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Europe's Problems Just Got Twice as Bad

Campbell R. Harvey is the J. Paul Sticht Professor of International Business at the Fuqua School of Business at Duke University and a research associate of the National Bureau of Economic Research in Cambridge, Mass. He is editor of The Journal of Finance. Harvey also runs a blog.

DURHAM, N.C. ( TheStreet) -- A massive 530 billion euro ($707 billion) liquidity injection took place today in Europe in the form of Long Term Refinancing Operations, or LTRO.

This "helicopter drop" does not solve the eurozone's problems; it merely delays them. The European Central Bank is treating the symptoms, not the disease.

LTRO was launched in December by the ECB, which offers unlimited loans to European banks for a three-year term at an interest rate of only 1%. The loans are unconditional; banks can do what they want with the funding.

That's a remarkably low rate, given that most of the banks are insolvent. They would have no hope of getting terms like that in the open market. In December, 523 European banks wanted a piece of the action.

LTRO1 amounted to 489 billion euros of bargain loans. Importantly, about 300 billion euros was rollover. That is, banks had loans that were due and they rolled them into new loans at the 1% interest rate. The amount of "new" liquidity was less than 200 billion euros.

How massive is massive?

Today, 530 billion euros was taken up by 800 banks. The size of LTRO2 was larger than expected and the number of banks participating was far bigger than expected.

Before LTRO2, the ECB's balance sheet stood at 2.7 trillion euros, far exceeding the size of the Fed's balance sheet in the depths of the financial crisis.

Unclear is how much of the LTRO2 is new liquidity. LTRO1 had about 190 billion euros of new liquidity. My estimate is that LTRO2 has about 400 billion euros of new liquidity. Note this is all in one shot too. It is not a gradual program like the Fed's so-called quantitative easing (QE).

So the ECB's balance sheet has exploded to approximately 3.1 trillion euros. Currently, the Fed's balance sheet is only (!) 2.2 trillion euros. In the November 2008 (QE1), the Fed balance sheet was 1.5 trillion euros. So the ECB's injection is massive.

What is the difference between QE and LTRO?

In November 2008, the Federal Reserve embarked on a quantitative easing program. The idea was to purchase mortgage-backed securities as well as U.S. Treasuries. That action bid up prices of the bonds and reduced interest rates. The increased prices helped bank balance sheets. The lower rates helped banks reduce the cost of lending. The lower rates trickled down to the average borrower, whether a small business or an individual.
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