The European Central Bank is the central bank for the seventeen-nation eurozone, with a mandate to maintain price stability in countries that use the euro by setting key interest rates and controlling the money supply. The role of the ECB has sparked increasing debate since the emergence of the eurozone sovereign debt crisis in late 2009. Some European policymakers and economists have called on the ECB to act more forcefully to alleviate the debt burdens of struggling eurozone states by buying the sovereign debt of those countries on the secondary market indefinitely, while others have argued such a move is outside the mandate of the bank. In September 2012, the ECB announced plans to enact a new round of bond-buying to calm markets and bring down borrowing costs for struggling eurozone sovereigns, but is expected to stipulate strict budgetary and structural conditions for participating countries. At the same time, eurozone leaders are moving forward with plans to empower the ECB to supervise the eurozone's largest banks, a move meant to fuel further European integration amid concerns over the health of the continent's financial sector.
History and Structure
The Maastricht Treaty of 1992, or Treaty on the European Union, mandated the creation of the European System of Central Banks, of which the European Central Bank and the twenty-seven EU national central banks are a part. Under the guise of the ESCB sits the Eurosystem, composed of the ECB and the national central banks of those countries that use the euro, which serves as the monetary authority for the eurozone. In an effort to fulfill Maastricht's goal of creating a European Economic and Monetary Union, the ECB took over responsibility for monetary policy in the euro area from member states in January 1999, two years prior to the circulation of the euro currency.
The ECB is made up of three decision-making bodies: the General Council, the Executive Board, and the Governing Council. The , which operates largely as an advisory body for the ECB, includes all of the EU's national central bank governors, as well as the president and vice president of the ECB. The Executive Board of the ECB, the hub of day-to-day operations and decision-making, consists of the ECB president, vice president, and four other members, all of which are appointed by the European Council. The Governing Council comprises the entire Executive Board and all of the national central bank governors of countries that use the euro--the Eurosystem--and meets bi-monthly to adopt decisions on monetary policy for the euro area.
Mandate and Function
The Statute of the ESCB, as outlined in a protocol to the Maastricht Treaty, empowers the bank with the primary monetary policy objective of achieving price stability. The bank is "independent within a clear and precise mandate; and it is fully accountable to the citizens and their elected representatives for the execution of this mandate," explains Hanspeter K. Scheller in his 2006 book, . The ECB, notes Scheller, "has been assigned exclusive responsibility for the single monetary policy for the euro area," while "exchange rate policy has also been denationalized and centralized."
"The ECB has shown it is willing to step in when fiscal authorities have not." – Iain Begg, LSE
To fulfill its main objective of price stability, the ECB's primary task is setting key interest rates for the eurozone, by which it seeks to keep inflation rates below but close to 2 percent over the medium term. At the same time, the ECB is the sole issuer of bank notes and bank reserves for the euro area. The ECB also manages the eurozone's foreign currency reserves to keep exchange rates in check; helps national authorities to supervise financial markets and institutions; authorizes national central banks to issue bank notes; and monitors price trends.
In the wake of the debt crisis, the ECB has been forced to step outside its traditional role, raising questions about whether it has violated its mandate. As the Economist explained in October 2011, the slow moving response of European leaders to the crisis created a vacuum that has "forced the ECB, the only institution in the euro area capable of intervening promptly and decisively, into territory far outside its custom and practice."
The Bank's Response to the Debt Crisis
The ECB's response to the eurozone sovereign debt crisis has generated a debate among policymakers over whether the bank should be a lender of last resort--like the U.S. Federal Reserve and the Bank of England--and to what extent it should intervene in eurozone fiscal policy.
In the wake of the 2007-2009 global financial crisis, the Fed enacted two rounds of quantitative easing, by which it purchased more than $2 trillion in Treasury bonds and mortgage-backed securities. The program was meant to encourage borrowing and ultimately spur hiring, part of the Fed's "dual mandate" to maintain price stability and foster full employment.
The ECB, however, is not saddled with an employment mandate and is prohibited from directly financing governments, making its purchases of government bonds--even on the secondary market--highly controversial. At the same time, the absence of a fiscal union, including a eurozone-wide treasury with mutualized debt, has made the ECB's potential role as lender of last resort more complicated; unlike the Fed, it must buy government bonds from a number of treasuries with varying degrees of risk.
Throughout 2011 and 2012, France called for the ECB to play the role of lender of last resort, but was repeatedly rebuffed by Germany. "If the central bank finances government debt, it's a modern form of the old bad habit that if the government doesn't have enough money, it prints money," German Finance Minister Wolfgang SchĂ¤uble (Bloomberg) said in January 2012. Many opponents of the ECB becoming the lender of last resort argue such a move would inevitably lead to the mutualization of debt.
Still, the ECB and eurozone governments have been engaged in "multiple games of chicken," says Iain Begg, a professorial research fellow at the London School of Economics' European Institute. "The ECB has shown it is willing to step in when fiscal authorities have not," but it also "knows it is stretching its mandate," argues Begg.
As the sovereign debt crisis in Greece came to a head in the spring of 2010, the ECB, under the direction of former president Jean-Claude Trichet, initiated its Securities Market Program, through which it began purchasing Greek government bonds on the secondary market. As the debt crisis eventually engulfed other eurozone states, the ECB ultimately extended the SMP to Ireland, Portugal, Italy, and Spain, implementing the program intermittently through January 2012.
