(photo credit: Wikimedia Commons)
The event of the week in the financial world was encapsulated in yet another
acronym – LTRO. If you are really interested to know what that stands for, you
could Google it, and find out via a site called (what else if not)
acronymfinder.com. You would then be presented with a choice, ranging from Legal
Technology Resource Officer, which doesn’t sound very suitable, to Locate the
Remaining Oil, which is certainly not what you want to do and comes via (who
else but) the Shell Oil company. Long Term Refinancing Operation, from the
European Central Bank (ECB), seems much more promising and is, in fact, the
The LTRO event took place on Wednesday and involved the ECB
offering an unlimited amount of money to European banks for a three-year period
– an unusually long time for a central bank operation, hence the LT part of the
name. The demand was expected to be large – the consensus forecast was 300
billion euros – but it proved to be enormous and reached almost 500 billion,
with over 500 banks participating in the auction.
What, you may ask, was
the great attraction? Was somebody giving away money free? Well, basically –
The interest rate on the money was very low, at around 1% per annum
and the maturity period, as noted, was exceptionally long. The exercise was
aimed at providing European banks, which have been under considerable funding
pressure recently, with cheap and plentiful funds, and this aim was certainly
achieved. The event was therefore hailed as a great success.
the LTRO was completed and it was clear how successful it had been; the markets
sold off. The euro fell against the dollar, share prices went down and so did
the prices of bonds of the troubled European countries. Why was there a negative
response to this seemingly highly successful and promising development? The
simplistic answer is that this was yet another example of the market adage “Buy
the rumor, sell the fact.” The markets had risen strongly in the days prior to
the LTRO auction, on the expectation that it would be successful – and that it
would make a major contribution to resolving the European debt crisis gripping
both banks and sovereign states. Once the expectations had been realized, smart
traders took profits by selling. This answer is probably partially correct, but
is by no means the full explanation.
It can’t be the full explanation,
because the hopes placed in the LTRO were not fully realized. The expectation
that the banks would take full advantage of the offer and would thereby relieve
the funding pressure they were suffering was more than realized. But the hope
that this event would mark a major step forward in resolving the wider crisis
was entirely unrealized.
Indeed, quite a few analysts noted that the
success of the LTRO, so far from moving the crisis nearer to a solution,
actually moved it further away.
In order to understand why the success
was partial and why even 500 billion euros didn’t help and may actually make
things worse, all you need to do is understand one thing – the difference
between liquidity and solvency.
But if you understand that, you have
effectively understood the entire European and global crisis and why it hasn’t
been – and may never be – resolved.
Liquidity is to the financial system
what oxygen is to living creatures. If you cut off the supply, the result is a
rapid collapse of all vital systems and then death.
Solvency is a much
more fundamental state of health and insolvency implies ultimately inevitable,
but not immediate, demise. A simple example would be a person suffering a heart
attack or some other traumatic medical event. The ambulance that rushes to his
aid will immediately give him oxygen and apply procedures to resuscitate him –
and then rush him to hospital. If they don’t do that, he will be DOA (dead on
arrival) and the hospital will not be able to help him. However, if they keep
him alive, they haven’t begun to solve his real problems, which are whatever
caused the heart attack, for instance clogged arteries. This will require a
long, complicated and dangerous operation, followed by a protracted recovery
period – after which, hopefully, he will be able to resume a normal
That, in essence, is the difference between addressing a liquidity
crisis and solving a solvency crisis. The European sovereign debt crisis is, and
always has been, a solvency crisis. But the politicians and central bankers, for
various reasons, have regarded it as a liquidity crisis and treated it as such.
Providing oxygen keeps the patient alive but does not prevent his underlying
condition from continuing to deteriorate, necessitating larger and more frequent
interventions to provide oxygen, blood, etc.
On Wednesday, the ECB
provided 500 billion euros of oxygen – the largest dose since the near-death
experience the financial system underwent in March 2009. That has not healed any
of Europe’s sick banks and countries. It has merely kept them alive and, in some
cases, extended their agony. That’s why the markets gave the LTRO only one or
two cheers and then re-focused on the absence, indeed the further deferment, of a
plan to resolve the solvency crisis – if it can be resolved