The European Central Bank as a painkiller not a remedy

2012-07-28

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There seems to be a consensus among economists that the ECB is not doing enough to arrest the crisis in the euro zone. The ECB is after all considered the big bazooka that can intervene in the markets to lower interest rates over the short-term thus buying up some additional time for policy-makers to implement their latest decisions that pave the road towards a banking and a fiscal union in the euro area. It is indeed correct that in theory the ECB could and perhaps should intervene in the secondary markets to prevent the worst from happening, however the answer is not as straightforward as many economists purport to show.

At first we must bear in mind that the ECB does not operate within the institutional framework other major central banks across the globe do. In the Euro zone there is no political union, no common treasury, no eurobonds, no unified banking system etc. Instead what we have in our case is a euro zone that resembles a federal system in monetary policy, but which has 17 sovereign states taking joint decisions and having to agree on ad hoc measures to make up for the initial flaws in the design of the euro. The lack of a common government produces great uncertainty as on one hand there is much controversy over how best to proceed forward; while on the other there is no legitimate pledge to secure the integrity of the euro, apart from some pompous statements of officials that they will do “anything” to preserve the single currency.

Within this context the ECB is facing several political and institutional constraints. The most apparent of them is that it is not backed by a common treasury, meaning that in case it needs to be recapitalized there will have to be a long decision-making process that will require the approval of 17 parliaments. Given that the ECB might need such a support, especially if/when it accepts to take losses on the Greek government bonds it holds or indeed on any other sovereign debt henceforth; the idea of a potential recapitalization may only be a source of concern. In addition without legitimate political checks and balances an omnipotent ECB that acts arbitrarily may only strengthen the fears of citizens across the euro zone that democracy is being eroded.

Moreover the actions of the ECB thus far have proven that monetary policy alone cannot prevent contagion, as in the absence of the instituions that guarantee the integrity of the single currency, any increase in liquidity will eventually end up in the perceived safe havens rather than be supplied to the states and the economies that need it most. For as long as the underlying confidence crisis is not addressed this will remain an unpleasant reality.

The two tranches of Long Term Refinancing Operation loans, worth €1 trillion, only succeeded in buying a few months time, when they were originally thought to be enough for a full three years. This is not because of the limited actions of the ECB, as many economists fallaciously suggest. It is due to investors being well aware of the institutional flaws of the single currency and the fact that no legitimate backstop exists to hold together the whole edifice. My take is that the single most important source of uncertainty is the lacunae that exist in the decision-making process and the fact that EU leaders keep dithering and contradicting their selves every few weeks on how to make the politically costly steps towards the federalization of the eurozone. Federalization of the euro area is the only way forward either we like it or not, the problem is that it is still highly uncertain whether that will be achieved.

Today just like last year during August, Spanish and Italian yields are at worryingly high levels and the ECB is the only institution under these circumstances that can buy a few more weeks until the ESM is brought into force. The ECB can either introduce a third round of LTRO loans which in my view is vain, as it will channel yet more funds to the perceived safe havens, while strengthening the negative feedback loop between stressed sovereigns and near-bankrupt banks; or it can step in the secondary markets through a reactivation of its Securities Markets Programme to buy Spanish and Italian bonds thus directly affecting the borrowing costs of these two states. Or perhaps there can be a combination of these two policies together with a further reduction of the benchmark rate.

Regardless of what the ECB will decide it must be made clear and above board that monetary policy alone cannot solve the crisis, even if the ECB greatly expands its already leveraged balance sheet. The ECB is at best a painkiller that can prolong maturities and keep rates artificially low. But as with ordinary painkillers, the effects tend to wear off faster the more they are consumed, while the after-effects are more deleterious as consumption increases. Same with monetary policy – it is not “free” nor does it always yield benign effects as many people seem to think. Ultimately the crisis in the euro area is a political issue, since it all comes down to how will power be distributed after the financial stress subsides and the necessary institutions are fully operational. Solutions or an eventual breakup will come from EU leaders, not from the ECB acting unilaterally.