Tuesday, October 25, 2011

The ECB: Unwilling Saviour

Joseph Cotterill at FT Alphaville reiterates an important theme today: the solution to the eurozone crisis really rests with the ECB.
The ECB is not here to save the world

...You might quibble with some parts of the plan [for much greater ECB support to eurozone sovereigns] but at least it is very clear about its starting point, the ECB. And of course many analysts have been calling for crisis solutions to move on from the EFSF’s finite balance sheet, to making use of the ECB’s omnipotent, effectively limitless balance sheet. Think of all the deep pockets of seigniorage, oodles of liquidity, et cetera. Only the ECB can absorb the quantum of sovereign losses, other analysts argue.

We definitely wouldn’t say this argument is wrong, or unworkable...

However... What we will say is that the ECB would never go along with it – based upon what the ECB has been doing so far.

...Frankly, at this point we’re open to theories on why the ECB has resisted the calls to provide sovereign liquidity.
The ECB is really the only institution that can establish a backstop in eurozone sovereign debt markets that is completely credible. This would be especially effective if the ECB targeted an interest rate for Spanish and Italian bonds rather than a quantity of intervention, as I've suggested previously.

But there's another reason that it would be appropriate for the ECB to be at the heart of the solution. In a recent paper (pdf) Paul DeGrauwe points out that an essential ingredient to the crisis is the fact that the adoption of the euro meant that sovereign nations in the eurozone could no longer borrow in their own currency. As he puts it, "in this sense member countries of a monetary union are downgraded to the status of emerging economies." The difficulty this creates is that since the central banks of these countries can no longer provide unlimited domestic currency liquidity to the government, default becomes a possibility in a way that it was not before euro adoption.

The solution to this flaw in the system is to have the new, joint central bank -- the ECB -- take up the role that individual central banks previously had of ensuring that their own government would never have to default on domestic currency debt simply due to liquidity problems. If the ECB were to assume that role today, default would be completely taken off the table as an option for investors to worry about in the markets for Spanish and Italian debt, which would guarantee that this crisis could no longer spin out of control as it is currently threatening to do.

Regardless of whether European leaders agree use the ECB as the immediate solution to the crisis, I would argue that if the eurozone is to survive in the long run, the ECB is going to have to be explicitly granted the authority -- and indeed the responsibility -- for doing just that. If they want to have a common currency and all of its benefits, the eurozone countries need to accept the drawbacks that come with it. And one of those drawbacks is that the ECB will have to not just be the guardian of the eurozone's inflation rate, but will also have to be an effective guardian of Europe's financial system, even at the potential cost of slightly higher inflation during certain limited episodes.

But as Cotterill points out, there is very little chance that the ECB will actually agree to take on this role. So do not expect this crisis to come to a neat conclusion this week.


  1. Anonymous11:27 AM

    When the ECB is buying bonds of an Euro zone member, it is effectively creating new money at expense of the other nations. The result would be that the country with the biggest deficits would have the biggest advantage. Up to a certain amount this might be ok, but not at a big scale. There is the Maastricht treaty and Germany will not allow to circumvent this at a big scale.

  2. Anonymous3:56 AM

    You can not expect civil servants, even as highly ranked as the members of the governing committee of the ECB, to take such delicate polical decisions. What would be needed to decide on such matters is, within the ECB but beside the existing monerary policy committee, a financial stability committee consisting of the ministers of Finance of the Euro Area.