24 November 2011. Despite consistent opposition from German leaders and economic experts, many still hope that the European Central Bank (ECB) will ultimately step in and perform the traditional Lender of Last Resort function by purchasing public sector debt directly from governments. For many Germans this represents yet another triumph of hope over experience. Yet the calls on the ECB to buy Italian and Spanish debt persist. Which side will prevail? And even if the German view ultimately doesn't prevail, has enough uncertainty been created that ECB action will be fatally compromised?


Ominous signs in the market

Investors are demanding a higher return for holding government debt to compensate for growing doubts about repayment. The higher interest rates feed worries about the capacity of certain sovereigns to repay their borrowings which then generates greater demands from investors. The preconditions for a vicious cycle of higher interest rates, default, and frozen bond markets are falling into place.

Few doubt that decisive action over the next few weeks will determine whether this vicious cycle will soon take off. The sheer quantity of Italian debt to be refinanced by April 2012--approximately 200 billion euro --focuses the mind on a straightforward question: where is the money going to come from? Few institutions or governments have such deep pockets. The ECB, however, doesn't need deep pockets for it can create money without limit.

A call for action

Advocates of mass ECB intervention argue that the expectation of sustained intervention will assure holders of eurozone debt that bond prices will be stable and so there is protection against large scale losses. Plus by committing to meet the financing needs of periphery countries over an indefinite time the ECB eliminates the risk of sovereign debt default and associated fears about adverse knock-on effects on the banking system.

A question of support

Absolutely critical to this strategy's success is the credibility of the ECB's commitment to stick to it for as long as it takes. This is where the German opposition is important. Suppose it was announced tomorrow that the ECB would act aggressively as a Lender of Last Resort. Surely there would be doubts as to the real level of German support for the new policy.

After all, a lot of the German opposition is based on an apparently-shared reading of its own history with hyperinflation of the interwar years. Would that suddenly change?

Also, in 2013 there will be a new German government who could hold a different position. With all this in mind, how credible would any sudden shift in the German position be? Ultimately, the very preconditions for the ECB to successfully stabilize Eurozone bond markets could have already been undermined. The markets won't forget which government is the largest shareholder of the ECB.

Is credibility possible?

These arguments highlight the mountain the ECB will have to climb so as to convince market participants that it is able to sustain a bond market programme.

Europe's monetary policy hawks may well lose the battle and yet win the war. The way opponents to widespread ECB debt buying have made their case makes it very hard to believe any subsequent volte face by currently hawkish governments. Proponents of a Lender of Last Resort function for the ECB really do have their work cut out for them.

Bild: Photocase / Elektromolch