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Tuesday, August 09, 2011

The ECB's SMP rationale

There are many questions surrounding the ECB’s decision to purchase Italian and Spanish debt under its Securities Markets Programme (SMP), but one that hasn’t been heavily probed is the ECB's rationale for its intervention (admittedly not the biggest issue but an interesting one nonetheless).

In its statement on Sunday the ECB claimed that it had decided to “actively implement” the SMP (read purchase Italian and Spanish debt) in order to help restore “a better transmission” of monetary policy. ECB President Jean-Claude Trichet reiterated this position again today saying:
"The ECB is fiercely independent. Ours are monetary-policy decisions. They are absolutely not negotiated"
So, the ECB is essentially suggesting that they have decided to purchase bonds not because they want to safeguard the eurozone but because it is essential for the ECB to effectively fulfil its primary goal of price stability.

This may seem like a trivial difference, but it is important to hold central banks accountable for their actions, particularly when they border on fiscal policy and politics such as this instance does. The ECB is clearly claiming that it is not stepping outside of its mandate; however, this does not look to be the case. (It’s not entirely the ECB’s fault given the position that eurozone leaders have put it in, but highlights the structural problems within the eurozone, when the so-called lender of last resort can only act if it justifies its actions under the auspices of 'monetary policy').

So could the SMP purchases ever actually form part of monetary policy transmission? Well, as an FT editorial points out today, the rising yields and falling prices of Italian and Spanish government debt, combined with the growing market turmoil, could put significant pressure on European banks (Italian and Spanish ones in particular, since they hold mountains of sovereign debt). Conducting monetary policy effectively through banks and financial markets where some of their core assets are dropping in value is far from easy.

This argument makes sense, except for one important point – why, if this policy is justifiable from a standalone view of monetary policy, did the ECB need to rally so hard (reportedly sending secret letters with effective demands to Italian PM Silvio Berlusconi) to get guarantees in return for its decision? It’s become clear that the ECB applied significant pressure to the Italian and Spanish governments to get the economic policies which it saw as desirable. In Italy this meant front-loading the budget cuts while in Spain it meant instituting more cuts this year to meet the deficit targets, and we’re sure there’s more to come.

The point here is that the ECB is stepping outside its mandate and, pretty much, engaging in fiscal policy. It is necessary to do this (to some extent) because the eurozone lacks a suitable lender of last resort (as we’ve previously pointed out), but the ECB can only do this by pretending its part of its monetary policy goals. This almost ridiculous situation highlights an on-going structural flaw in the eurozone – specifically, who is the final backstop and how accountable are they?

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