Thursday, 16 July 2015

The ECB does not learn from its past mistakes

In 2011 at the height of the sovereign debt crisis when investors panicked, the ECB announced its “Securities Markets  Program” (SMP). This aimed at stabilizing the government bond markets. Unfortunately the SMP program was structured in the worst possible way, i.e. the ECB announced it was ready to buy a limited amount of bonds during a limited time. This backfired immediately for obvious reasons. When hearing this announcement panicky investors decided to sell their Greek, Italian, and Portuguese bonds as quickly as possible to be sure they would beat the other investors before the ECB closed the window.  As a result, the ECB had to buy a couple of hundred billion of government bonds without pacifying the markets. The spreads continued to increase.
It took the ECB a year to learn from this mistake. In September 2012 the ECB started with the OMT program. In contrast with the SMP program the ECB promised to buy unlimited amounts of bonds for an indefinite period. The unlimited nature of the commitment made all the difference. Investors were pacified and expected that bond prices would not drop further. As a result, they started buying government bonds of the periphery country. The beauty of the OMT program is that the ECB pacified the market and did not have to buy one euro of government bonds.
Now fast forward to Greece.  The banking crisis in Greece started when the ECB announced that it would cap the amount of liquidity available to the Greek banks. Customers ran to the bank to withdraw cash from their accounts as quickly as possible before the cap became effective. Today (16th July) the ECB announced that the cap will be increased by €0.9 billion. This will accelerate the desire of the Greek depositors to withdraw cash from the bank, as they know that the available cash is limited. Instead of reducing the banking crisis, the ECB is in fact intensifying it, pretty much like in 2011 when the SMP program intensified the panic sales of government bonds.
The correct announcement of the ECB should be that it will provide all the necessary liquidity to the Greek banks.  Such an announcement will pacify depositors. Knowing that the banks have sufficient cash to pay them out they will stop running to the bank. Like the OMT, such an announcement will stop the banking crisis without the ECB actually having to provide much liquidity to the Greek banks.

These are first principles of how a central bank should deal with a banking crisis. I would be very surprised if the very intelligent men (and one woman) in Frankfurt did not know these first principles. This leads me to conclude that the ECB has other objectives than stabilizing the Greek banking system. These objectives are political. The ECB continues to put pressure on the Greek government to behave well. The price of this behavior by the ECB is paid by millions of Greeks.

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