Lack of enforcement of rules that had been agreed to is clearly an important cause of the current mess in the Eurozone. Violations of the Stability and Growth Pact by Germany and France have been frequently mentioned as a tipping point after which other EZ states stopped behaving in a fiscally responsible way. Frankel has also stated that had the ECB refused to accept as collateral for its refinancing operations securities issued by states that were violating the Stability and Growth Pact, the current crisis would be less severe. Applying a sliding scale of differentiated haircuts might also have helped.
What if we looked at the current criticism of the ECB with the above in mind? Last Thursday the ECB basically stated that it would continue temporary purchases of government bonds on the secondary market only after strict conditionality is imposed on the respective governments by the EFSF/ESM. This should not have been a surprise to anyone who has read the ECB’s previous decision of 14 May 2010 on the Securities Market Program and Draghi’s comments in London in full. In the preamble to the decision on the Securities Market Program, it was stated that:
“The Governing Council has taken note of the statement of the euro area Member State governments that they ‘will take all measures needed to meet their fiscal targets this year and the years ahead in line with excessive deficit procedures’ and the precise additional commitments taken by some euro area Member State governments to accelerate fiscal consolidation and ensure the sustainability of their public finances.”
Clearly, that is a soft statement, but we also interpret it as a signal that the temporary relief offered by the ECB was conditional on the governments fulfilling certain fiscal conditions. Given that this soft conditionality has not worked, it is only logical that the ECB is looking for more formal ways to enforce it.
We should also remember that the Statutes of the ESCB clearly state that “overdrafts or any other type of credit facility with the ECB or with the national central banks in favour of Community institutions or bodies, central governments, regional, local or other public authorities, other bodies governed by public law, or public undertakings of Member States shall be prohibited, as shall the purchase directly from them by the ECB or national central banks of debt instruments”.
Duy, among others, has argued that “saving the Eurozone, at least with any semblance of economic dignity, requires the ECB to acknowledge its role as lender of last resort for sovereign debt”. This interpretation of a central bank’s responsibility blurs the traditional distinction between providing liquidity in a crisis versus bailing out insolvent debtors. This is equivalent to stating that the ECB should breach the limits of the mandate that has been extended to it. That would not only mean a complete loss of credibility for the ECB as an institution, but also personal legal liability for the ECB council members. Once again – breaching the rules that had been agreed to previously is one of the reasons of the current mess in the Eurozone and asking the ECB to violate the boundaries of its mandate cannot be a way out of it.
Now, we are not in any way stating here that the current institutional setup of the Eurozone is either optimal or sustainable. Even more, we think that it clearly isn’t.
There can basically be two kinds of stable fiscal relationships in a monetary union. The first one could be described as the “no bailout” system with no or few restrictions on state budgets, but also no (or very limited) collective liability. This is close to the relationship between the federal and state governments in the United States. The second one is a system with collective liability, but also strict limitations of the fiscal sovereignty of the states.
The EMU has currently moved into a fiscal relationship that is not sustainable in the long run. The members have already moved away from the “no bailout” system by implicitly accepting collective liability for at least some of the debts of other members through the bailout programs and the EFSF. At the same time strict conditionality has not always followed, as the example of the Spanish bank bailout shows. It is only logical that other member states are increasingly reluctant to provide further funds without strict conditionality (see, for example, Ilves, for an extensive discussion of this point). Moreover, debt monetization by the ECB would be an extreme case of unconditional “bailout” where other member states would pay for fiscal deficits and debt relief to troubled states by way of higher inflation without the troubled member states being forced to achieve any real adjustment. This is likely to result in countries with sound budget and debt situation to leave the monetary union.
The EMU has only two ways out of the current mess. One is to step up the efforts related to a move towards a tighter fiscal union by establishing a banking union, redistributing a larger share of GDP (currently only about 1% contrasted to 20% in a federal system such as the US) through the EU budget, further restricting the fiscal sovereignty of member states going forward while at the same time allowing for “fiscal devaluations” in southern Europe to regain competitiveness, subjecting all member states requiring help by the EFSF and the ESM to strict conditionality as well as the ECB intervening in the bond markets to offer temporary relief in addition to that offered by the EFSF/ESM.
The other option is to explicitly move back to the “no bailout” system by accepting debt restructuring or “controlled” default by the states whose debt and/or budget situation has become unsustainable, the EFSF and ECB accepting losses on their holdings of the government debt of the respective states, governments of the solvent member states bailing out systemically relevant banks losing capital as a result of the defaults/restructuring and setting up and financing a minimum-income scheme at the level of the Eurozone to prevent absolute poverty as has been argued, for example, by Boeri. Similarly as in the case of debt monetization, in this option it is likely that some states will be forced to leave the Eurozone, but those leaving in this case would be the fiscally and structurally weaker ones. Although a sovereign default doesn’t automatically mean exit from the Eurozone, the option of returning to the “no bailout” system at this moment already appears to be more risky for the EU than tighter fiscal integration. However, if tighter fiscal integration cannot be achieved for political reasons, it is the only other realistic option.
In our opinion, unconditional debt monetization cannot be a “third way” or “middle of the road” scenario for the Eurozone as it would certainly result in disintegration and chaos. ECB’s refusal to embrace this option is not a policy failure.
Boeri, Tito, “A no-further-bailouts principle”, VoxEU.org, July 20, 2012 http://www.voxeu.org/article/no-further-bailouts-principle
Decision of the European Central Bank of 14 May 2010 establishing a securities markets programme (ECB/2010/5) (2010/281/EU)
Duy, Tim, “Second Policy Failure of the Week”, EconoMonitor, August 3, 2012
Frankel, Jeffrey, “Could Eurobonds be the answer to the Eurozone crisis?”, VoxEU.org, June 27, 2012 http://www.voxeu.org/article/could-eurobonds-be-answer-eurozone-crisis
Ilves, Toomas Hendrik. 2012. “I’ll Gladly Pay You Tuesday”. Policy Review No. 172. March 30, 2012. http://www.hoover.org/publications/policy-review/article/111786
Protocol on the Statute of the European System of Central Banks and of the European Central Bank, www.ecb.int