Recent commentary has highlighted the fact that a Greek debt default would be a disaster for ECB policy-makers given the central bank's exposure to losses based on its past and prospective activities as the Euro area lender of last resort (LOLR). A 50% write-off on the value of Greek bonds would impose significant capital losses on the ECB, which purchased large quantities of the assets as part of its support buying of peripheral state bonds. This was necessary to contain yields and preserve financial stability whilst politicians attempted to secure a long-term solution to fiscal problems in the European periphery. In the event such losses are realized, re-capitalization of the ECB by EU member states would eventually be required. Default would also impose large losses on many private banks in Europe. These institutions would then turn to the ECB, as LOLR, to access liquidity under its flexible 12 month refinancing facility. Contagion effects in debt markets could amplify pressure on such credit lines, as well as force the ECB to resume risky bond purchases, both of which conflict with the instincts of ECB policy-makers to tighten monetary policy at a time when Euro area inflation is above target.
The role that the ECB has assumed in dealing with the immediate consequences of the sovereign debt crisis, and the dangers to which it is exposed in the event of sovereign default, illustrate a potential cost of currency unions that is often overlooked in textbook discussions of optimal currency areas. In that analysis, currency unions are optimal if there is some mechanism for handling asymmetric demand shocks in the absence of national monetary policies. This could be either labour mobility across borders, wage and price flexibility, or a supra-national fiscal policy that delivers stabilization. The recent episode highlights the fact that the formation of currency unions not only reduces multiple national interest rate policies to one, but also implies a single LOLR, obliged to provide emergency bank funding across the entire currency union, even if financial stress originates from a small number of states. This can certainly lead to inefficient outcomes, just as in the case in which a single interest rate is applied to countries at different stages of the business cycle.
One example of such inefficiency occurs when generous liquidity arrangements are extended to all Eurozone banks, even those operating in parts of Europe in which the banking system is under much less pressure than is currently the case in Greece, Portugal and Ireland. The result is to artificially raise profits and negate market incentives for banks for which generous liquidity facilities are not justified. Another example of inefficiency is that, through extending its LOLR offer to all European banks, the ECB contributes to global excess liquidity in a way that may exacerbate the inflation problems that it has placed at the top of the current policy agenda.
How would these inefficiencies have been avoided had current Eurozone countries retained their monetary independence? The sovereign debt crisis would surely have emerged in some form, and its effects would have been negative and long-lasting. But there would have been much greater flexibility in national monetary policy and exchange rate policy, and therefore better capacity to make the adjustments needed for recovery from such a crisis. The usual story is that states facing solvency problems could devalue their currencies in order to generate the export revenues needed to start repaying debt. If that alone proved insufficient for recovery, national monetary independence provides mechanisms for implicit debt default via domestic inflation and currency depreciation, both of which are achieved at much less cost than explicit default. But in addition to this, LOLR policies could have been tailored to national needs and interests. Central banks in peripheral nations could have provided liquidity assistance to distressed banks and governments, effectively monetizing part of public and private debts, whilst those in other parts of Europe could have normalized LOLR operations through shortening the maturity of any re-financing they provide, regulating the quantity or the price, and narrowing the range of collateral accepted in return for credit. This would support any increases in interest rates in those countries intended to fight inflation, as well as prevent any subsidy to financially sound banks in the form of artificially cheap and plentiful finance.
What does this comparison imply for the traditional debate concerning the optimality of currency unions? In addition to finding a mechanism for replacing interest rate policy as a means of offsetting demand shocks, nations must find some way of handling the collapse of multiple LOLRs to just one, and the problems this creates when members of the single currency area face debt crises arising from either the public or private sectors. The importance of doing this is arguably under-stated by the historical record on the frequency of financial crises and LOLR interventions in the banking system. As many observers have pointed out, the frequency and intensity of debt crises is likely to increase in the future because of the fact that the creation of the Euro has shut off an important mechanism for stabilizing aggregate demand, and leaves states facing sluggish economic growth vulnerable to mounting debt problems.
What form might a solution take? One possibility is the European Stability Mechanism, the fund being established to provide assistance to Eurozone states from 2013 onwards should they be forced to withdraw from the bond market and seek debt restructuring and financing from other sources. Of course, debate will continue as to whether or not this system will achieve the scale and popular support needed to succeed, but it at least offers some hope of relieving the pressure on the single LOLR, and represents a much more realistic prospect than a full fiscal union of the kind that exists in other large currency unions such as the United States.