August 14, 2012 7:41 pm
ECB is right to ask for more eurozone action
The European Central Bank has been widely criticised for announcing that while it stands ready to buy sovereign bonds, this is conditional upon countries asking for support from eurozone bailout programmes and accepting “strict and effective conditionality”. Bond purchases could buy time. But a bond buying programme that does not require policy changes would contribute nothing to addressing the eurozone crisis and would pose risks, including digging deeper debt, growth and banking holes.
The eurozone’s elected leaders and parliamentarians have been slow to act since the start of the crisis, causing great hardship for millions of Europeans. The issues facing these leaders are complex. But sheltering them from pressure to act only increases the likelihood of continuing failure to do what is needed. And the longer the crises go on, the deeper the holes, the stronger the measures ultimately required, the harder it is to regain confidence and the higher the probability of failure in some form. In the words of a major money manager, “the cost of doing nothing is not nothing”. Of course, as an American commenting on the eurozone, I should acknowledge that this point applies to the US as well, in its failure to address effectively the fiscal, public investment and reform issues critical to our future. (And in full disclosure, Mario Draghi, the ECB president, is a close personal friend.)
The effect of ECB financial support without adequate policy is exemplified by the ECB’s longer-term refinancing operations to eurozone banks, which used the money in part to buy sovereign debt. Many analysts thought that LTROs would buy at least a year, without focusing on how that time would be used. When political leaders continued their inadequate crisis response, markets noticed and crisis conditions recurred more quickly than expected.
Some argue that the ECB could stave off crises in bond markets indefinitely: by buying all bonds in the secondary market and those issued for rollovers and new financing. However, in the 1990s, when the international community addressed serious financial and economic crises in Mexico, Asia and Russia, we concluded that money without policy simply would not work, and that if there is broad-based capital flight, no amount of money is enough.
Today, capital flight could include all forms of eurozone credit assets – sovereigns, private sector debt, bank deposits, bank wholesale funding and so on – sold in what would become a vicious cycle. It could include a sharp depreciation of the euro against other major currencies – not as a policy measure to increase exports, but rather as a reinforcing part of the crisis. And that raises another risk of ECB credit extension without policy conditionality: the spectre of debt monetisation and the loss of ECB credibility. That could create fear of longer-term inflation, through future inflationary expectations and increased money supply. (There is virtually no realistic likelihood of short-run inflation.) That fear, the ECB’s loss of credibility, and continued policy failings could spur a capital market crisis at some unpredictable point.
An effort by the ECB to keep pace with capital flight would in time lead to ruinous inflation and an even more massive crisis. No serious central bank would carry monetary expansion to that level. More broadly, the loss of central bank credibility with respect to long-run inflation is a matter of paramount importance for any financial system.
Eurozone reform programmes are often criticised for involving a level of austerity that undermines growth. But that ignores the necessity for sufficient deficit reduction to win market confidence and thereby avoid crippling interest rates. An effective reform plan for the pressing crises would involve enough deficit reduction to win market confidence, but limited enough to allow for growth. That programme should also include measures that apply now to sustain fiscal discipline, strengthen banks and promote growth, for example by increasing domestic demand in Germany to expand that market for eurozone countries. Such a programme is critical and would enhance economic confidence.
A workable fiscal balance could have been struck earlier in the crisis countries, except Greece. The question is whether, after so much delay, with rising bond yields, worsening economies, and declining market confidence, that can still be done. If not, the policy challenges would be enormously difficult and hugely consequential, since additional writedowns in major economies could easily have destructive contagion effects.
In the long run, the eurozone will require big structural change: eurozone bonds, fiscal union and other measures. But this would take a long time to accomplish and should not be confused with measures to address today’s threats.
None of this analysis applies to the different question of conventional short-term ECB funding to banks against good collateral for purposes analogous to the Federal Reserve’s actions to affect overnight interest rates. These operations do not reduce pressure on elected officials, affect bond markets in stressful times, or threaten ECB credibility.
The only effective way forward is exactly the proposal that the ECB has now made: a combination of supportive funding combined with policy to address the eurozone’s deeply threatening crises.
The writer is a former US Treasury secretary
Copyright The Financial Times Limited 2012.