The automatically financed zone

Portugal: “In the euro area...you have an automatic financing of your current account deficit,” said Jean-Claude Trichet uneasily in February. The president of the European Central Bank should know. His ECB cash machine is funding not just the trade deficits of the euro periphery but their banks and governments.

Since mid-2008, banks in Greece, Portugal, Ireland and Spain have taken ¤225 billion of the ¤332 billion in additional liquidity supplied by the ECB, according to RBS research. The total amount of liquidity tapped is equivalent to a staggering one third of annual GDP in Greece and Ireland and one fifth of GDP in Portugal.

Since the local banks buy government debt, the ECB funding has effectively replaced funds that banks and governments were previously able to raise – too cheaply and abundantly – in euro debt markets. The ability of banks to use the central bank like an ATM is helping to keep some government debt markets open. It’s not a free ride, though. Portugal paid a percentage point higher interest rate last week than a month before on a five-year bond. Like its peers in the euro periphery, Portugal suffers from high current government deficits and the weight of debt and imbalances created by years of cheap borrowing.

Portugal’s problems are starting to get more attention.

The deficit on its current account, the broadest measure of trade, was 10 per cent of GDP in 2009 and government debt could easily rise from 77 percent of GDP in 2009 to 90 percent by 2012.

The government has recently reinforced its fiscal tightening plans but needs to go further. If it were to do so, however, Portugal’s banks would suffer still more - and lean more perhaps on the ECB.

What will happen? Trichet and the member governments hope the countries pull through. But it looks as though the EU and the ECB will be propping up periphery economies for years. That amounts to an implicit subsidy from the many to the profligate few. If any of these countries actually default, the ECB’s unwilling entry into fiscal policy would become painfully clear.