The European Central Bank was widely lauded for the way it steered the eurozone through the immediate trials of the GFC. But now it faces some even bigger challenges. On the one hand, it is seen as having dented its credibility in its radical response to the sovereign debt crisis that engulfed Portugal, Italy, Ireland, Greece and Spain – the so-called PIIGS. At a deeper level, it faces an existential crisis engendered by saddling 330 million people in 17 disparate economies with a single currency and a single interest rate mechanism.
The European Central Bank lost its innocence in the early hours of May 10 last year. Leaders of the European Union had spent the night frantically putting together a €750 billion rescue package designed to wow investors who had been pushing embattled Greece towards default and were starting to focus on other heavily indebted EU countries.
As part of the rescue plan the ECB’s president, Jean-Claude Trichet, announced that the bank, which sets the monetary policy of the 17 eurozone member states, would begin to buy sovereign bonds from the countries under pressure – a measure he had previously unequivocally ruled out.
The EU’s shock-and-awe rescue package temporarily calmed financial markets, but the backflip decision to buy bonds sparked outrage. Observers accused the bank of bowing to political pressure, losing credibility and, worse, risking an inflation push. Some feared the bond purchases would open the floodgates to a US-style quantitative easing. The most vicious reactions came from inflation-wary Germany, with an MP from the governing coalition calling for Trichet’s early resignation. (Trichet comes to the end of his term in October this year.)
In an unusual public rebuke, German central bank chief Axel Weber, also a member of the ECB’s rate-setting governing council, said he was “critical” of the purchases and warned of “significant” risks to price stability, making it crystal clear he too disapproved of Trichet’s actions. Worryingly, Weber’s words revealed tensions within the consensus-driven bank.
It doesn't take much to slip into deflation.– Karl Whelan
For the critics, there was no doubt the ECB had lost its way. Founded in 1998, the ECB’s main objective is to keep inflation low, a goal that’s enshrined in Article 105.1 of the treaty establishing the European Community. Other goals, such as supporting economic growth, are subordinate to price stability.
In contrast, the mandate of the US Federal Reserve is finely balanced between fighting inflation and promoting employment, as is the Reserve Bank of Australia’s charter. The ECB’s seat is in Frankfurt – a concession to Germany, which had to give up its beloved deutschmark when the euro was introduced in 1999. Germans were wary of handing over monetary control to an organisation that included members of southern European countries with their perceived laxer attitudes towards inflation.
In its early years the ECB was under intense scrutiny. But both its first president, Wim Duisenberg, and his successor, Trichet, made it clear the bank’s primary goal was to restrain inflation, keeping it “below, but close to, 2 per cent”. That’s lower than the RBA’s target band of 2 to 3 per cent. And while the RBA, like many other central banks, pays close attention to core inflation stripped of volatile elements such as energy and food prices, the inflation hawks in the Frankfurt ECB tower tend to focus on the headline rate of consumer price rises.
The other inflation indicator the bank closely follows is M3 money supply (a wide measure of cash readily available to spend), where it aims for an annual growth rate of about 4.5 per cent.
The ECB has succeeded remarkably in keeping a check on price rises, with the annual inflation rate averaging 1.97 per cent since the introduction of the euro, according to Trichet. “You don’t get this result by chance,” he said in an interview with The Wall Street Journal earlier this year. “We are profoundly attached to our mandate.”
The bank has been criticised for its inflation fixation. Politicians such as French president Nicolas Sarkozy have sought to extend the bank’s mandate to focus stronger on growth and jobs creation, and economists argue the bank needs to be more flexible. “The ECB’s focus is too narrow,” says Karl Whelan, professor of economics at Dublin’s University College. “The Fed and the Bank of England can change their targets; for the ECB it is nearly impossible. Inflation targeting was all the rage in the mid-1990s, but economic thinking can’t just stand still.” Whelan also fears the ECB’s inflation target may be too low. “It doesn’t take much to slip into deflation.”
This is especially a concern as the bank has to come up with a one-sizefits-all interest rate for the euro area, with its 330 million inhabitants. The 17 members range from heavyweights Germany and France to minnows such as Slovakia and Estonia. Economic growth varies hugely. While some countries are experiencing robust growth that calls for higher rates, others are stuck in a recession that, if anything, warrants looser monetary policy.
But while the ECB has resisted calls for more flexibility in its fight against inflation, it has proven much more pragmatic in dealing with the challenges of the global financial crisis and the euro area’s sovereign debt crisis.
The bank surprised many observers with its swift response to the sudden drying up of liquidity during the credit crunch of August 2007. Its executive board met and within hours pumped a hitherto unprecedented amount of cash into frozen money markets.
It helped that the Eurosystem – the ECB and the central banks of member states – already offered more flexible refinancing opportunities than most other central banks. For example, it was able to accept a wide range of assets as eligible collateral from the private-sector banks in these operations. Consequently, the Fed and the Bank of England amended their operational frameworks to mimic the Eurosystem’s refinancing set-up.
When the collapse of Lehman Brothers in September 2008 caused financial markets to freeze up again, the ECB cut its key interest rate, the repo rate, faster and steeper than ever before and supplied the banking system with hundreds of billions of dollars of liquidity – but its actions during the euro area’s recent debt woes threaten to turn into a full-blown credibility crisis for the bank.
To help flailing Greece and to prevent its financial malaise from infecting the whole euro area, the ECB decided to accept Greek collateral irrespective of its credit rating and to buy sovereign debt to stabilise bond markets of the struggling PIIGS. The measures helped calm markets but came at a high cost, as they were perceived to contradict the bank’s mandate and its own words.
