ECB, liquidity, and sovereign debt

21 December 2011

The ECB has been keeping its powder dry compared to other central banks, but given the very difficult economic situation in Europe, it has started to do things more proactively, or fired its first volley. There have been concerns about liquidity, in that banks were not trusting each other, therefore they were not lending to each other, and the interests for banks borrowing money from other banks were rising. When banks don’t lend to each other, they won’t be lending to businsses. Another bout of severe credit crunch beckoned. To use an organic and medical metaphor that some people wheel out, the economic body will have suffered yet another massive coronary, because money is its blood and the financial institutions are its heart, and credit crunch is a blood clot. In an attempt to avoid such a situation, the ECB has offered cheap loans to banks, and collectively the banks borrowed 489,191 million euros. With an injection of a huge sum of money, it will ease concerns that banks harboured about other banks, and they will be more willing to lend to businesses.

This may address some of the issues surrounding banks’ liquidity, but it doesn’t really address the issue of sovereign debt crisis. The recent agreement is at best a route map and a declaration of intent for the medium to long term, but measures are urgently required to calm down the markets in the short term. The ECB can still, for example, print money and mop up the Italian and Spanish bonds, and the eurozone states can still decide to issue Eurobonds. I doubt that it is a question of economic feasibility as such, but political. The single currency has always been a political project as much as an economic one: the economically strong eurozone members, primarily Germany, will have to decide whether it is worth keeping the euro or not. If it does, then the euro is not beyond salvation, since there is a lot of firepower left in the ECB, and in the eurozone.

Or so I understand. But then, I don’t understand economics.