Europe Economic Crisis: Has ECB Provided the Solution?

The latest liquidity operations by European Central Bank (ECB) appear to have averted a threatening catastrophe in the eurozone banking sector, at least for the time being. But it would be wrong to think that they have solved the region’s deeper fiscal and economic problems, or secured the future of the single currency itself, according to Capital Economics.

Having lagged behind other central banks throughout much of the global economic downturn, the ECB suddenly appears to have taken some positive steps says Capital Economics. Its three-year Longer Term Refinancing Operations (LTROs) in December and February have been credited with both averting a banking disaster and easing the sovereign debt crisis.

While the eurozone’s banks may have escaped an imminent funding crisis, they still face heavy refinancing needs, very weak economic conditions and the risk of huge further asset write-downs, reports Capital Economics. Against that background, it is unlikely that the LTROs will translate into a sharp rise in bank lending to companies and households.

Capital Economics notes that although banks have used some of the LTRO funds in government bonds, they are unlikely to invest too heavily in countries to which they have previously been trying to reduce their exposure. As such, the operations are no substitute for the widely called-for “silver bullet” option in which the ECB uses the might of its balance sheet to stand directly behind the Italian and Spanish bond markets.

Capital Economics expects the ECB do more to address the crisis, including more direct forms of quantitative easing (QE). But the message from the central bank has been consistently clear – while it is prepared effectively to act as lender of the last resort to the region’s banks, governments have to sort their own problems out. It may already be close to the limit of what it is willing and able to do.

The bottom line is that the ECB has not solved the broader economic and fiscal problems facing the eurozone, says Capital Economics. Also neither can it be expected to do so in the future, given both the unique constraints of its own position and the general limitations on the power of monetary policy. The ECB has administered an effective, but temporary anesthetic. It is up to the region’s governments to deliver the cure.