On January 14 last year Trichet had ruled out “special treatment of any kind” for Greece. Then, early in May, the bank announced it had “decided to suspend the application of the minimum credit rating threshold in the collateral eligibility requirements” in the case of Greek bonds – in effect, giving Greece special treatment.
Even more momentous was the shift in the bank’s policy towards buying sovereign bonds, “an unprecedented departure from its past practice and from its prior view of how an independent central bank ought to behave”, Citi chief economist Willem Buiter said. Time and again the ECB had ruled out buying sovereign bonds, fearing a blowout in inflation. Plus, buying bonds comes dangerously close to helping governments finance budget deficits, which would breach euro area rules.
“Taken together these factors show that the ECB has moved into taking quasi fiscal policy decisions that benefit some member states more than others,” Whelan says. “This will have long-lasting consequences for the perception of the ECB’s ability to withstand political pressure.”
The purchase of government bonds is one of the most contentious decisions the ECB’s governing council has faced and caused a deep split within the 23-strong group (the 17 central bank chiefs and the six members of the executive board) that sets monetary policy at its fortnightly meetings.
Germany’s Weber publicly vented his opposition and Trichet himself conceded that an “overwhelming majority” – but not the full council – had voted in favour of the measure.
The ECB has moved into taking quasi fiscal policy decisions that benefit some member states more than others … this will have long-lasting consequences.– Karl Whelan
After the Greece crisis it soon became obvious the ECB wasn’t about to embark on a Fed-style quantitative easing program. The bond purchases peaked during the Greek crisis last European summer, with about €50 billion worth of bonds bought, and have slowed significantly in 2011.
During the Ireland crisis at the end of the year, when PIIGS bond yields again jumped, the ECB stubbornly resisted calls for a significant increase in purchases. Instead, it pushed Dublin to accept an €85 billion bailout.
“The ECB was a driving force behind the [Irish] bailout,” says ING chief economist Carsten Brzeski. But this time it operated more behind the scenes. “It’s learned not to risk a bloody nose,” he says, referring to Trichet’s public rebuttal of an IMF involvement in the Greek bailout before having to cave in. By the end of January the ECB had some €76.5 billion worth of government bonds on its books – small fry in comparison to the Fed’s quantitative easing programs, which were launched with the explicit goal of propping up the economy.
And in a further difference, the ECB takes great pains to ensure the bond purchases don’t swell money supply and add to inflation risks. Whenever the bank buys bonds it drains the liquidity it creates by offering banks seven-day term deposits, neutralising the effect on money supply. In contrast, the quantitative easing programs are a monetisation of debt, which amounts to printing money.
“There has been no crossing of any line” by the ECB in its decision to buy bonds, a defiant Trichet said in an interview with the Frankfurter Allgemeine Zeitung last year. “In contrast to other central banks, we are not buying government bonds to push money into the markets … we’re absorbing all the liquidity.” Indeed, much of the initial criticism has given way to a more differentiated view. Yes, the bank bowed to political pressure, but it was an emergency that required a pragmatic response rather than a dogmatic one. With the debt markets situation deteriorating rapidly and as governments struggled to respond, the ECB was the only player willing and able to react swiftly.
“In early May, it [the ECB] was all that stood between the euro area members and a sovereign debt crisis that would have triggered a banking crisis not just in the periphery of the euro area but also in the core euro area,” Citi’s Buiter writes in a research note published in January.
In recognition of his personal role, Trichet was awarded Germany’s prestigious Charlemagne prize for services to European unity. “In an increasingly unstable environment on world markets he has brought calm and created confidence through thoughtful, swift and decisive action,” the prize committee declared. The main bone of contention for many observers now is that the bank is still reluctant to reveal the exact composition of the bonds it bought – just as it keeps mum on how much and what kind of collateral it accepts and how it values the collateral when it’s illiquid. “It would be helpful in understanding the scale and scope of the quasi-fiscal actions of the ECB/Eurosystem, and to enhance its public accountability for the use of what are, after all, public resources to have information in the public domain on exactly what securities the Eurosystem purchases … and the prices it pays,” Buiter says.
The ECB has a tradition of lacking transparency. While the RBA and the Fed regularly publish minutes of their board meetings, revealing decision-making processes and internal controversies, the ECB shrouds itself in secrecy. “It’s the old school of central banking,” says long-time observer Paul de Grauwe, an economics professor at the University of Leuven.
Apart from transparency, there’s also the issue of bad debts potentially blowing out in the balance sheet of the bank, especially if it were to come to a restructuring of sovereign debt as seems increasingly likely in the case of Greece and may be possible for Ireland and Portugal. When the bank nearly doubled its capital base in December to €10.8 billion, the move was interpreted as signalling that it expects to take a loss on the value of the bonds it holds on its balance sheet.
The threat of bad debts isn’t the only challenge ahead. Inflation is picking up in the euro area, putting a rate rise on the agenda – which could snuff out any revival in the PIIGS. But if the ECB waits too long to tighten, it may stimulate more growth in countries such as Germany, driving up prices.
The good news is the euro area governments seem to be moving closer to a longer-term solution to the debt crisis, hoping to introduce a wide range of mechanisms that will reduce the need for the ECB to step in.
The ECB will be happy to shed its role as crisis manager and refocus on its main goal of fighting inflation. But it has shown that it takes financial stability as seriously as price stability and can come up with unconventional measures in an emergency. Says ING’s Brzeski: “The ECB has emerged strengthened from the crisis – as opposed to the Fed.”
