Four fallacies about the role of the ECB in the crisis of the Euro

2011-12-19

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The European Central Bank has been receiving much criticism for not providing a final backstop to the eurozone countries, by becoming a lender of last resort. The criticism includes demands for the ECB to start monetizing debts, i.e. print money to buy the debts of sovereigns, or to engage in quantitative easing, which is again a similar story only it is related to the financial sector. In short the ECB is blamed for not using its firepower to kill off the crisis. There are a series of misconceptions and fallacies that fuel this ongoing criticism that need be deconstructed. First of all it is utterly false to believe that the ECB has infinite power that it can use. Second the ECB is not a federal institution subject to a very specific framework, accompanied by a counterparty treasury with jurisdiction over the exact same currency area; but a completely independent supranational entity. Third the ECB is already intervening in the markets buying sovereign bonds via its Securities Markets Programme (SMP). Fourth the ECB, just like any central bank cannot print money at no cost since it has to consider factors such as rising inflation over the medium term, moral hazard that can easily produce adverse effects; and in the case of the ECB legal obstacles and democratic issues, given the peculiarity of the current (incomplete) EU/Eurozone institutional framework.

The first fallacy is that the ECB has infinite power. In theory a central bank can print and thus spend as much money as it wants. Yet this does not imply that its power is infinite. A loose money supply, apart from being damaging for the economy as it creates perverse incentives and distorts the capital structure, is also bad for the credibility of the central bank. Some argue, including Krugman, that credibility is not important if the currency is about to collapse. Though there certainly is a sense of reason underpinning that argument, it remains narrow-sighted and errs fundamentally on assuming that the massive intervention of the ECB will stem the crisis. If the ECB loses its credibility then the negative dynamics will accelerate. The last thing you want is people’s confidence in the central bank to be eroded, since then the currency will dramatically lose value and the money supply will suffer greatly, while investors will simply avoid spending their money in Europe. In effect the collapse of the euro will happen within days or generally within a much shorter time-period than normal, if the ECB no longer enjoys the faith people currently have in its role.

Second the ECB is a supranational entity, functioning within an incomplete institutional framework that lacks a genuine fiscal union, in which there is a common treasury with powers to raise revenue and issue bonds of its own. For as long as this setting exists the ECB will have to violate a number of deontological, legal, political and democratic principles. It is always unwise to give powers that go beyond the scope of the Treaties to institutions that cannot function properly and legitimately. Criticism can certainly be directed to those who built the current architecture in the first place, but the demands for the ECB to take action despite these barriers are nothing more than academic exercise, completely detached from the European reality.

Third the ECB is already intervening in the secondary markets buying sovereign bonds. This is done through its Securities Markets Programme that has so far accumulated €705 billion, out of which the €261 billion were bought in the last months ever since the SMP resumed during the summer. The exposure of the ECB to the debts of the GIIPS is rising. In order to understand the extend of this exposure, one needs to consider as well the increasing burdens that are put on the Eurosystem (ECB + the Central Banks of the 17 eurozone member-states) via loans to private banks in exchange for potentially toxic, or at least of dubious quality, collaterals. The Eurosystem is already accruing mountains of debt and there is no sense whatsoever to the argument that “more intervention” is beneficial, since it is clearly a policy of reallocating the problems of the system without addressing them effectively. More debt is a time-bomb in the foundations of the European economy and certainly does not solve anything.

Coming doing to the fourth and final issue, monetizing debts (printing money) does not come without a cost. There is no such thing as a policy that can provide goods and services at nobody’s expense. Always someone will have to bear the cost. Alas there is no Santa Klaus to pay for it hence some group of humans will have to. The cost of printing money, apart from all of the above that are essential, is inflation, which falls on everyone. Many disregard the impact of moderately rising prices in an economy. Though there is a point to be made in favor of such an approach in the good times, this certainly does not hold true during a recession, or if growth remains stagnant. If prices rise while the total number of goods and services produced remains the same or declines, then people who will also continue to receive the same amount of nominal wages (at the very best), will eventually become poorer, as their purchasing power will decrease. Poorer consumers lead to decreasing aggregate demand that translates into less revenues for suppliers, which itself leads to further deterioration. In short inflation creates major problems to an economy that does not grow, eventually making the downfall worse. After all inflation cannot be exchanged for the structural malignancies of the system, since again all that will happen is a postponement in the future of the necessary reforms at a much higher cost.

With all of the above in mind I need to lay down some common principles that must always be respected by central banks including the ECB. First a central bank must always do whatever it can to protect the economy from distortions in the capital structure. This means it must never allow for cheap money to be poured in the system, as that will produce perverse incentives, induce individuals to invest without calculating the risk, effectively leading to the creation of bubbles. Second a central bank must do whatever it takes to prevent the money supply from collapsing. This means that it must always supply liquidity provided that the recipients are solvent. Liquidity must never be injected into insolvent entities since that leads to the creation of bottom-less black holes that distort the whole system and retard growth. With all these taken into account, my view is that the ECB holds a relatively positive approach to the crisis of the euro. Solutions to the problems of the single currency will never be given by any central bank, no matter how it acts and the ECB is not an exception.