The Central Bank Dilemma: So Much Money, So Little Leverage
By acting more like its American counterpart, the European Central Bank (ECB) can help calm the continent’s shaky markets. But don’t expect it to “solve” the crisis – at least not without cooperation from Europe’s stingy commercial banks.
MUNICH -- The weakest link in a chain, or so the saying goes, is the strongest. In the present crisis, the weakest link is the banking sector. Indeed, all discussions about how to solve the reigning chaos end with the question: What about the banks? If Greece goes belly up, or the euro crashes: What about the banks?
But the real question, which is what the banks could do to help solve the crisis, isn't even being asked anymore. Maybe that's because it has become apparent that banks in their present structure are quite simply not equipped to deal with major faults in the financial markets.
Credit worthiness, their most important capital, turns out to be pretty volatile in difficult situations. Right now, U.S. banks are hesitant about lending dollars to their Old World colleagues. But it's not only transatlantic business that is suffering: interbank lending in general has pretty much dried up – just the way it did after the Lehman bankruptcy.
What that means is that right now, when banks want to borrow, they don't turn as they normally would to other banks, but often go directly to central banks, which are presently financing commercial banks like never before.
The European Central Bank (ECB), for example, is currently offering not just euros but dollars, which it has to borrow from the U.S. Federal Reserve. In this past Wednesday's concerted action, the Fed lowered the interest rate that the ECB has to pay for the dollar, which means that European commercial banks can get cheap dollars at the ECB.
The move came as a surprise, and eased the money market – which is why the exchanges reacted with a burst of currency fireworks. But by Thursday the euphoria was gone. Because if one thing is manifestly clear, it is that such measures help in the short-term but offer no permanent solution to the banking sector's problems. On the contrary: the move shows just how serious the crisis, now in its fourth year, really is.
But these days, politicians expect a lot more from central banks. They are not only supposed to ensure calm, and make sure the banking sector is functioning properly, they're supposed to help get a handle on the crisis as a whole.
In the United States, the Fed does that voluntarily – it sees its duties as not only keeping prices stable but looking out for healthy economic growth. And it goes very far to ensure that. It buys government bonds by the billions, which is to say, it prints money. It has already announced that it would keep interest rates low into 2013.
In Europe, the ECB is having a tougher time dealing with what it calls "unusual measures." While it can work to ensure that prices remain stable, it cannot work to foster healthy growth, much less rescue states. But it is now expected to become more American, to do what the Fed does, including act as lender of last resort.
All of the ECB's attempts to resist these demands have failed. The pile of debt in Greece and other countries is going to cost more, and sooner, than anyone thought. Somebody has to pay, and that somebody is the ECB.
But even if, theoretically at least, the bank had an infinite amount of money -- that's not going to solve the crisis. Charles Plosser, who sits on the Fed's Open Market Committee, admits it is frustrating that monetary easing has so far achieved so little. "It's possible we don't have the right instruments to heal the disease the system is suffering from," he said in an interview with Handelsblatt. "We not only have to understand what monetary policy can do, but what it can't do. When a doctor makes a wrong diagnosis, he can make the patient's condition worse."
The European Central Bank (ECB) can calm markets too, but not solve the problems – especially not by buying junk bonds. On the contrary, by flooding the market with money today, the ECB is creating tomorrow's inflation. With low interest rates and bond buys, it's making significant amounts of money available to commercial banks, which have not been lending. Instead they've been busy hoarding. The businesses that the money is supposed to serve barely see any of it.
That's the dilemma in this crisis. The central banks would need the help of the commercial banks to get all that cheap money being hoarded into circulation. Instead, it's the other way around. The central banks are helping the commerical banks. So the chain doesn't break.
Read the original story in German
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