On Monday, Standard & Poor’s downgraded Greece’s credit rating to CCC. After a year of failures, the Eurozone crisis has not been contained. Ironically, a central role in this debacle belongs to the European Central Bank (ECB).
The three-notch downgrade makes Greece’s debt the lowest-rated in the world by Standard & Poor’s. As a result, restructuring of Greece’s debt —with a bond swap or by extending maturities on existing bonds — looks likely to be imposed by European policymakers as a way to share the burden of Greece’s crisis with the private sector. “In our view, any such transactions would likely be on terms less favorable than the debt being refinanced, which we, in turn, would view as a de facto default according to Standard & Poor’s published criteria,” said S&P in a statement.
Now, fast forward to a secret meeting at Luxembourg on May 6, when the Greek situation was discussed by the finance ministers from the large euro countries, President of the ECB Jean-Claude Trichet, Eurogroup President Jean-Claude Juncker, the EU economic affairs commissioner Olli Rehn and Greece’s George Papaconstantinou. After a year of muddling through approaches in the Eurozone, Greece had failed to fulfill its austerity requirements. Still, debt restructuring was not in the agenda. Juncker ruled it out and, when the proposal to re-profile Greek debt came up, Trichet went ballistic and walked out – as the observers put it.
Until recently, Trichet and executive board member Lorenzo Bini Smaghi have been intensely opposed to any restructuring of Greece’s public debt. They—and others within the ECB and outside of it—have insisted that a debt restructuring in Greece would lead to financial Armageddon.
While these fearful comments about massive contagion and financial disaster may have little conceptual or empirical basis, there is another, far more pressing reason for the European leaders’ concern for contagion. It has less to do with proposed debt restructurings than with the potentially severe implications of the flawed effort to bail out indebted Euro economies, and the time bombs inherent in the ECB’s asset base.
From bad choices and denials to bad medication and vultures
In 2000, the European Council adopted a new 10-year strategy aiming to “make Europe, by 2010, the most competitive and the most dynamic knowledge-based economy in the world.” During the past decade, the key goals of the strategy have failed; in terms of economic growth, Europe has been lagging behind most regions worldwide.
In late March 2010, the EC agreed on the key elements of the Europe 2020, another 10-year strategy aiming at “smart, sustainable, inclusive growth.” As the new strategy was formally adopted in June 2010, it was already dead on arrival. The Eurozone had already been swept by a severe, systemic and pervasive debt crisis.
After a year of muddling through, escalating costs of bailouts, increasingly violent protests against the austerity programs, and no end in sight for the Eurozone crisis, denials prevail.
Recently, ECB President Trichet stated that public finances in the euro area as a whole are “sound” and governments will be able to “stop the adverse debt dynamics” caused by the financial crisis. By the same token, he reinforced market expectations that the ECB will follow up April’s’ first interest rate increase in nearly three years with another hike in July, even if the economic outlook faced “an environment of elevated uncertainty.”
Yet, persistent denials augmented by wrong medication are not likely to revive a patient haunted by vultures circling above.
With its bad decisions in spring 2010, the ECB entrapped itself in a narrow hole, which it is now making deeper. In the early days of the crisis, the European Union leaders rushed to aid Greece, in an essentially political effort to sustain Europe’s economic integration. As so often before, the way to a nightmare was paved with good intentions.
Instead of opting for an essentially doomed approach, Brussels should have turned Greece to the International Monetary Fund (IMF). Instead, the ECB took hundreds of billions of euros worth of risky securities as collateral to boost up the banks of the struggling Eurozone.
What was supposed to save European integration is now about to threaten the very basis of this integration.
Time bombs in Frankfurt
The ECB administers the monetary policy of the 17 EU Eurozone member states. It is thus one of the world’s most important central banks. The new ECB headquarters is located in the eastern part of Frankfurt, the largest financial center in the Eurozone. The skyscraper will be some 185 meters tall. It is expected the complex will have twice the floor area compared to the current, temporary home.
While it was expected to become a financial and architectural symbol for Europe, construction of the headquarters was put on hold in June 2008 as the ECB was unable to find a contractor that would build the Skytower for the allocated budget of €500 million – which, however, is peanuts in comparison to the billions of risky euros hidden in the ECB asset base.