"The key issue is how you deal with moral hazard issues." – Lorenzo Bini Smaghi, Harvard
The bank's bond purchases on the open market provided liquidity to indebted sovereigns, while helping to temporarily bring down rising borrowing costs for the major economies of Italy and Spain. However, the argument against ECB intervention in bond markets is that it reduces for eurozone governments the "incentive to adopt more stringent measures" to get their fiscal houses in order, explains Lorenzo Bini Smaghi, a former ECB Executive Board member and current visiting scholar at Harvard University's Weatherhead Center. "The key issue is how you deal with moral hazard issues," says Bini Smaghi, noting that after the ECB started buying Italian bonds in mid-2011, the government backtracked on its commitment to fiscal and structural reforms. "Any additional bond buying should be based on some kind of conditionality," he argues.
At the end of his eight-year term in 2011, Trichet, known as an inflation hawk (FT), moved to reverse low interest rates that had been set during the global financial crisis. Between April and July 2011, Trichet raised the ECB's main interest rate twice, bringing it to 1.5 percent. The move elicited criticism from a number of economists, including Paul Krugman (NYT) and Nouriel Roubini, who said that Trichet's tightening of monetary policy exacerbated the eurozone crisis. Trichet, for his part, defended the rate hikes, arguing that maintaining price stability was the most important step the ECB could take.
Initially, there was much trepidation in Germany about Mario Draghi (Bloomberg) replacing Trichet at the helm of the ECB in late 2011. Many conservative German policymakers feared that an Italian central banker would not be as vigilant about maintaining sound monetary policy or fighting inflation. Draghi reassured his detractors that he was committed to maintaining Trichet's policies, and ultimately secured the endorsement of German Chancellor Angela Merkel.
However, two days after taking office in November 2011, Draghi promptly lowered the bank's benchmark interest rate (Bloomberg) to 1.25 percent in an effort to combat slow eurozone growth. He then cut the rate again to 1 percent (CNN) in December of that year, and to a record low of 0.75 percent in July 2012 (Reuters), amid worsening economic data for eurozone countries, including Germany.
In a further effort to generate liquidity and encourage bank lending (WSJ), the ECB initiated a Long Term Refinancing Operation (LTRO) in late December 2011, by which it made available $640 billion in inexpensive, three-year loans to 523 EU banks. The ECB enacted another round of its LTRO program to lenders at the end of February 2012 by providing $712 billion to 800 banks.
Evolving Role of the Bank and Next Steps
After French President Francois Hollande unseated incumbent Nicolas Sarkozy in May 2012, the debate in the eurozone shifted from one centered around austerity to one centered on growth. Hollande pressured German Chancellor Angela Merkel to moderate her stance on budget cutting in peripheral eurozone states, and allow for policies that would stimulate economic growth amid a worsening recession. At the same time, the ECB faced renewed calls to act more forcefully to shore up the eurozone through open-ended government bond purchases.
On September 6, Draghi announced a new, highly anticipated--and potentially unlimited--ECB bond-buying program to provide a "fully effective backstop to prevent potentially destructive scenarios" (Reuters). Draghi suggested there would be strict conditions attached for eurozone governments taking part in the program, and that the eurozone's rescue fund would also participate in the bond-buying.
Leading up to the ECB's announcement, there was a heated discussion across two levels, explains Guntram B. Wolff, deputy director of Bruegel think tank. There has been a debate, mainly in Germany, over whether the ECB should be engaging in any bond-buying scenarios at all, Wolff explains. Many German conservatives, including Bundesbank chief Jens Weidmann, have argued that such a move is "essentially monetary financing," says Wolff. ECB monetary financing, or providing direct financial support to governments, is illegal under the EU Treaty. However, the broader debate, says Wolff, is whether the ECB should enact bond-buying programs for all struggling eurozone countries that request financial assistance--and, if so, which kind of budgetary and structural conditions should be attached?
The Bundesbank's Weidmann was the only member of the ECB Governing Council (MarketWatch) to vote against the ECB's most recent bond-buying program. Weidmann has cautioned critics about the risks of hyperinflation--exemplified by the Weimar Republic during the early 1920s--if a central bank does not remain independent of fiscal policy and focus on maintaining price stability.
Commenting on ECB bond purchases in an interview with Der Spiegel at the end of August, Weidmann noted, "Such a policy is too close to state financing via the money press for me. The central bank cannot fundamentally solve the problems this way."
"What does this do to the ECB balance sheet?" – Uri Dadush, Carnegie
ECB bond buying has, thus far, allowed peripheral eurozone states to avoid many hard structural reforms, cost adjustments, and fiscal measures, argues Uri Dadush, a senior associate at the Carnegie Endowment for International Peace. "All it does is buy time," Dadush says. He outlines a number of risks to a new ECB bond-buying program, including the risk that troubled eurozone countries "will delay adjustments indefinitely, and the ECB will get caught up in buying more bonds to keep the markets at bay." The other notable risk is that the "credibility and viability" of the ECB is at stake, Dadush says. "What does this do to the ECB balance sheet?"
Meanwhile, as part of EU efforts to spearhead greater fiscal and political integration, officials began work in the summer of 2012 on plans for a eurozone banking union. To start, the EU would develop a supervisory agency to monitor the major banks in the eurozone, situated under the ECB. While such a banking authority would certainly expand the power of the bank, Bini Smaghi argues that such a role is well within its mandate. "Financial stability," he notes, "is a key element in achieving price stability."