Eurozone bond markets remain volatile, with Spanish and Italian rates at near unsustainable levels. The European Central Bank could stabilise these markets, but is too risk-averse  

It is becoming increasingly obvious that the European Central Bank is the only institution that can stabilise the government bond markets in the eurozone. These bond markets have been gripped again by fear and panic, leading to unsustainable increases in the government bond rates in Spain and Italy. If this is left unchecked, these countries will be pushed into default.

The self-fulfilling nature of these developments is key to understanding the crisis. Spain and Italy are solvent nations. However, fear and panic do two things. First, they drive the interest rates on the government bonds of these countries to unsustainable levels. Second, they leads to sudden stops in liquidity making it impossible for the governments of these countries to continue to service their debt.

To avoid this they are forced to start excessive austerity programmes that lead to deep recessions and a collapse of government tax revenues. As a result the budgetary situation is worsened, not improved. The fear of default creates the conditions where default becomes inevitable. Countries are pushed into a 'bad equilibrium'.

The ECB is the only institution that can prevent panic in the sovereign bond markets from pushing countries into this state, because as a money-creating institution it has an infinite capacity to buy government bonds. The fact that resources are infinite is key to being able to stabilise bond rates.

The ECB is unwilling to stabilise financial markets this way. Many arguments have been given as to why the ECB should not be a lender of last resort in the government bond markets. Many of them are phoney.

Some are serious like the moral hazard risk. The latter, however, should be taken care of by separate institutions aimed at controlling excessive government debts and deficits. These are in the process of being set up (European semester, fiscal pact, automatic sanctions, etc). These disciplining and sanctioning mechanisms should relieve the ECB of its fears about moral hazard (a fear it did not have when it provided €1,000 billion to banks at a low interest rate).

The deeper reason for the ECB’s reluctance to be a lender of last resort in the government bond market has to do with its business model. This is a model whereby the ECB has as a main concern the defence of the quality of its balance sheet, i.e. a concern to avoid losses and to show positive equity, even if that leads to financial instability.

It is surprising that the ECB attaches such importance to having sufficient equity.  In fact, this insistence is based on a fundamental misunderstanding of the nature of central banking. The central bank creates its own IOUs. As a result it does not need equity at all to support its activities. Central banks can live without equity because they cannot default.

The only support a central bank needs is the political support of the sovereign that guarantees the legal tender nature of the money issued by the central bank. This political support does not need any equity stake by the sovereign. It is quite ludicrous to believe that governments that can, and sometimes do, default are needed to provide the capital of an institution that cannot default.

All this would not be a problem were it not for the fact that the ECB’s insistence on having positive equity is in conflict with its responsibility to maintain financial stability. Worse, this insistence has become a source of financial instability.

For example, in order to protect its equity, the ECB has insisted on obtaining seniority on its government bond holdings. In doing so, it has made these bonds more risky for the private holders, who have reacted by selling the bonds. This also implies that if the ECB were to take up its responsibility of lender of last resort, it would have to abandon its seniority claim on the government bonds it buys in the market.

The correct business model for the ECB is to pursue financial stability as its primary objective (together with price stability), even if that leads to losses. There is no limit to the size of the losses a central bank can bear, except the one that is imposed by its commitment to maintain price stability. In the present situation the ECB is far from this limit.

A central bank should be willing to take such losses if in doing so it stabilizes financial markets. In fact when it successfully stabilises financial markets losses may not even appear. Today, the fear of making losses paralyses the ECB. The ECB should set aside these fears.

Put differently, today's investors have become very risk averse, fearing being caught in a crisis that could wipe out their wealth. In such an environment it is important that the central bank is willing to take some risk, thereby offsetting extreme risk aversion in the market.

If instead the ECB is equally, if not more, risk averse, the financial markets cannot be stabilised. Because of its deep pockets, it is the central bank that in times of fear has to stand up and be fearless.  That’s the central bank we need. Not one that runs away.

Paul De Grauwe is John Paulson Chair in European Political Economy at the London School of Economics. This blog first appeared on the LSE's Europp site