ECB holds the key to solve the current European sovereign debt crisis

Last Friday, on the EU Summit, 26 out of the 27 EU nations agreed to a tight fiscal union and stringent fiscal discipline, with the only exception of UK not signing. While this agreement is important to address long term issues with regard to the lack of market confidence in European sovereign debts, it does not provide any solution to the problems at hand. Without full commitment of the ECB to supporting the sovereign debts, any other method will prove to be inadequate. No rescue fund is large enough to staunch the spreading of the crisis. Not EFSF (European Financial Stability Fund). Not IMF (international monetary fund). Only the powerful printing press of ECB.

We have to understand the true nature of the current crisis. Clearly there is widespread budget deficit problem among the EU nations. I believe Greece has to restructure its debt to be solvent. But we need to separate solvency problem from liquidity problem. Outside of Greece, we have a liquidity problem, not solvency, at least not yet. But investors have lost confidence. They are pulling out of the sovereigns of Italy and Spain, threatening the solvency of these nations. And I do not believe the fire will end there. It will spread further to France, and even Germany, eventually destroying all Euro denominated sovereign debt markets. The very survival of Euro is now at the mercy of the whimsical financial market.

In a crisis of this nature and proportion, what's the rightful role of a central bank? The answer is unequivocal: the central bank should act as the lender of last resort and move decisively to arrest the quick erosion of confidence in the financial market. But facing with a crisis of unprecedented scale, ECB chose to hand off, doing little. The half-hearted bond buying efforts are like using water cups to try to extinguish a house fire. The correct action for ECB to take should be 100% backstop of any sovereign that is committed to future fiscal discipline. That should bring down the interest rate on those sovereigns and give them time to work out their long term budget problems.

I understand the concern of "moral hazard". But I think now is the right time to act. The 26 EU countries, including all 17 Euro nations, have agreed to stringent austerity measures and future fiscal discipline. That should remove ECB's rightful concern about moral hazard.

The other argument against ECB buying the sovereigns is the fear of inflation. That should be the least of the worries right now. Given the austerity measures that many EU nations are undertaking, it is very hard to imagine any real chance of high inflation. Furthermore, ECB may not have to print much new money at all to stop the crisis spreading. Oftentimes the show of determination by the central bank is sufficient to stop the capital outflow from the sovereigns of the troubled nations.

One more benefit of ECB buying sovereigns, a very important one, is that it will restore the financial stability of the banks that are affected by the sovereigns. This is two birds with one stone.

My suggestion is nothing new or innovative. My opinion is shared by many. I simply can't understand why ECB goes against this. Probably because Germany is the primary beneficiary of the crisis. German ten-year bonds are yielding below 2%. But watch out Germany. Don't be complacent. Fire in your neighbor's house could spread to your own.