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Carrying the Water for Politicians

02/29/2012

The European Central Bank announced their second round of Long-Term Re-financing Operations” or LTRO this morning.  It was bigger than the first round, and over 800 banks signed up.  The European markets rallied on this news.

But, what is it?  Consider that the interest cost of government bonds in Europe has increased significantly, which starves their national budgets and spending plans.  Getting those costs down is a substitute for raising taxes or cutting entitlements, which politicians lack the courage to do.

Also, consider that the ECB told European banks a year ago to raise additional capital, so they would be strong enough to absorb expected losses.  Unfortunately, the banks found very few investors willing to inject additional capital and therefore failed to raise the capital as instructed by the ECB.

Today’s LTRO announcement allows the ECB to make an additional $700 billion in loans to banks at a rate of only 1%.  Those banks must give collateral for the loans.  So, they buy government bonds as collateral for the ECB loan.  As the demand for government bonds is then increased, the price goes up, which drives down the interest rate, allowing the governments to sell bonds at lower interest rates.

Now, if the bank borrows at 1% from the ECB and buys a bond paying 4%, then the bank is making 3% pure  profit, which adds to their capital.  (3% on $700 billion each year will buy a lot of coffee at Starbucks!)  Thus, the ECB is making it easier for banks to fulfill the requirement to increase their capital.

Lastly, this LTRO program restored short-run confidence and stabilized the financial crisis in Europe, which was a spectacular success.  It is just another example of monetary policy being forced to compensate for the failure of fiscal policy (read democratically elected politicians).

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