Banks and governments in Europe are going to default, or else the ECB is going to inflate, or both will happen. Alternatively, a long series of painful restructurings will transpire. The source of these financial problems is the ECB itself, according to a paper by Boone and Johnson. The ECB made the repurchase (repo) market its major operational tool. It allowed thousands of banks to use sovereign debt as collateral. It made short-term borrowing more attractive than long-term via its collateral rules. It didn’t distinguish credit risk among sovereigns. It encouraged moral hazard, because banks believed that no sovereign would be allowed to fail as the amounts of government debt used in these repo operations ballooned. The banks themselves had no leverage limits and borrowed heavily in the short-term repo markets. They and outside investors assumed confidently that the ECB would not allow the system that it had fostered go under. With sovereign debts falling in value and with the repo market drying up, this whole system is failing.
These problems and failures are not failures of free markets or of capitalism. Central banks like the FED and the ECB are not free market institutions. They are fiat money institutions. Being centralized and powerful, when they go wrong, which they always do, their blunders and errors are compounded into very serious systemic problems.
7:53 am on December 12, 2011
