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Trichet Must Mine Lessons From the Fed

Author: Sebastian Mallaby, Paul A. Volcker Senior Fellow for International Economics
July 23, 2011
Financial Times


Half a century ago, when the European project was bright-eyed and young, a youthful Jean-Claude Trichet worked for a stint as a coal miner. Years later he described going “several hundred metres under ground, sometimes in extremely narrow coal veins, a metre or 90cm wide, crawling between the stanchions with a pickaxe”. The experience drove the 18-year-old student to embrace the politics of the French left. In an interview with Anne Sinclair, aka Madame Strauss-Kahn, Mr Trichet recalled the claustrophobic peril of the mine as “a very, very strong experience”.

Now, Mr Trichet is nearing the end of his tenure as president of the European Central Bank. His office near the top of the Eurotower in Frankfurt is a world away from the dark mine of his youth; he has grown sleek and urbane; his politics have drifted rightward. And yet he surely is reliving the subterranean terror of his youth, as the eurozone threatens to cave in on top of him.

The difference this time is that Mr Trichet's reaction to the danger is not just personal. The future of Europe could depend on it – as his fellow European leaders understood this week, breathing a sigh of relief as he dropped his previously stiff resistance to a deal that effectively allows Greece to default.

The deal yielded a new bail-out for Greece but no credible plan to staunch contagion to the rest of the eurozone. To give the Greeks some breathing room, private lenders are being asked to choose among a variety of unappealing options, some of which involve waiting decades before their money is returned. Despite much chest-beating to the contrary, lenders to other European governments now know they may be treated the same way.

Despite Mr Trichet's earlier doubts about this deal, there is no mystery about what needs to be done in the medium term. Italy and Spain, whose economies dwarf Greece, Ireland and Portugal, must at all costs remain solvent. They can only do that if investors choose to lend to them at reasonable rates; but now that Greece's creditors have been hit, rates must surely rise to reflect the risk of similar restructurings. To prevent Italy and Spain from succumbing to a self-fulfilling loss of confidence, both have to be “ringfenced”.

Europe's leaders now seem to understand what they must do; but they lack the political space to deliver. On Thursday they promised to allow the European financial stability fund to lend pre-emptively to countries not yet in crisis, presumably Italy and Spain. But the summit communiqué refers ominously to “conditions” that borrowers must meet, while there is no plan to make the EFSF bigger. In short, the deal is almost certainly too little, too late.

The machinery of Brussels will now grind away at its own pace, while market sentiment could shift instantly. All of this brings us back to Mr Trichet. Even before he took the helm of the ECB, he used his perch as head of the French central bank to press for a stronger fiscal union. He has pointed out the asymmetry between the ambition of the single currency and the lack of a single budgetary authority, suggesting that Europe's immature federation is partly to blame for the crisis. The implied comparison with the strong central government of the US is clear. And yet the real lesson from America is, paradoxically, the one that Mr Trichet is resisting.

The truth is that, even in America, crisis lending is mostly done by the central bank. In the dark days after the Lehman bust, Hank Paulson, Treasury secretary, begged Congress for $700bn of bail-out funds. He got it – but not before panicking the markets by being rejected the first time. Even then, the Treasury's intervention was massively surpassed by the Federal Reserve, which pumped $3,300bn into distressed markets. It turns out that the best lenders of last resort are, in fact, the traditional lenders of last resort; central banks that do not have to deal with sluggish parliaments, but can print money. Their responsibility for financial stability is arguably equal to their responsibility for fighting inflation. Indeed, Europeans who gaze enviously at the US should recall that, when the Fed was established in 1913, its central purpose was crisis lending.

If Mr Trichet's ECB really did emulate the Fed, the ring fence for Italy and Spain could be established instantly. He could simply declare that he stands ready to buy sovereign bonds issued by both. The combined net sovereign debt of Italy and Spain comes to around €2,200bn. Mr. Trichet could plausibly promise to buy the whole lot – which would guarantee he would never have to.

Of course, central banks, especially young central banks, do not like to take these risks. Purchases of bonds would let irresponsible governments off the hook and might stoke inflation fears, however unfounded. Mr Trichet has so far resisted riding to the rescue. But the lesson from the political dithering in Europe is that he may soon have no choice. Sometimes moments of dark danger can force changes of ideas – to socialism, or this time to something more constructive.



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

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