Will The ECB Sell Its Soul To The Devil And Buy Government Bonds

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After categorically denying it would ever plan to buy government bonds since the ECB was created, the opposition against such a plan seems to be decreasing as the central bank has stated that it plans to do everything it can to increase the liquidity in the system and to avoid a possible (and increasingly likely) period of deflation in the Eurozone.

Draghi promised to put his bazooka to work and pledged in September to try to pump 1000B EUR into the markets. At that time, it sounded like his plan to provide more liquidity through allowing the banks to get their hands on dirt-cheap loans provided by the ECB (by paying just 0.15% on a 4-year loan) and the purchase of Asset-Backed Securities (‘ABS’) on the open market would be sufficient to effectively increase the liquidity into the financial system. However, the first round of the Long-Term Refinancing Operation was an absolute dud as only a fraction of the available money was taken up by the banks. On top of that, a large part of that money was requested by Italian banks which were (and still are) facing some tough times as their exposure to the domestic market is usually very high.

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This obviously results in the need to push another button on Super-Mario’s bazooka and now the possibility to purchase government bonds on the open market seems to become more and more likely. Several members of the ECB have now started to openly discuss this subject and it is becoming a accepted topic for discussion as it’s no longer ‘off-limits’ like it used to be just a few years ago.

Draghi might be too focused on tackling the inflation problem and there have already been reports of members of the ECB committee not agreeing with his leadership tactics and totalitarian way to push his ideas through. So it’s not a big surprise to see the Central bank of Austria – in the person of president Nowotny- issue a ‘wait a minute’-statement.

Ewald Nowotny; Source

Nowotny stated that it’s way too soon to start discussing when a potential start of government bond purchases might occur and he is absolutely right that the ECB should wait until it sees the effects of the previous measures before going a more aggressive route. Austria has sided with Germany several times before, and it looks like both countries will team up once again. The problem is that the approach of the ECB hasn’t worked so far and probably won’t work in the near future either as the cash injected in the system is not dripping down to the citizens. The main culprit for this is that the banks prefer to invest the cash into a buoyant stock market instead of making it easier for people to borrow money.

And this problem sure as hell won’t be solved by purchasing government bonds. Yes, there will be more cash and liquidity in the financial system, but no, this will not reach the common people who are needed to keep the consumption going. The problem here is that the ECB continues to rely on the banking system as ‘middle man’. This would theoretically work, but isn’t working at all as banks are still recovering from the global financial crisis.

The big shots in the ivory towers of the ECB have absolutely no clue about the real life situation out there and it’s actually increasing the risk of the financial system. Because the banks aren’t passing on the money to their customers, the ECB is pumping more liquidity into the system. But they forget one thing. The money doesn’t reach the European consumers because the interest spread for the banks is quite (read: too) low, and they can make bigger gains elsewhere.

However, if that situation would be reverted and if the interest spread would increase again, banks would be incentivized to increase the lending facilities. However, if all the ECB-printed cash would suddenly hit the market then you’ll have a real problem because the real inflation will most definitely overshoot the targeted inflation. The solution for the ECB isn’t to pump cash into the banks and hoping it will reach the ‘real’ economy, no. The only solution is incentivizing the banks to effectively open up the credit doors again. The most effective tool to change this interest spread is to lower the ECB yield, but this benchmark rate is already at a historically low level, so the ECB is – understandably- panicking. Buying up government bonds might be grasping at the last straw.