Tuesday, November 15, 2011

Is the ECB Determined to Go Down with the Ship?

With the risk premium on Italian government debt growing, the best hope for a resolution to the Euro crisis would seem to be for the European Central Bank to announce an unlimited intervention to cap the yield on sovereign bonds.  However, it steadfastly refuses to do so - presumably because it feels that such an action might risk a violation its prime directive of "inflation rates of below, but close to, 2% over the medium term."

In a recent Project Syndicate column, Brad DeLong argued that the ECB is failing to step up to the plate as the lender of last resort:
The ECB continues to believe that financial stability is not part of its core business. As its outgoing president, Jean-Claude Trichet, put it, the ECB has “only one needle on [its] compass, and that is inflation.” The ECB’s refusal to be a lender of last resort forced the creation of a surrogate institution, the European Financial Stability Facility. But everyone in the financial markets knows that the EFSF has insufficient firepower to undertake that task – and that it has an unworkable governance structure to boot.

Perhaps the most astonishing thing about the ECB’s monochromatic price-stability mission and utter disregard for financial stability – much less for the welfare of the workers and businesses that make up the economy – is its radical departure from the central-banking tradition. Modern central banking got its start in the collapse of the British canal boom of the early 1820’s. During the financial crisis and recession of 1825-1826, a central bank – the Bank of England – intervened in the interest of financial stability as the irrational exuberance of the boom turned into the remorseful pessimism of the bust.
Similarly, Barry Eichengreen writes:
Here’s where the political cover comes into play. Merkel and Sarkozy need to make the case that if the euro is to become a normal currency, Europe needs a normal central bank – one that does not merely target inflation like an automaton, but that also understands its responsibilities as a lender of last resort.
More on this from The Economist, Antonio Fatas, Gavyn Davies and Martin Wolf as well as a nice "news analysis" from the NY Times

If Italy is fundamentally solvent and merely facing a self-fulfilling "liquidity" panic (as investors sell bonds, yields rise, making it more costly to service its debts, which lowers the chances it will avoid default leading to investors selling bonds...), then it may not require much more than an announcement of a willingness to intervene to quell the crisis.  By restoring confidence, the ECB could bring yields down without having to do much actual bond-buying (i.e., Super Mario* can be Chuck Norris).

The crisis potentially spells the end of the Euro - so the ECB is putting its mandate ahead of its own self-preservation.  That is, it appears willing to risk its very existence for the sake of what it sees as its duty.  As a matter of economic policy, it looks disastrously foolish, and yet, there's something oddly noble-seeming about it.

*Admittedly, referring to Italian policymakers named Mario as "Super Mario" is getting stale quickly (and I can't imagine how much they must despise it); and the press needs to decide whether it is ECB President Mario Draghi or new Prime Minister Mario Monti who is called "Super Mario" (or perhaps not... a quick search of "Super Mario" on the FT reveals a potentially confusing solution: "Super Mario Brothers").  The Guardian compares two of the "Super Marios" and this FT profile argues Draghi earned his "super."


Ralph Musgrave said...

Comparing the ECB to a normal central bank is a very questionable exercise. A normal central bank acts as lender of last resort for COMMERCIAL BANKS, not for geographical areas or countries – as is the case, or potentially is the case with the ECB.

As for Barry Eichengreen and Martin Wolf, they don’t seem to grasped the point that if the ECB buys limitless volumes of dodgy periphery debt, this amounts to a subsidy by responsible shareholders in the ECB (Germany etc) of less responsible shareholders (the periphery).

There are no prizes for guessing what Greeks would do if their debt was effectively written off or “haircutted”: they’d award themselves pay increases, earlier retirement: all the usual goodies they’ve grown accustomed to helping themselves to.

That is not to say that the EU as opposed to the ECB couldn’t subsidise the periphery. But that is a POLITICAL decision: not a decision for a central bank. The south east of England subsidises the less well off areas of England: the decision to do that is taken by politicians, not by the Bank of England.

Plus the cultural and emotional ties between different areas of a given country (like England) are sufficiently strong that the wealthier parts of such countries do not mind subsidising the less wealthy areas. The cultural and emotional ties between different EU countries are not so strong.

Bill C said...

Thanks for the comment.

That's a fair point that lending to soverigns is different from the more usual conception of "lender of last resort" to the banking system (which the ECB has been doing). I'd originally wanted to note that but it didn't fit with the flow of the post, so I'm glad you brought it up. The Gavyn Davies post I linked to discusses the implied resource transfer.

I think its also worth remembering that the booms in the peripheral countries were fueled by rates that were too low for them because they were set by the ECB based on European averages (high weight on Germany) and that the beneficiaries of "bailouts" are the creditors at least as much as the borrowers. That is, I think there are some weaknesses in the general virtuous northerners versus slovenly southerners story.