The ECB’s role has evolved in its decade-long existence. In this note I describe how the choices of the ECB have damaged the institution’s legitimacy. This matters because decreased legitimacy lowers the ECB’s future policy effectiveness and weakens the legitimacy of all other institutions of governance in the EU, including the European Commission, the European Court of Justice, and the European Parliament.
In evaluating the ECB’s performance, I split the last eight years into two parts:
- The benign period up until August 2007 when the institution was focused on price stability; and
- The period after when the ECB was called upon to help contain the liquidity crisis and, within its powers as a central bank, to mitigate the banking sector insolvency and sovereign debt crises.
Prior to August 2007 the ECB produced stable and only slightly above-target inflation. However, it lacked procedural transparency. The Treaty makes it clear that it was intended that members of the Governing Council should vote. An astonishing 834 words are devoted to describing exactly how the voting mechanism is to work. Unfortunately, in comparison to other central banks that are supposed to make decisions by majority rule, such as the central banks of Japan, Sweden, the UK, and the US, the ECB is opaque about how its policy rate decisions are reached. It does not reveal the vote or publish minutes. When questioned by the press or the European Parliament about the lack of procedural transparency, ECB President Trichet’s stock response has been to view transparency as being equivalent to explaining one’s decisions ex post and to extoll the virtue of the ECB in this regard.
It turns out that votes on policy rates are never taken. Apparently, some small subset of the Governing Council decides, prior to the meeting, what the policy rate will be and this is then presented to the entire Governing Council, which we are to believe always or almost always unanimously approves. This explains how the Governing Council is able to produce the lengthy post-policy meeting statement that Mr Trichet views as the ECB’s major contribution to transparency. With the decision made before the meeting, there is ample time to prepare it.
That this extraordinary decision-making mechanism has gone on for so long with no formal explanation beggars belief. Who gets to make the decision? Why is it that no Governing Council member has ever insisted upon their legal right to a vote on monetary policy? Is there really never any dissent? How can that be? That we are able to ask these questions about an institution that is supposed to be one of the world’s two most important central banks is not good for its legitimacy. Moreover, while this arrangement has functioned well enough so far, what would happen if some future president were a little less like Mr Trichet and a little more like, say, Davíð Oddsson?
In Mr Trichet and the Governing Council’s defence, the ECB is woefully badly designed. The Governing Council has 23 members – a ludicrous size for a decision-making body. If each member gets a ten-minute opening statement, the rate-setting meeting would have gone on for almost four hours before any actual debate begins. With no formal way of reducing the size of the decision-making body, Mr Trichet may have had little choice but to make monetary policy informally.
In the period after the crisis the ECB has done a reasonable job relative to other central banks. It initially responded to the August 2007 liquidity crisis by dousing markets with liquidity in an attempt to drive down the interest rate. This was bad as the problem was not that financial institutions could not borrow at a reasonable interest rate using the good-quality collateral demanded by the Eurosystem. Instead, it was that they could not sell their asset-backed securities or use them as collateral because the markets for these assets had dried up. However, as the liquidity crisis continued and widened into a solvency crisis, the ECB’s policies evolved. When – for example – the spread between the three-month LIBOR and the overnight indexed swap rate widened, the ECB responded sensibly by undertaking liquidity-providing longer-term refinancing operations with a maturity of three months and offsetting these with their main (short-term) refinancing operations. In mid-October 2008 it made the necessary and massive changes in what was to constitute eligible collateral.
Financial stability role
Unfortunately, the ECB has not been a model of openness in its financial stability role. It does not tell us how it values illiquid marketable securities or how it decides its haircuts. When a member of the ECON committee of the European Parliament asked about how asset-backed securities are valued for collateral, Trichet said, “This is done by the system in ways which I considered appropriate but that we can improve at any time if we judge that they should be improved…”. In other words, I’m not going to tell you and only our opinion matters.
