Why is the ECB doing this?
At the end of last year Europe was heading for a disaster. Portugal, Italy, Greece and Spain (aka PIGS or Club Med) saw the cost of borrowing rising rapidly. Interest rates went up above 7% and even as high as 18% at one point! Even when paying such high interest rates the PIGS could only just about get access to new money to avoid a default (being unable to pay old loans back). The PIGS entered a negative debt spiral that would ultimately lead to disaster.
Negative debt spiral explained
As governments spend more money than they get in through tax revenues they need to borrow money to bridge the gap. As most Euro zone countries have been running deficits for decades it means that when the time comes to repay this loan they will need to borrow new money to pay the old loan off. In other words every year they need to borrow more money. When investor confidence in a country weakens (as is the case now with the PIGS) investors are only willing to lend more money if they get a higher rate of interest (because the loan becomes more risky). But of course with higher interest payment the deficit will increase, the total debt will increase, interest rates go up further, and you are in a negative debt spiral.
Once you are in this spiral it is very hard to come out of it without some form of intervention. Without intervention the likely outcome is that the country will be unable to acquire new financing and cannot pay back their loans: they default.
With the cost of borrowing rising fast for the PIGS the ECB decided to intervene, hence the LTRO in last December and again now (February 2012).
Who is ultimately receiving this money?
That depends on the individual banks – they can use this new liquidity in various ways. The most used option is that they take the 1% loan and buy a higher-yielding bond for a guaranteed profit. Another option would be to increase lending to small businesses and individuals, but we have seen very little of this happening. Some of last December’s LTRO was used to pay off existing loans from the ECB.
What are the results?
The last LTRO in has averted a new credit crunch, and interest rates for PIGS bonds have gone down. So in the short term the operation was successful. But the ECB is taking a trillion-euro bet: the weakest banks in the weakest countries are gobbling up ever more sovereign debt, concentrating systemic risk. The LTRO reduces the likelihood of defaults, but increases the losses should it happen. And all of this is not a real solution, the ECB is just buying time. You cannot resolve a debt crisis by creating more debt.
Why this LTRO and not QE like the Bank of England does?
The ECB is twisting itself in knots by bailing out Club Med very inefficiently through the back-door via the banks rather than purchasing bonds directly. That would be a breach of the no-bailout clause of the Lisbon Treaty. Also ECB lending to eurozone banks is just about acceptable to the German public, not least because most barely understand it, but outright bailouts are not. So all this is just to pretend to the Germans – and to themselves – that they are not doing QE. (See the article Why QE wont stimulate the economy for more information on QE.)
Just an observation
It is interesting to see that when Greece needs €130bn they can only get it by handing over their sovereignty to Europe. They get horrendous austerity measures forced down their throat: tax increases, wage cuts, job cuts, pension cuts, forced sale of assets, permanent policing from the EU on tax collection. Basically the EU took over control of Greek finances (and thus Greece).
But the banks get unlimited access to funds and all this without any demands being placed on them. €1 trillion is eight times the size of the last Greek bailout! And to put this into persepective: 1 trillion equals 1 million per day for 2740 years...
You can’t blame the Greek people if they throw out the current government in the coming election in April and then throw out the EU officials from their country!
