What's the best place to publish an ECB letter setting out your country's economic policies?

Former Spanish Socialist Prime Minister José Luis Rodríguez Zapatero has upset quite a few people after he included the letter he received from the ECB and the Bank of Spain in August 2011 in his recently published memoirs. Though bits and pieces of the letter had already been disclosed, the full content was never really made public. In a radio interview today, Zapatero has justified his decision to keep the content of the message secret at the time because at least part of it "would have put stability at risk".

Courtesy of El País, we have had a look at the letter – and we thought it was worth translating a few key points:

• The first priority identified by the ECB and the Bank of Spain is labour market reform. The letter reads, “We deem it necessary to adopt additional measures that improve the functioning of the labour market […] We are enormously concerned about the fact that the [Spanish] government has not adopted any measure to abolish inflation-indexing clauses. Such clauses are not an appropriate element for the labour markets in a monetary union, as they represent a structural obstacle to the adjustment of labour costs.” 

• The letter goes on, “The government should also adopt exceptional measures to promote wage moderation in the private sector [...] We suggest revising other labour market regulations shortly, with a view at speeding up the re-integration of unemployed people in the labour market [...] We see important advantages in the adoption of a new exceptional work contract that is applied for a limited period of time, and where compensation for dismissal is very low.” 

• The second priority is the adoption of “bold measures to ensure the sustainability of public finances. The government should prove in a clear manner, by action, its unconditional commitment to the achievement of its fiscal policy targets, irrespective of the economic situation. To this end, we urge the government to announce, by the end of this month, additional measures of structural fiscal consolidation for the remainder of 2011 worth at least more than 0.5% of GDP.” “Simultaneously”, continues the text, “the application of national fiscal norms must be continued in order to ensure [central] control over regional and local budgets (including the authorisation for debt emissions by regional governments).” 

• The third priority is product market reform. According to the letter, the Spanish government should “increase the competitiveness of the energy sector in order for prices to better reflect the cost of energy” and “increase the competitiveness of the services sector, in particular by addressing the regulation of professional services.” 

Therefore, as in the case of Italy (see our blog post from September 2011), the letter was a lot more than just a push to shape up. It was a detailed and quite prescriptive to-do list in return for ECB bond-buying - even boiling down to specific policy measures and the size of fiscal cuts. Furthermore, it did not shy away from touching on politically sensitive issues for Spain – just think of the demand for more central control over regional spending or the abolition of wage indexation.

All this put the ECB squarely in the realm of domestic fiscal policy, somewhere many would agree it should not be. In any case, any country considering applying for an OMT bond-buying programme should consider these points when wondering how prescriptive the conditionality might be.

The closing paragraph of the letter sounds a lot like a warning. It reads, “We are confident that the [Spanish] government is aware of its highest responsibility in the good functioning of the eurozone in the current [economic] conjunction, and that it will adopt in a decisive manner the necessary measures to regain the confidence of the markets in the sustainability of its policies. Such measures […] should greatly benefit not only the Spanish economy, but also the eurozone as a whole.”

Therefore, it is no surprise that many of the letter’s ‘suggestions’ have become government policy – though under the centre-right cabinet led by Mariano Rajoy, who took office at the end of 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?

Trichet: I have a dream (an EU finance minister)

Jean Claude-Trichet is reaching the end of his term as ECB President, which is probably the reason why felt able to say this today:

"In this Union of tomorrow, or of the day after tomorrow, would it be too bold, in the economic field, with a single market, a single currency and a single central bank, to envisage a ministry of finance of the Union?"

In a provocatively political speech in Aachen, Trichet set out some ideas on what 'fiscal union' inside the eurozone might actually look and feel like, particularly for eurozone governments that call on their neighbours for financial help in future.

Trichet argued that there should be a "second stage" - a point at which recipients of bailouts are no longer able/willing to implement prescribed conditions, such as austerity - where other member states i.e. those stumping up the cash for the bailout "take themselves decisions applicable in the economy concerned":

"One way this could be imagined is for European authorities to have the right to veto some national economic policy decisions. The remit could include in particular major fiscal spending items and elements essential for the country’s competitiveness."

Given that a growing number of people are realising that the mid-to-long-term future of the eurozone is likely to require the 'twist or bust' choice between some form of fiscal union or some countries exiting, the question for the likes of Trichet is how do you sell 'fiscal union' to the general public.

Trichet dressed up his core message with various quotes from European philosophers and 'fathers of European integration' but this is unlikely to cut the mustard with the ordianry voters in Athens, Lisbon, Munich, or Amsterdam. As the FT's Martin Wolf noted this week, "How will the politics of these choices now play out? I truly have no idea. I wonder whether anybody does."

