Cheap ECB cash could prove to be the worst form of bailout

Over on Telegraph blogs, we argue:

Stemming the crisis through cheap central bank money sounds so easy. The logic goes: Italy and Spain have economic problems which cause markets to push up their borrowing costs, which now have reached "irrational" levels as fear has taken hold. If left unchecked, this could threaten the Eurozone and Europe’s economy. The European Central Bank, it is said, has "unlimited" ability to create credit or cash and act quickly. Hence, it must “stand behind the currency” and save the euro – and Europe.

So when the ECB today announces that it will intervene further in the crisis, probably by buying up short term government debt, many bankers and politicians will love it. Bankers because it avoids losses (at least for a bit), politicians – including British ones – because it might just save their skins at the polls.
But for Europe’s long-term economic future, this is also why large-scale ECB intervention is so risky. Europe has for decades lived beyond its means and needs to adjust if it wants to thrive in this century and the next. Faced with economic reality, there’s still hope that over a number of years (if domestic politics allows it – a big if admittedly) countries like Spain and Italy will finally push through much-needed reforms and achieve the 20-30 per cent internal devaluation needed to become reasonably competitive with Germany inside a currency union. And Europe as a whole would be better off.

But bailouts – whether by government or the ECB – can, at best, buy time. At worst, however, they act as an outright disincentive for necessary reforms. This risk was eloquently highlighted by Professor Leszek Balcerowicz – former Polish Finance Minister (and central bank head), famous for implementing the Polish structural reform plan following the fall of communism – at an Open Europe event last week. All bailouts, he said, come with "moral hazard". But if mishandled, ECB bond-buying could actually turn out to be the worst form of Eurozone bailout, as it completely de-links the bailout cash from reforms needed, creating a moral hazard problem of massive proportions (in addition to creating a number of other problems such as undermining the rule of law and making ECB susceptible to political influences). We’ve seen the signs already. As ECB board member Jörg Asmussen noted recently, "There cannot be a repeat of the mistakes with Italy in the summer of last year, when the ECB bought Italian sovereign bonds and the time was unfortunately not used for necessary adjustment measures".

And ECB money doesn’t come from a magic tree. From June 2011 to April 2012 its exposure to weaker Eurozone economies increased by 106 per cent, from €444 billion to €918 billion, and has only continued to rise since then. If ECB head Mario Draghi acts on his promises of unlimited intervention, this exposure could increase exponentially. At the end of the day, someone has to pay for this. Whether taxpayers (who ultimately back central banks) through write downs and losses (and resulting recapitalisation of the ECB) or savers through higher inflation in the stronger parts of the eurozone economy (bound to happen sooner or later).

As the ECB itself knows, it’s very difficult to counter these risks. Once the ECB taps are opened, it’s incredibly hard to turn them off without causing huge market distortions and creating an even graver crisis than the one that the original intervention was meant to stave off. That is why the ECB is right to insist on countries committing to reforms (through an intergovernmental decision) before it bails them out. Perhaps that mix could work for struggling Eurozone countries. But there's also a huge risk that Europe, in the long-term, will pay a very high price for what is only (at best) a short-term fix.