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A Cheer for ECB's Attempt at Shock and Awe

Author: Sebastian Mallaby, Paul A. Volcker Senior Fellow for International Economics
September 15, 2011
Financial Times

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At the start of the euro crisis, the continent's politicians bristled with pride and independence, saying they did not need support from the International Monetary Fund. Soon enough, the IMF was allowed into the kitchen, but the rest of the world's governments were excluded. Yet the crisis has now reached the point at which it threatens a teetering global economy, so with five central banks acting in concert on Thursday to backstop Europe's banking systems, a new era of global financial co-ordination has begun.

The catch is that the latest intervention addresses just one part of the continent's problem. Banks in Europe fund themselves partially with dollars. Because of fears for their stability, investors have been balking at buying their commercial paper. Now, with the help of central banks in the US, Japan, Britain and Switzerland, the European authorities propose to provide the dollars that can't be raised in the markets. This is excellent news for Europe's banks, which is why their stocks are soaring. But it won't solve Europe's other problem, which lies with its sovereigns.

The European Central Bank has consistently been better at backstopping the continent's banks than at propping up its governments. Since the sovereign debt of Spain and Ireland was, to a large extent, created by its bankers, where is the justice in generosity just to the banks? Since Europe's problem now consists of two simultaneous equations – weak banks and weak governments – why focus lopsidedly on half of the challenge?

The recent policy towards Italy has been a case in point. In early August, yields on ten-year Italian bonds climbed above 6 per cent. A further rise threatened to turn Italy's manageable debt burden into an unbearable deadweight. The ECB responded by buying Italy's bonds and driving the yields below 5 per cent. But instead of defending that victory, the central bank squandered it: Italian government yields are now back up at 5.6 per cent. The first rule for central bankers facing down markets is not to show weakness. We need shock and awe, not a house call from an empathetic shrink.

Why won't the ECB do for Europe's governments what it happily now does for Europe's banks? The crude answer is Germany – and particularly the top German central bankers who have opposed buying government bonds. But the logic of these figures is elusive. They cannot really believe that government bond purchases will stoke inflation. The ECB has a better record on price stability than did the Bundesbank, and with growth in the eurozone weakening, inflation is a distant threat. Nor can they seriously think that the bond purchases conflict with the central bank's mandate. The ECB is not supposed to buy government bonds in the primary market, but it has done so before in the secondary market. Under its mandate to ensure financial stability, it has the right to do so on a larger scale.

The best explanation of the German position is that, by seeming crazy enough to allow Italy and Spain to go under, the central bank can terrify politicians into slashing their deficits. But this bluff is hugely risky. In Italy, unemployment for under 25s stands at 29 per cent. In Spain, the share is 44 per cent. Further austerity in these countries is neither economically sensible nor politically defensible. In these circumstances, outside efforts to impose austerity via tough conditionality are unlikely to work – a point that NYU's William Easterly demonstrated more than a decade ago in his critique of conditionality in World Bank programmes. Anyone who thinks Europe can be the magical exception to Easterly's evidence should ask themselves how well conditions are succeeding in the case of Greece.

With luck, the involvement of the authorities outside Europe may help the Germans and their neighbours out of this intellectual cul-de-sac. Just as bank rescues must consist of liquidity without conditions, so, like it or not, government-bond rescues must be the same. Liquidity with strings attached is, by definition, not liquidity: it says you might provide some money when the markets crave certainty. Bailing out feckless states may be unappealing, but then so are bail-outs for bankers. The longer the ECB hesitates, the larger the rescue will have to be in the long run.

 

 

This article appears in full on CFR.org by permission of its original publisher. It was originally available here.

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