AN UNCOMFORTABLE FINAL STRETCH FOR TRICHET / THE FINANCIAL TIMES COMMENTARY & ANALYSIS ( A MUST READ )

July 31, 2011 9:25 pm

An uncomfortable final stretch for Trichet

By Ralph Atkins in Frankfurt


Other eurozone policymakers have fled on holiday, hoping for respite from the region’s debt crisis. Jean-Claude Trichet, however, remains in Frankfurt this week, for August’s European Central Bank governing council meeting and press conference – a fixture since global financial turbulence erupted four years ago.


Still, the euro’s monetary guardian can take stock and draw lessons from recent events – not least for Italy’s Mario Draghi, who takes over as ECB president in three months. A first conclusion is that the crisis is far from resolved, and may have entered a more dangerous phase.


The revised rescue package agreed recently in Brussels could, finally, have put Greece on track towards debt sustainability, although that remains questionable. But by, in all probability, pushing the country into technical default eurozone leaders set a worrying precedent. Just as the ECB warned, contagion effects are now escalating, last week embracing Cyprus and driving up borrowing costs in Italy and Spain. Rather than ringfencing Greece, eurozone politicians may have turned it into a systemic problem.


Mr Trichet argued vehemently against any kind of Greek default because of the signal it would send, and because he feared the ECB would be left to clear up the mess.


A second lesson is that further conflicts between the ECB and eurozone governments are inevitable – perhaps even desirable. Some economists argue the ECB should reassure investors it is always the ultimate backstop, allowing politicians freer rein. Unfavourable comparisons are made with the US Federal Reserve. By continental European standards, the Fed has seemingly unlimited powers to ensure economic stability, through large-scale asset purchase programmes; the ECB is fixated on fighting inflation.


Eurozone politicians would dearly like the ECB to show more flexibility. But so far it has denied them that luxury – and left unclear what it would do in a worse-case scenario. Now more than ever, the central bank wants a lever of influence to ensure politicians take the steps necessary to stop the eurozone falling apart. If eurozone politics has become a game of chicken, the ECB does not see why it should withdraw first.


At the Brussels summit, Mr Trichet won concessions. One was an assurance that, in the case of Greece being declared in “selective default”, eurozone governments would provide €35bn ($50bn) in collateral to allow Greek banks to continue borrowing from its life-saving liquidity window. That averted the ECB having to decide whether to continue to accept dodgy Greek government bonds as collateral; it made a selective default semi-palatable.


Another gain was agreement that the €440bn European financial stability facility, the European Union’s bail-out mechanism, would in future be able to buy government bonds on the open market. This was long an ECB demand, and would allow a government-sponsored vehicle to act as a financial backstop, leaving the hands of the ECB clean. What is more, EFSF intervention will be “on the basis of an ECB analysis”, according to the concluding statement of the July 21 eurozone leaders’ summit. No one is yet quite sure what that means in practice but it could give the ECB considerable influence – with the bill being paid by finance ministers, not landing on its balance sheet.


The ECB is rightly wary about the damage Berlin might wreak if unchecked. ECB policymakers were alarmed at the German government’s determination to secure commercial banks’ participation in the latest Greek rescue – despite the damaging signal sent to potential investors. In the event, the extra collateral eurozone governments will have to provide and the cost of shoring-up Greece’s bank system will mean taxpayer commitments will vastly exceed the relatively modest sums raised from the private sector. That still did not stop Berlin from pressing ahead with the plan.


ECB eyebrows rose even further as chancellor Angela Merkel’s coalition government squabbled and Franco-German splits delayed decisions.


In the end, Mr Trichet did compromise, agreeing that an attempt at an orderly Greek debt restructuring could go ahead. That has not helped his credibility, especially after last year’s U-turn in which he first agreed to rule out an ECB bond purchase programme and special favours for Greece – and then relented. This week’s press conference will be one of the least comfortable he has experienced.


But the ECB’s chicken-game playing skills have not yet been fully tested. If Mr Trichet had not won the agreement reached, would the ECB have allowed the collapse of the Greek banking system, with disastrous consequences for the rest of the eurozone? The central bank can only accept adequate collateral from sound banks; there are legal limits on “monetary financing”, or central bank funding of governments. At some point, central bankers’ powers reach limits. For all its omnipotence, the Fed did not prevent the 2008 collapse of Lehman Brothers, and has stood clear of the US budget crisis.


Yet ECB policymakers have interpreted its rule book flexibly in the past; last year’s bond purchases were a case in point. Would it really have jeopardised the eurozone’s future? Constructive ambiguity is a useful weapon for central bankers.
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Copyright The Financial Times Limited 2011