Sizing up the role of the ECB

  Global markets declined on Thursday after ECB President Mari Draghi confirmed that the ECB had no plans to increase or expand its bond purchasing of sovereign debt. Many economists and investors expressed disappointment that the ECB failed to act decisively and extend their capital reserves to heavily indebted euro zone countries such as Italy.

President Obama also weighed in and made his frustrations heard in the media. “Europe is wealthy enough that there’s no reason why they can’t solve this problem” Obama said. ” If they muster the political will, they have the capacity to settle markets down, make sure that they are acting responsibly and that governments like Italy are able to to finance their debt” he explained.

Role of the ECB

The German based European Central Bank functions to control inflation levels within the Euro zone and establish monetary policy. Although often compared to the U.S. Federal Reserve, which has additional vested powers to stimulate economic growth and activity in one country (U.S.), the ECB does not function much like the Federal Reserve from an operational standpoint. The Euro zone currency region consists of 17 sovereign countries with diverse economies and varying debt levels.

Klaus Baader, chief economist at Societe Generale told Bloomberg’s Francine Lacqua yesterday that the ECB has limited powers to directly support governments. “The ECB cannot by law fund governments. To be true to that spirit ahead of the summit it would be unwise to signal that it would take the heat off governments” Baader emphasized.  He went on to explain that the ECB is the “lender of last resort” to the banking system, not the governments.

The ECB does not have an endless supply of capital reserves. The ECB already has exposure to heavy euro debt in countries such as Ireland and Greece.

Gavin Davis, a professor at London School of Economics and external adviser to British Treasury wrote on his blog for the Financial Times,  ” The equity capital of ECB is only 83 billion euros, which is very small when compared with possible future losses of peripheral debt, which exceeds 500 billion euros (including bonds held as collateral)”

Davis stated. ” On top of it’s equity capital, the ECB has 383 billion euros of ‘revaluation reserves’ mainly resulting from increases in gold prices which have not yet been taken on the books” Davis continued.

ECB Printing  More Euros?

The most important source of a central bank’s value is its ability to create more legal tender at no cost to itself. After printing money, the ECB and central banks can buy financial assets and gain a profit, a process known as seigniorage. ” The seigniorage process is limited by only one thing, which is the danger of creating inflation by printing too much money”  Davis stated.

The ECB is owned by all of its members in proportion to their share of Euro zone GDP.  All future seigniorage (profits) is owned by all of its members. If the ECB board decides to aggressively purchase Italian bonds, it is essentially transferring acquired wealth away from a country like Germany to Italy, which still holds a risk of a future default.

Here’s a comparison that comes to mind for someone living in the United States. Imagine a mildly indebted U.S. state such as Connecticut being asked to bail out a heavily indebted state such as California which has engaged in heavy spending over the years. Deciding to bail out California would be an unpopular decision by many citizens in Connecticut. Similarly, many Germans are unhappy with international calls for the ECB to bail out more and more indebted euro zone countries such as Italy.

Growth Rates in Euro Zone

On Thursday ECB President Draghi said that the 17 countries in the Euro zone grew 0.2 % in the third quarter. Declining output makes the debt crisis even worse by cutting tax receipts. The unemployment level is 10.3 %. ECB President Draghi lowered growth projections for 2012, saying output could fall as low as 0.4 % for 2012 to 1.0% growth.

* In the morning I will post another shorter and updated article about recent developments from the European Summit and reports about new capitalization requirements among Euro banks in Euro zone to maintain Tier I capitalization ratios ( 8 billion euros more than only 2 months ago).



About Johnathan Schweitzer 1651 Articles
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