The problem, he said, is contraction of global liquidity.
What he is worried about, apparently, is disruption of the global funding system as continental European banks retrench. In normal times, these global banks serve as funding intermediaries, gathering short term funds from all ends of the earth at one price, and lending them on to other ends of the earth at a slightly higher price. Trouble for these banks means trouble for global credit markets.
The underlying problem, as everybody knows, is sovereign debt. Once considered riskfree, and accepted at par by the ECB as collateral, today sovereign debt is anything but. Timid purchases by the ECB have perhaps stemmed disorderly rout, but orderly rout is still rout.
Some private investors, notably MF Global, saw opportunity and stepped in to fill the gap left by public authorities. We know how that worked out. Funding sovereign bond holdings with “repo to maturity” left MF Global exposed to liquidity risk; liquidity kills you quick. Having seen the fate of MF Global, other private investors are understandably loathe to step in. Contraction of global liquidity is the consequence.
All eyes then are on the public authorities. In a characteristically incisive column, Wolfgang Munchau puts his finger right on the problem. “As of last week, the eurozone no longer had a functioning sovereign bond market…As of now, there is only one significant risk-free asset in the eurozone—German government bonds.” The supply of risk-free assets has thus shrunk even as the demand for risk-free assets has expanded. It is not a matter of price—there are simply not enough risk-free assets to go around.
Munchau pushes (again) for launching a Eurobond as the long-term solution but also, recognizing that such a launch will take time, for endowing the EFSF with a banking licence as the short-term solution. The former, he says, is a prerequisite for the latter because it offers a credible exit strategy from the short term monetary expansion using the balance sheet of the EFSF.
Be that as it may, his idea is essentially to use the EFSF to do what the ECB seems unwilling or unable to do—act as dealer of last resort by announcing “unlimited purchases of national soveeign bonds to keep their spreads under an agreed cap—say 2 per cent for 10 year bonds”. The ECB would backstop the EFSF, but the monetary expansion would be at the EFSF not the ECB. (See also here.)
The world is watching, but more specifically the world’s central banks are watching. For lack of decisive action by the ECB, we have seen balance sheet expansion first at the Swiss National Bank, then at the Bank of Japan, and now perhaps the Bank of England. “Forget the G7, Watch the C5” has been my slogan for a while, and last week’s G20 fizzle confirms.