Friday, December 9, 2011

ECB Liquidity support for Euro Banks, Italy and Spain

In my blog of October 27th. I had stated (point 4)that only the ECB had to act like a normal central bank for the Euro area (i.e. provide unlimited liquidity in times of financial crisis) if basically solvent Euro countries were to be saved from becoming insolvent.  The best way would be to change the ECB constitution to allow it to do so (in parallell with changes to impose tough fiscal rules on Euro-countries).  This may however take too long to stave of a crises in the next 12 months.  One possibility that has been suggested is the issue of Euro Bonds.  However, it is unclear whether this has any greater feasibility till the fiscal rules have been changed by treaty.  There is however, an alternative that may be worth considering.
     National Banks within the Euro area, such as the German Bundesbank still exist, but do not have the authority to undertake monetary policy (interest rates) or to create money (Euros). This authority has been ceded to the European Central Bank (ECB).  They do, however, still have the capacity to issue euro bond to raise hard cash and their debts are still implicitly or explicitly guaranteed by their National governments. Thus these would have triple A rating in countries with a similar rating.  To the best of my knowledge, there is nothing barring the ECB from buying such bonds as part of any effort to increase liquidity in the Euro zone. The money raised in this way could in turn be used by the National Banks to create bilateral funding arrangements in the IMF.  Given the triple A rating of the IMF, this would preserve the triple A chain.  The funds could then be used to provide liquidity support to fundamentally solvent (even if currently stressed) Euro governments, under a fund program that ensures that these governments undertake the policy reforms that ensure debt sustainability (point 1 of Oct 27 blog).  Non-Euro area countries with a current account and trade surplus, such as China could also contribute to the bilateral fund in the IMF if they choose to do so.

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