The current turmoil in the eurozone bonds markets shows striking parallels to the situation in autumn 2008. Then, bank depositors had lost confidence in the stability of the institutions holding their assets, and the threat of a bank-run could only be avoided by comprehensive government guarantees for all banks. Today, we are observing a bond-run: a self-fulfilling crisis of confidence in the stability of most eurozone sovereign borrowers. This is driving long-term rates up, so that for more and more countries a temporary liquidity problem is becoming a permanent solvency problem. As regulators still treat government bonds as the safe core of the financial system, this vicious circle threatens the stability of financial institutions not only in the eurozone but also in the rest of the world. It intensifies the recessionary tendencies in the global economy so that in turn the financial situation of governments becomes worse. It’s a perfect vicious circle.
It can be broken only by stopping the bond-run as soon as possible. The authorities could use the Emergency Financial Stability Fund to enable the European Central Bank to act as a lender of last resort without violating its statutes. The ECB would provide practically unlimited amounts of liquidity while the EFSF guaranteed the ECB against the solvency risks that it would incur.
The recent bond-runs have developed because the authorities hold sharply clashing views on the propriety of bond purchases by the ECB. The Bundesbank has been and remains vociferously opposed. But the deflationary threat is real and is beginning to be recognised even in Germany. The statutes of the ECB call for the maintenance of price stability and that requires equal diligence with regard to inflation and deflation. The asymmetry is not in the statutes of the ECB but in the minds of Germans who have been traumatised by hyperinflation. However, the board of the ECB is an independent authority whose independence has to be respected even by the Bundesbank.