The ECB’s haircut policies are hard to fathom. Why do haircuts increase sharply with an asset’s maturity even when the potential illiquidity does not necessarily do so? This policy only encourages the issuance of short-term debt. No wonder banks are facing massive short-term debt refinancing requirements during a period that they are also trying to access the markets for additional capital. With no explanation, one might wonder if the ECB even has a coherent theory of how to determine haircuts.
This opacity about collateral policies is potentially much more damaging to legitimacy than the lack of transparency in monetary policy. In deciding what securities to accept as collateral and how to value and haircut them, the Eurosystem is redistributing wealth.
In its attempt to maintain financial stability the ECB and Eurosystem have had to walk a fine line between providing just enough liquidity to keep potentially solvent institutions afloat and subsidising the financial sector. Given the lack of transparency it is not easy to judge how well they have done at this, but a couple of examples show that sometimes – through design or otherwise – they have strayed into the subsidisation territory.
- One example was the policy of allowing Icelandic banks to borrow from the Eurosystem using each other’s debt as collateral.
- Another was the unlimited one-year fixed rate liquidity provision of June 2009 which may have been a transfer of about €1 billion from taxpayers to delighted banks (see Buiter 2009).
Playing Santa Claus to banks – Icelandic or otherwise – is not part of the ECB’s mandate and does not enhance its legitimacy.
So far, the ECB appears to have been less competent in managing the sovereign debt crisis than it was in managing the liquidity and banking crises. That ECB policymakers did not speak out about the state of Greek finances, although they must have realised by 2004 that Greece was verging on insolvency, and that they continued to accept Greek sovereign debt on the same terms as they accepted German sovereign debt must have suggested to the market that there were two possibilities. Either, the ECB had superior information suggesting Greece was unlikely to be insolvent or the ECB knew that Greece – or at least its creditors – would be bailed out if Greece were to become insolvent. This may have led the market to be complacent for far too long.
Securities Market Programme
The introduction of the Securities Market Programme threatens the ECB’s legitimacy as the potential fiscal role is an inappropriate activity for an independent central bank. One can imagine that it must have been distasteful to Mr Trichet to undertake such a task, but – understandably – he may have viewed it as a less unpalatable option then allowing Greece to default in May 2010.
Not all uses of the Securities Market Programme are inappropriate, however.
- In the event of a wholesale creditor run based solely on self-fulfilling expectations, it is reasonable for a central bank to intervene and act as a lender of last resort to financial institutions that would otherwise be solvent.
- Likewise, in the event of a run on sovereign debt that is based solely on self-fulfilling expectations, it is reasonable for a central bank to make it clear that it stands ready to purchase as much of the debt as it takes to halt the run.
- As the recent rise in the yields on Spanish and Italian debt was likely a result of fear-based self-fulfilling expectations, the ECB was justified in its purchases of this debt.
The failing of the institution is that it is not credible that it is willing to purchase enough of the debt to contain the run.
Unfortunately, the ECB’s insistence on secrecy with respect to the programme is particularly damaging. It is widely believed that the average discount to face value paid for the Greek debt acquired (prior to August at least) was no more than 20%. The national central banks appear to have sought out the lucky counterparties. And, the ECB won’t say who they are or how much they paid. The possibilities for corruption under such a system are endless. And one does not have to be a conspiracy theorist to imagine that taxpayers throughout the Eurozone were called upon to subsidise German and French banks after their own governments failed to exercise proper regulation and supervision.
Advice for the new President
The incoming ECB president does not face an enviable situation. The sovereign debt crisis is gaining strength, dampening the economic recovery that might have otherwise been expected to follow the liquidity and solvency crises. His predecessor set a reasonably high standard for competency, but his opacity damaged the legitimacy of the organisation.
Buiter, Willem (2009), “Recapitalising the Banks through Enhanced Credit Support: Quasi-Fiscal Shenanigans in Frankfurt”, Maverecon, Financial Times, 28 June.
This post first appeared at VOX and is reproduced with permission.