Goldman Sachs On The European Solution That Europe Refuses To Use

Photo: World Economic Forum on Flickr

There is one good reason the eurozone is going to avoid full-scale economic disaster:The European Central Bank.

That’s what a note by Goldman Sach’s chief European economist says. While the ECB — and other European countries who advocate its independence and autonomy — is unlikely to quietly acquiesce to a more active role in the crisis, it will ultimately do so to prevent “Lehman-style financial catastrophe,” and it will probably have the resources to do so effectively.

He explains how the European Central Bank will be able to stretch its resources to provide significantly more firepower than the European rescue fund currently has at its disposal:

– The ECB has been able to effectively subsidise PIIGS borrowing so far, though this assistance will not ultimately be enough.

– Although the ECB only holds €81 billion ($112 billion) in equity (€383 billion in total on its balance sheet) it has a lot more capital available.

– The ECB can call on national central banks to provide more funding.

– The Eurosystem can issue debt, in the form of bank notes. Pill thinks it could raise as much as €2.5 trillion ($3.5 trillion) this way.

Thus, the note suggests that the ECB might be the ultimate backstop against an escalating crisis.

But that’s not completely assured:

The ECB’s risk absorbing capacity, while significant, is not inexhaustible. Compared with the potential needs for solvency support—the risk embodied in the large stock of outstanding peripheral sovereign debt and the balance sheets of troubled banks—the Eurosystem’s economic capital is not overwhelming…

Nevertheless, the ECB retains considerable firepower. As a result, we believe it will be able to prevent a Lehman- style financial catastrophe in the Euro area. But its ability and willingness to avoid this catastrophe should not be confused with its adoption of a pro-active approach to getting ahead of the market, e.g., by setting a cap on peripheral bond yields and enforcing that through unlimited purchases of sovereign debt. Such a pro-active policy remains unlikely, in our view.

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