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Monday, November 14, 2011

David Cameron has got it wrong on the ECB

We had a piece in the Sunday Telegraph over the weekend, discussing the recent calls by Prime Minister David Cameron for the ECB to step in and become full lender of last resort for the eurozone:
In recent days, Prime Minister David Cameron has suggested that the European Central Bank (ECB) should step in and fully backstop the eurozone. Unfortunately, this looks to be misguided for a number of reasons.

These calls are not only economically flawed but could be politically divisive - asking the ECB to fulfil such a role could undermine the long-term sustainability of the eurozone, and sacrificing the long run to save the short run is always self-defeating.

Firstly, even if the ECB were to intervene (by stepping up its purchases of bonds for example) it would only provide a liquidity boost and wouldn’t address any of the solvency or structural problems in the eurozone. There would no benefit in Greece, Portugal and Ireland. Furthermore, this money would be provided to states such as Italy and Spain without conditions, meaning the pressure to enact necessary economic and institutional reforms would be removed. It is vital that these countries enact such reforms if they have any hope if becoming competitive again and maintaining a sustainable debt load. Therefore, such a move by the ECB could end up being counterproductive.

More importantly though, such ECB intervention is a red line for the German government and much of the German electorate - they are therefore not likely to take kindly to such external recommendations. Many commentators suggest this will be overcome due to necessity, however, at that point it will become a broader political question for Germany, specifically, whether it wants to remain in a monetary union where the central bank, to which it offers the biggest guarantees, has become a full lender of last resort for sovereign states.

As such, if the ECB were to act in the way Mr Cameron suggests, it could create a huge political division within the eurozone and may erode German support for the project as a whole. Needless to say then that, from a UK-German relations perspective, these suggestions were not well advised.

But why is it such a big deal for Germany? For well-documented historical reasons, Germany fears any policy which may stoke inflation and although this may not be a threat in the short term, there is a valid fear that becoming the lender of last resort for states could undermine the ECB’s ability fight inflation effectively. Huge ECB intervention could significantly damage its independence and credibility.

Consider where we are now - the ECB has consistently resisted fulfilling this role as lender of last resort despite widespread calls from politicians. If it were to give in now, most would see it as giving into their demands. This would knock market belief in its independence while it would be in a weakened negotiating position with politicians at any future discussions on similar issues.

This should not only alarm Germany but the rest of the eurozone as well, since the ECB could be seen as an ineffective institution, this would undermine the future of the eurozone completely.

Lastly, it is also clear that neither the ECB nor the eurozone has any clear exit strategy were the ECB to step in and ‘temporarily’ aid struggling states. Similar problems can be seen with its lending to European banks - many have now become reliant on ECB funding, meaning the ECB cannot retract it at any point in the near future without causing huge disturbances in financial markets.

Such a situation with states would be undesirable and dangerous. At some point, ECB action may become inevitable and unavoidable, but at that point it would be almost impossible for the eurozone to survive in its current form. However at the moment, it is not the right policy for Mr Cameron to be advocating for the eurozone or for UK-eurozone relations.

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