There are more indications today that the European Central Bank’s strategy of handing out cheap money to European banks and having them back-door alleviate the lending costs of troubled sovereigns is working. A recent bond sale out of Italy indicates that the banks are cashing in on the yield spread between what they borrow from the ECB and what they lend to those sovereigns. Italy saw its short-term bond yields decline sharply at the sale, almost in half compared to just a couple months ago. The long-term bond yield remains elevated, close to the 7% margin for 10-year notes that precipitated bailouts of Ireland and Portugal. But the short-term yields are down.

This is happening even as the economies weaken in these countries. Italy’s holiday shopping season was a calamity, the worst in a decade. Austerity measures are starting to reveal their bite, and more are coming down the road.

One theory here is that the ECB lent Euros to banks at 1% to allow them to capture higher yields on government bonds and make money in the exchange. The increased demand reduces yields and allows the countries in question to borrow at lower, sustainable costs. But that only takes in short-term notes, because there’s a three-year limit to the 1% borrowing cost. The long-term bond yields remain high, which means that countries like Italy and Spain would still be forced to “give confidence” to the bond markets by reducing their long-term budget deficits.

Of course, Italy and Spain can borrow at any term they like. If they get a good deal on 2-year notes, they don’t have to worry as much about the 10-year ones. So this sounds like more of a justification for the politicians in control in these countries to claim that the markets still want them to engage in austerity, when the reality of the situation shows otherwise.

I’m not sure that the ECB is focused as much on the sovereigns as they are the banks, however. New data today shows that banks are using the ECB’s overnight deposit facility in record numbers, protecting their money in safe havens. Basically, the ECB is trying to do what the Fed did in the US: protect the banks at all costs, while the people get little support. As Martin Wolf writes:

Thus the ECB is determined to fund banks freely, at low rates of interest, thereby subsidising them directly and the governments they lend to, indirectly.

Why lending to banks that use the money they borrow to lend to governments is good, while lending to governments directly is bad, is hard to understand. The only obvious difference is that in the case of lending via banks, the intermediaries may themselves go broke. That makes them unavoidably unreliable conduits. Yet if this complex procedure gets round theological objections to direct financing of governments, those who believe some financing of governments is now needed should be content.

In short, the recent decisions of the ECB look like a clever way of relieving the funding constraints suffered by banks and vulnerable sovereigns. This does not redress solvency concerns directly, though the subsidy may be large enough to make a difference even here, particularly for the banks. But it should mitigate – if not eliminate –liquidity constraints, which have proved of rising importance over the last year and half.

When you look at the European crisis as fundamentally a banking crisis, the actions taken by the major players become much more clear. Nobody’s “saving” Europe. They’re saving rich bankers who made bad deals and don’t really merit being saved.

David Dayen

David Dayen

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