, and current conditions have put those contracts outside of the self-enforcing range, or at the very edge of it.  Making the ECB a sovereign LOLR won’t address these fundamental self-enforcement problems, and indeed, it may make them worse.