Wednesday, December 28, 2011

European Central Bank Bets the Ranch

The European Central Bank has evidently been taking EU sovereign debt as collateral, even as it expands its balance sheet to a record size in order to finance the EU's banking system. Taking sovereign debt as collateral bets the solvency of the ECB on the solvency of the EU. In the event of a sovereign default, the banks borrowing from the ECB may well not be able to repay their debts to the central bank. The ECB might theoretically try to sell its collateral to recover its losses. But the very act of selling the sovereign debt would likely push down its value, impair European banks all the more, and further weaken the ECB. The ECB, for practical purposes, may be making uncollateralized loans when it takes EU sovereign debt as "collateral."

The ECB surely realizes this. But it may have little choice, since Europe's banks probably have limited amounts of other assets they could tender to the ECB as collateral. Without the ECB's loans, the European financial system would probably have to pull back on lending, forcing an economic contraction at a time when Europe desperately needs growth to escape the claws of the sovereign debt crisis. So the ECB probably has little choice but to bet the ranch. Its hopes of repayment rest primarily on whether or not Europe grows. Europe's prospects for growth depend heavily on whether or not its governments can institute effective fiscal policies. Given the EU's political dysfunction, one cannot help but wonder whether the ECB will lose the ranch.

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