After all, truly autonomous national central banks no longer exist in the Eurozone. Rather, the ECB’s balance sheet is a reflection of the European System of Central Banks (ESCB), which comprises the ECB and the national central banks (NCBs) of all EU Member States. Since not all the EU states have joined the euro, the ESCB could not be used as the monetary authority of the eurozone. Consequently, the Eurosystem (which excludes all the NCBs which have not adopted the euro) became the institution in charge of those tasks which in principle had to be managed by the ESCB.
During the past year, the Eurozone crisis has resulted in an abdication of responsibility as core banks in countries, such as Ireland, Greece, Portugal and Spain have unloaded risky financial assets, amounting to hundreds of billions of euros, into national central banks. In turn, these central banks have distributed substantial sums to their countries’ financial institutions, seeking to deter their collapse. In the process, they have accepted securities as collateral, the real value of which is significantly or far less than their nominal value.
By early 2011, for instance, the ECB had accepted almost half a trillion euros of the so-called asset-backed securities as collateral.
The problem is not so much that the ECB has become an enormous “bad bank” for bad loans; but that it is sitting on a cocktail of good and bad loans and the distinction between one and the other has grown increasingly blurry.
Weber debacle reconsidered
So when Trichet stormed out from the secret meeting in early May, after arguing that debt restructuring in the Eurozone could not be controlled and would result in a financial chaos, the concern may have had more to do with the potential default of Greece (and the future of other fragile Euro economies) – which, in turn, would shift spotlight to ECB’s assets and their value.
Trichet’s term at the ECB expires in November. His was to be a legacy of stability, prosperity, and growth. Now it looks more like instability, impoverishment, and stagnation.
Only a few months ago, the debacle over Trichet’s successor foreshadowed the current scramble in the Eurozone. In Germany, Chancellor Angela Merkel had done her best to ensure that Alex Weber, President of the Deutsche Bundesbank, would succeed ECB President Trichet. In early February, however, Weber announced that he would be resigning his chairmanship of the Bundesbank, effective April 30, 2011; a year earlier than the expiry of his term of office. The move threw open the candidacy for the ECB, but it was not a surprise.
In May 2010, the ECB, in an effort to save the euro, decided to buy up government bonds of highly indebted countries like Greece, Portugal and Ireland. In contrast to Trichet, Weber saw this as a serious violation of the principle that money should not be printed to finance government debt.
In addition to criticizing the measure internally within the ECB council, Weber also took the unusual step of making his reservations public. In doing so, he incurred the wrath of Trichet. Like De Gaulle once perceived himself as France herself, Trichet saw himself as the ECB: “There is only one ECB statement, and it comes from me.”
In retrospect, it is Weber’s concerns about the job that have proved valid. He was horrified to assume responsibility for a policy he believed fundamentally incorrect and for risks he would never have assumed. Moreover, the future seemed to promise only more of the same; in negotiations over the future euro crisis mechanism, Merkel did not push through automatic, tough sanctions against those in violation of European budget deficit rules.
Put simply, Europe was going in a wrong direction, which reflected everything but sustainable monetary and fiscal policy. Few months ago, Weber was said to have done damage not just to the German government but to the entire Eurozone. In reality, by bowing out, he retained the integrity that ECB lost in 2010.
Transferring risks from the periphery to the core of Europe
At the end of 2010, there were almost 29,000 securities on the ECB’s list of “eligible assets,” amounting to €14 trillion. National central banks determine which securities are placed on the list and under what conditions. The ECB has no obligation to supervise these central banks, not to speak of an ability to monitor individual central banks.
The bottom line: even Trichet does not know the kind of risks that lurk in the ECB books. And, with maturities ranging from 30 to 90 years, these securities pose ongoing risks far into the future.
The ECB is about to learn the hard truth that Keynes warned of. “If you owe your bank manager a thousand pounds, you are at his mercy,” Keynes once said about the sterling debts. “If you owe him a million pounds, he is at your mercy.”
In other words, if the Eurozone crisis economies owe ECB large amounts of money, it is no longer just a problem of these Euro economies; it is now also and especially the problem of the ECB.
As the risks of the peripheral Europe were transferred to the ECB, they became the risks of the core of Europe.