Friday, November 11, 2011

Why the ECB saving the euro is anything but simple


Our ongoing conference today in Frankfurt, on the current and future of the ECB in the eurozone, could hardly be more timely. We're posing two questions: should the ECB act as the eurozone's lender of last resort, and has the ECB acted within its mandate in this crisis?

In fact, all eyes are now on Frankfurt, as new ECB President Mario Draghi - an Italian and former banker - is faced with a quite awful dilemma: should he shore up his credentials with the German monetary establishment (which would involve hard money policies, staying well clear of any major ECB intervention on the bond markets), or appeasing markets by buying large amounts of Italian government bonds, described by some as a 'silver bullet' (which it isn't).

Draghi's decision the other week to cut the ECB's interest rate has already raised suspicion in some German quarters that the Italian can't be trusted. FDP MP Frank Schäffler - the most vocal critic of current ECB policies - simply stated:
"The hawk has become a dove on his first day in office."
At his first press conference, Draghi went out of his way to insist that its government debt-buying scheme - the Securities Markets Programme (SMP) was “temporary” and “limited”. But since then Italy has been sucked deeper into the crisis, and Draghi may not escape making a tough call on radically extending the SMP, which would lead to many in Germany asking for his head on a plate. Though the pressure on Italian bonds have eased slightly over the last two days - ten years bonds were at 6.7% this morning - and there's talk of the 'Monti effect', markets remain extremely nervous about the complete absence of a fire wall around Italy should the smelly stuff really hit the fun. With EU leaders unable to agree a top-up of the eurozone's temporary bailout fund, the EFSF (they cannot get more loan gurantees through their Parliaments), and with the IMF out of the picture, the ECB would basically stand alone.

To date, the ECB has bought €183bn of government debt through the SMP, including Spanish and Italian bonds. However, for the ECB to act as an effective lender of last resort for the eurozone, and to back stop Italy's €1.8tr bond market, it needs to go far beyond current levels of purchases. We're talking hundreds of billions - if not trillions - worth of government bonds (RBS, for example, estimates that €700bn could be needed to contain Italy).

So why doesn't the ECB step in and save the day? Its pockets are deep enough (it can massively expand its balance sheet as it controls the future supply of money) and doesn't have to go through slow-moving and unpredictable parliaments for approval (that pesky thing called democracy).

Well, there are at least three problems.

Economically: Whilst it clearly comes with some immediate benefits, ECB intervention would not deal with competitiveness gaps in the eurozone or actually solve the eurozone's debt structure in the long-term (as it would merely be passing debt from one balance sheet to another). All ECB intervention does is deal with short-term market jitters and liquidity issues. The ECB could also run into some problems if its financial position is compromised by taking on even more risky debt.

Politically: Large-scale ECB intervention would require nothing short of a major cultural and psychological shift in Germany. As we've noted repeatedly, an independent, strong central bank that stays well clear of any policy that might trigger inflation (read monetising debt) is one of the very founding principles of modern Germany. A central bank that serves as a tool for politicians to paper over cracks in the economy, by flooding the markets with cheap money, remains a hugely frightful prospect in Berlin, for well known historical reasons.

Much like in the internal CDU debate, the German discussion about the role of the ECB reflects a head-on clash between two vital German post World War II objectives: an unambiguous commitment to price stability, on the one hand, and an unambiguous commitment to 'Europe' on the other.

So for UK PM David Cameron to say that he does not 'understand' why some people in Germany are so opposed to the ECB playing a major role in propping up governments, is a bit like Angela Merkel saying that she does not understand why the sovereignty of the British Parliament is so important for the British (for example).

In essence, this would involve messing with some pretty fundamental principles here. Taking the ECB down such a slippery slope towards large-scale debt monetisation could mean that German support for the entire euro project would start to diminish.

Legally: According to the ECB's and the EU's rulebooks, can the ECB really engage in debt monetisation? Despite being limited in comparison to what would be needed for the ECB to shoulder the role of lender of last report, German President Christian Wulff has dubbed the ECB's actions "legally questionable".

German Professor Markus C. Kerber Kerber has already launched a complaint against the ECB with the EU's General Court in Luxembourg (the former Court of First Instance). In his booklet "Die EZB vor Gericht" (The ECB in the dock) he sets out his arguments. In addition to the SMP itself (established on 14 May 2010), Professor Kerber also challenges the ECB's decision to drop its quality requirements for the collateral that Greek, Irish and Portuguese banks can post with the ECB in return for loans (The decisions made on 6 May 2010, 31 March 2011 and 7 July 2011). He claims these that articles violate articles 123 till 125 of the EU Treaty, saying:

Here are the main legal arguments why Kerber thinks the ECB's actions are illegal:
- Art 123.1 bans the ECB and national central banks from buying bonds of member states, either directly or from secondary markets, when the purpose is not mere monetary policy but amounts to fiscal policy (propping up insolvent governments). Kerber cites several economic analyses (as for example this one by DB Research) to back up this claim that the SMP is driven by fiscal policy and therefore illegal.

-The suspension of requirements specifically Greek, Irish and Portuguese government bonds to be accepted as collateral for banks which want to obtain ECB funding is in breach of the ban on privileged access to ECB funding of art. 124. It also goes against the legal rationale behind art. 125 (the famous ban on bailouts).

- The fact that the ECB and its President Jean-Claude Trichet have consciously taken on all this exposure, endangers art. 127, which orders that the primary objective of the European System of Central Banks shall be to maintain price stability. As an example, he cites the purchase of €45 billion of Greek government bonds at the end of 2010, and the emergency liquidity assistance programme, which allows the Irish or Greek Central Banks to rescue their own banks. He claims that because this exposure to European citizens has been taken on consciously by the ECB and its President Jean-Claude Trichet art. 127 which prescribes price stability has been violated.
This is pretty chunky stuff but it does show why large-scale ECB intervention could come against some serious challenges.

1 comment:

Blankfiend said...

German support for the Euro project has already started to diminish. Go ahead and establish an unlimited transfer mechanism to funnel German wealth south indefinitely, and "diminish" turns to "vanish."