The problem with the eurozone crisis is that no one really knows what the problem is. It is probably fair to say, though, that the main failure is that key players all seem to have an incentive to take actions that ultimately end up making things progressively worse, which, in this case, may ultimately be the disorderly collapse of the common currency area and the associated repercussions.
Situations like this – when people’s well intended actions lead to bad outcomes – are not uncommon, and economics as a plethora of names for them: the prisoners’ dilemma, time inconsistency, the tragedy of the commons, and moral hazard are amongst them. Nash was the great thinker that formulated the mathematics behind the literature. In pretty much all of these situations, the fundamental problem is what is sometimes referred to as institutional design. It’s the institutionalised rules of the game that lead society to perverse outcomes. When it happens, the solution is to change the rules (see Brennan and Buchannan – the reason for rules).
The most obvious symptom of poor incentives in the euro area is that banks prefer to clear through the ECB rather than with one another. This is leading to the remarkable imbalances in Europe’s remarkable clearing house. Essentially, for one reason or another, banks prefer to have the ECB act as a central counterparty to settle positions rather the settle between themselves as they usually do.
This isn’t a bad thing. The ECB clearing house is designed to facilitate this indirect clearing to prevent the common currency from fracturing along national lines. Since it is a federation of national central banks, if the ECB did not offer to stand ready and ensure that demand for a euro member’s central bank liabilities always matched supply, then the central bank’s liabilities (national monies) would float in value against the others. So this is the vital link that keeps the euro zone a common currency area.
Nevertheless, it seems to be getting a bit out of hand, and suggests that there is a flaw. There are 2 key constraints on the extent to which banks use the system: their willingness (the profitability of using the Target system versus direct clearing) and the supply of “eligible collateral” which is the collateral a bank must post to get access to the system. The fact that it is profitable to do business via the ECB is no surprise. Right now troubled banks in France and Germany have a big incentive to get risk off their balance sheets (remember it was German and French banks that made bad lending decisions – they held a lot of subprime assets and also lent heavily to the Euro area periphery during the early stages of the crisis). So everything else constant, as the euro area crisis deepens, these banks will increasingly prefer a claim on the ECB than on periphery banks – it’s just good business sense. The solution is to charge these banks for a target deposit. Normally these banks receive interest on these deposits, but given that the return on German government bonds has recently gone negative from time to time, the banks should now be paying for it, otherwise they are being subsidised.
The reason that these banks should be charged for the privilege is not only that they are being subsidised, but that the subsidy is causing problems elsewhere. The thing is that when a German bank, say, chooses not to clear with the periphery, it necessarily forces the periphery to borrow from the EBC’s Target system, which requires that the periphery banks hold eligible collateral. Eligible collateral is the supply of supposedly high quality assets that the banks must post in order to borrow from the ECB Target 2 system. So, if a Greek bank has a shortfall in deposits (that might have been deposited in a German bank), then the Greek bank can borrow from the ECB by posting, say, government bonds as collateral. This is one reason why the demand for German government bonds has gone through the roof. It is considered to be amongst the highest of high quality eligible collateral, so banks are clamoring for it, and when that happens, the price of German debt goes up and the yield (interest rate) on the debt goes down (so much so that the yield has even been negative at times).
German bonds aren’t the only source of eligible collateral. Initially all euro area members bonds were treated equally and could all be used as eligible collateral – this equal treatment effectively created an artificial incentive for banks to demand the cheaper Greek or Portuguese bonds, and during the initial stages of the crisis, banks in the periphery found themselves buying not German bonds, but periphery government bonds, and lots of them. So Greek banks ended up with lots of Greek government bonds, which as the crisis deepened turned out to be not-so-high quality bonds. As Greece’s economic woes deepened, the debt was downgraded, and the Greek bonds are no longer considered to be eligible collateral. And having lost almost half of their deposit base due to deposit flight, the Greek banks have a huge need, but no way of buying eligible stuff. They are well, screwed (almost).
So what do you do when the Greek banking system runs out of eligible collateral? Well, one option is to let the banks fail; after all, if they have lack high quality assets and are dependent on the Target system for liquidity shouldn’t they fail, or at least get taken over by some other bank? But letting banks fail in the middle of a crisis is a risky business, and whatismore, it might exacerbate rather than resolve interbank settlement problems – recall the Lehman Brothers failure which cause massive interbank failure and catalysed the global financial crisis. For Greece, it would almost certainly mean that the liabilities of the national bank would no longer be a perfect substitute for those of Germany, and Greece would effectively be out of the euro area. Doesn’t sound good – this is what is meant by a disorderly exit.
The simpler (safer) option might just be to change the rules and lower the quality of the eligible collateral, and indeed the ECB has done just this a few times, and when that doesn’t work, the ECB can always provide emergency lending assistance. It did it for Germany right after Lehman, and, yes, it is now doing it for Greece, so that Greek banks can buy more Greek government bonds.
The Greek government also has a direct interest in lowering the eligibility standards, because it keeps up some demand for its otherwise worthless bonds. Recently, the ECB refused to lower the quality of eligible collateral for Greek banks any further. Instead, it allowed the National Bank of Greece to borrow directly from the ECB, via what is known as Emergency Lending Assistance. The amount of the increase was just sufficient to allow Greek banks to finance a Greek government budget short fall. If the demand had not been satisfied that way, the Greek government would default and lose access to its IMF EU program, which it could still do, but it won’t be the ECB’s fault.
This was a long post, but the point is that it seems that everyone has an interest in seeing the euro system be driven to the brink of failure. The target system is designed to tolerate extremes, but one wonders if the political and financial systems are. What would have happened if Greece didn’t get the ELA? So here is a question for you. What will cause Greece, or more importantly Spain or Ireland, to the point where neither the collateral eligibility requirement nor ELA gets extended?