Before Christmas, TH asked a bunch of not so nerdy economists whether the euro crisis was/is a liquidity crisis or a solvency crisis. There was no shortage of liquidity amongst TH’s buddies and the ensuing discussion was a bit reminiscent of this Monty Python classic:
So what is the answer: Liquidity or solvency? Is there a run on Europe’s sovereign bond market or are some more governments on the verge of default? Fortunately, the ECB has helped answer the question – its both.
The ECB’s balance sheet grew by 10% in the week before Christmas due to a doubling of its long-term refinancing operations (cheap long term loans to banks). This means that euro area banks have suddenly been injected with an abundance of cash. With the ECB now lending freely to banks, any liquidity crisis should have been washed away (at least for now).
So what happened? Italy is Europe’s canary in the coal mine right now. It just had a big long term bond issuance. Unfortunately, despite the ECB’s action, Italian 10 year bond years have only been marginally affected. They are still hanging about at 7%, which is the lucky number that triggered IMF program for Greece and Portugal. Thus, the injection of liquidity did nothing the help with long-term borrowing issues. If 7 percent is an unsustainable yield for Italy, then it looks as if Italy could be insolvent. That being said, Italy has a good history of debt tolerance at high bond yields, so TH reckons there is a reasonable chance that the Italians could get themselves out of this.
Second, there clearly was a liquidity element to the euroarea crisis before Christmas. Since last week’s LTRO operation, short term borrowing costs for the Italian government have fallen sharply. It appears that bond holders are no longer worried that the Italian government won’t be able to repay in the next few months simply because of rollover risk (i.e. the risk that the Italian government won’t be able to refinance its debts that are coming due, a bit like someone might be worried that banks may not refinance their mortgage due soon).
So, it seems that all of TH’s mates were right. Europe was suffering from both types of crises. The ECB seems to have resolved the liquidity shortage for now. The much more challenging question is: can a central bank resolve a solvency crisis?
What do you reckon? Feel free to comment. Thanks to Mr Kilmatin Esq., Melany (the anonymous lover of fine shoes), Nether bee Ricardo S-K and Mr Frene for their comments. A post on tariffs and subsidies is on its way.