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ECB IOUs
October 2012

 

Is the drama of the euro better understood as farce or tragedy? As in the best traditions of the old Whitehall Theatre in London's West End, people come and go between plush hotel rooms with no idea of why they are there or what they are doing. For the actors and actresses involved, the politicians, bureaucrats, economists and the assorted hangers-on, it has all been a lot of fun since Jacques Delors published his famous report on European economic and monetary union in 1989. The cast has changed from time to time, but the European political elite's efforts to create the single currency have kept everyone entertained for more than 23 years. 

Except that the whole exercise is now     becoming far more serious than the impresarios of "ever closer union" thought possible. Germany, the top impresario in European integration since it began in the 1950s, could face a bill running into hundreds of billions of euros if the single currency area cannot hold together. But the more emphatic its commitment to preserving the eurozone, the larger are the sums at stake and   the greater is the potential for loss. Even worse, the entire project of European integration could be blighted if the eurozone   has to be restructured. Germany's determination to model a continent after its own   image would again have led to geopolitical tragedy.  

As always in international finance, the details are technical and complex. Individuals and companies settle payments across their accounts at commercial banks. The commercial banks, in turn, settle debts between themselves at a special kind of account, their cash balance at the central bank. 

In the eurozone banks can make payments to other banks only if they have a positive balance at the European Central Bank (ECB). If a eurozone bank has more payments going out than coming in, it must attract new euro cash deposits or obtain a loan from another bank. If banks in one eurozone country (read: Germany) do not trust banks in another eurozone country (read: Spain) and refuse them new loans, banks in "Spain" may be unable to meet their liabilities as they fall due and so are forced "to close their doors". 

Bankers have long known about the risk that, even if they run profitable businesses with good assets and strong franchises, they may not be able to fund their assets. One function of central banks has therefore been to "act as a lender of last resort", or as a provider of "emergency liquidity assistance", if inter-bank funding becomes difficult. So the growing distrust between banks in "Germany" and "Spain" has over the last two years had to be met by large loans from the ECB to Spain's banks and indeed, in practice, to banks in other troubled PIIGS (Portugal, Italy, Ireland, Greece) nations.

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