Keeping the ECB independent is key to the euro’s survival

Over on the FT A-list, we've got a response to a piece by Jim O'Neill, who argues in favour of a Greek restructuring and bank recapitalisation (as we have many times before). On many points we agree with O'Neill but we do differ on the role of the ECB in solving this crisis.

We argue:

Jim O’Neill sets out some important and necessary steps for how to solve the eurozone crisis – including a restructuring of Greece’s debt, recapitalising Europe’s banks and greater leadership from the European Union leaders. However, the problem in the eurozone crisis was never primarily one of not knowing what to do, but how to get there within the constraints of a supranational currency, pegged to national democracies and fiscal policies. What’s clear, however, is that spraying more liquidity at the eurozone crisis is in itself not a magic panacea – and could even make the single currency less sustainable in the long term.

The notion that the European Central Bank should offer an “unlimited” backstop for eurozone nation states, as Mr O’Neill mentions, is a case in point. Clearly, the loser from the “muddling through” approach employed by EU leaders over the past year has been the ECB. It has seen its credibility drained and its independence compromised (for example through its U-turns on accepting junk bonds as collateral). In fact, an important component of finding a long-lasting solution to this crisis is that any financial backstop for the eurozone is established at the intergovernmental level, not through the ECB.

There are a number of reasons for this, many of which stem from the central bank’s experiences during this crisis. First, the cheap and plentiful liquidity that the ECB has provided to European banks created perverse incentives and moral hazard, possibly leading banks to chase profits through higher yields on peripheral sovereign debt, thereby increasing exposure to the crisis. In addition, this unlimited credit created a set of so-called ‘zombie banks’ reliant on ECB liquidity to survive, but without any conditionality to reform the bad practices and mismanagement that got them into this situation in the first place. The lack of an exit strategy from these policies shows why transferring this model to the sovereign debt markets would be dangerous and undesirable.

We go on:

Furthermore, let us not forget that, unlike the Federal Reserve and other central banks, the ECB does not have a dual mandate – its primary aim is that of price stability. If markets do not believe it can achieve this, and if the line between politics and monetary policy become increasingly blurred, then market instability and fluctuations may become the norm for the eurozone. That the eurozone lacks a lender of last resort, is a structural flaw in its fabric which has been sorely exposed by the current crisis.However, papering over it with unlimited liquidity in the near term will not solve the problem. And perhaps most importantly, forcing the ECB into the role of lender of last resort could seriously jeopardise German support for the entire euro project, with the ultimate outcome equally unpredictable to that of the current market turmoil. The Germans still take ECB independence seriously, as witnessed by the dramatic resignation of Jürgen Stark over the ECB’s bond-buying programme. As attractive as it may sound at first glance, we should be wary of the temptation of sacrificing the ECB’s credibility at the altar of a short-term fix.

Finally, let’s not forget that, even following a solution to this crisis, a vast array of countries will be left with mismatched interest rates, an overvalued currency and a convoluted decision making process. The problems in the eurozone run much deeper than additional liquidity can solve. Yes, Greece needs to restructure, banks need to be recapitalised and if an inter-governmental, democratic way can be found to top up the European financial stability facility, with more focus on banks, this should also be explored. Alas, this may not be enough to save the euro.

The ECB has been heavily involved in this crisis and it may have to continue its current role, but it's important it goes no further. The credibility and independence of the ECB is vital if the euro is ever to work in the medium to long term. Besides, having to sacrifice the principles of the institution which underpins the whole monetary union in order to ensure its short term survival surely says enough in itself about the underlying conflicts within the fabric of the eurozone.