ECB Presidency: Now what?

Axel Weber's elevation to President of the European Central Bank was long seen as a mere formality - a natural step towards the realisation of a"German-speaking euro". So reports in today took plenty of people by surprise, including Chancellor Merkel and the markets. Apparently, the Governor of the German Bundesbank has decided to pull out of the race because, in the words of a European official quoted by the WSJ, he has "other plans". Some papers suggest that these plans could involve a top job at Deutsche Bank.

The situation is somewhat confused. According to Bundesbank sources, Weber might still want to run for ECB-President. Weber himself has said he will not make any comments until he discusses the issue with Merkel. But our guess is that Weber has thrown in the towel.

First, Weber doesn't have lots of friends in the eurozone's "periphery" countries. He's a fierce (and vocal) opponent of the ECB's purchases of junk bonds from Greece, Ireland & Co. And he's probably keen on raising interest rates to curb inflation, because, at the end of the day, this is what the ECB is there for. But such a policy would be poison for vulnerable economies in the eurozone, that are trying bounce back from the economic downturn.

Germany may also have decided that sacrificing Weber's ECB Presidency was a price worth paying in return for France's backing for the "pact for competitiveness".

So now what? Merkel is said to be lacking a "plan B". The only viable alternative would be Klaus Regling, the chairman of the European Financial Stability Facility, but he has no intention of quitting his current post.

Sarkozy would presumably be quite keen to replace Trichet with Christian Noyer, the Governor of the French Central Bank. Or maybe with IMF Director Dominique Strauss-Kahn (simultaneously neutralising a possible rival in next year's French Presidential elections). But nationality matters, and it's very unlikely that another Frenchman is appointed in place of Trichet.

Italy's Mario Draghi has therefore emerged as the strongest contender. He has been doing a decent job in protecting Italian banks from the crisis, and his international reputation as Chairman of the Financial Stability Board is up to scratch. He's also considered more diplomatic than the hawkish Weber.

However, his previous position at Goldman Sachs could prove to be an obstacle. In addition, as ECB President Draghi would also chair the European Systemic Risk Board, the new EU watchdog in charge of macro-prudential supervision. But Italy has already secured the chairmanship of the European Banking Authority (Andrea Enria). There are four new financial supervisors in the EU, and giving two of the chairman positions to Italy might prove too much, especially as the UK, Germany and France got none.

The situation remains fluid, in other words. Trichet is leaving the Eurotower in October and what's clear is that the eurozone can hardly afford a row over his successor.

So that €750bn bailout was just a misunderstanding?

In an interview with the FT published today, Jean-Claude Trichet makes a pretty extraordinary comment. He seems to deny that the eurozone was ever really in crisis:

"I don’t think that the euro area was close to disaster at all – seen from the inside."

So €750bn eurzone bailout packages, €110bn 'loans' to Greece and the ECB compromising its independence by buying government debt, are just business as usual? Trichet blames the misconception that the euro is in trouble on a lack of understanding:

"Seen from the outside, I would say that it’s always difficult for external observers to judge and analyse correctly the capacity of Europe to face up to exceptional difficulties."

If only Trichet were right. Unfortunately it seems that EU leaders are still unwilling to admit to the fundamental failures of the EMU project - such as huge divergences within the eurozone and monetary union without fiscal union. Tightening budget rules is all very well, for example, but what about a country like Spain that wasn't in breach of them running up to the crisis?

Until the eurozone elite faces up to this fairly simple and fundamental reality, the truth is that it is they that 'don't get it', not us mere 'outsiders'.

Bundesbank suspects a French conspiracy

The Bundesbank isn't exactly happy about the ECB's decision to start bying government bonds directly from banks - effectively making the once heralded 'independent' bank a dumping ground for bad eurozone loans. The ECB has bought some €25 billion worth of Greek bonds so far.

Spiegel reported over the weekend that Bundesbank officials have openly expressed their suspicions that the entire operation is a French stitch-up - a way for French banks to unload their Greek junk bonds. German banks aren't benefiting from the move since they've promised the German Finance Ministry to keep Greek bonds until May 2013.

One high ranking official is cited by the magazine suggesting that ECB President Jean-Claude Trichet, a French national, gave into pressure from French President Nicolas Sarkozy to change the ECB's stance opposing the purchase of member state governments' bonds - hence the conspiracy charge.

The ECB and the Bundesbank appear to be drifting further apart. Or as Le Monde puts it today, "A perfume of divorce is floating between the Germans and the ECB".