What Is the European Central Bank Thinking?

Paul De Grauwe explains why the ECB, rationally by its own lights, is refusing to act as a lender of last resort. Once it has to deal with a full-scale banking crisis, it will step up, says De Grauwe: the costs of failing to do so are vast and instantaneous. But a sovereign debt crisis, which is all we have at the moment, unfolds more slowly, which makes delay seem more attractive.

The sovereign debt crisis occurs at a snail's pace compared to banking crises. When investors sell government bonds and push the interest rate upwards, they affect the cost of borrowing of governments with some delay because the maturity of the bonds is typically of the order of five to seven years. As a result, there is not the imminent threat of a rapid collapse as there is with a banking crisis.

The result is that when the central bank faces a sovereign debt crisis the lack of immediate danger has the effect that a conservative central bank, such as the ECB, will attach more weight on the long-term benefits of reducing moral hazard. The central bank will therefore wait far longer to take action.

Note that this does not mean that moral hazard risk is more important in sovereign bond markets than in the banking sector. Bankers are just as likely to take additional risk when they know that in times of crisis the central bank will provide liquidity, as governments are. In addition, there is no reason to believe that the risks bankers take on is less dangerous than the risk taken on by governments. The only difference is that the imminence of a collapse is higher during a banking crisis than during a sovereign debt crisis. As a result, a central bank is likely to reduce the weight on moral hazard risk.

Well, it looks as though Europe will get there in the end. But when the ECB does finally act to deal with the banking crisis it is about to let happen, the cost of intervention will be much bigger, as De Grauwe also explains. Eurozone bank liabilities are three times greater than the area's public debts, and a full-blown banking crisis implies a much worse recession.

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