Draghi and transmission December 1, 2011 at 3:03 pm

From Mario Draghi’s speech today:

Dysfunctional government bond markets in several euro area countries hamper the single monetary policy because the way this policy is transmitted to the real economy depends also on the conditions of the bond markets in the various countries. An impaired transmission mechanism for monetary policy has a damaging impact on the availability and price of credit to firms and households.

It is worth spending a moment on why this is true. First and most obviously, falling bond prices causes losses at banks which threaten their solvency – or at least the perception of their solvency. This in turn makes it difficult for them to lend, not least because it is difficult for them to borrow.

There are more subtle and possibly just as significant other mechanisms at work too though. As bond prices decline, repo haircuts increase, and that creates funding stress too. Banks are pushed to fund more at the central bank as less collateral becomes acceptable in the private markets.

Confidence bites too as banks delever so that they can claim to be relatively well capitalized. An arms race of competitive deleveraging can even set in. This is particularly toxic as it further impairs the monetary transmission mechanism: central bank money doesn’t go into increased lending, but rather into reducing private funding.

Liquidity alone is not enough in these circumstances: capital is needed too. That, I fear, will be one of the next steps in the unfolding saga of central bank intervention.

Update. In that context, Bloomberg’s account of the new EU rules on state support for banks is worth reading.

Separately, Bloomberg also reports remarks made by Mervin King today about yesterday’s intervention:

“This is not a solution,” King said at a press conference in London to present the Financial Stability Report. “All this can be is to help with temporary relief for liquidity problems, but those problems are a result of solvency issues.”

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