The growing failure of European monetary union can’t be measured by superficial yardsticks such as the number of tiny euro-area economies at risk of meltdown or of monthly turbulence in currency markets. The main development has been the dashing of hopes for monetary stability.
The euro crisis isn’t over and confidence in the European Central Bank has faded. The ECB now presides over a bloated balance sheet that has expanded to about 2 trillion euros ($2.54 trillion) from 1.084 trillion in June 2006 and camouflages the massive creation of monetary reserves.
When the economic recovery accelerates, the ECB -- crippled by a near-insolvent balance sheet -- will fuel asset bubbles by keeping interest rates too low for too long. The next business cycle will be both violent and short. Belief in European monetary stability is now dead.
Let’s go back to the idealist vision at the launch of the euro. The promise was a zone of monetary stability in Europe, insulated, to a large degree, from the raging monetary storms, including most notoriously the Great Inflation of the late 1960s and 1970s, but also featuring a sequence of credit- and asset- market explosions in the 1980s and 1990s.
The visionaries imagined that the ECB would be the reincarnation of Germany’s Bundesbank, bringing the benefits of a hard currency to euro-area citizens. And all of this could happen without the economically strong member countries having to support the weak.
Such idealism had already started to fade when the credit quakes sounded in 2007. The drama of the sovereign-debt crisis this year finally demonstrated that idealism had been an illusion. It wasn’t just a question of German taxpayers waking up to the huge bills for monetary union, but the deep flaws of the ECB and its monetary framework became all too apparent. If it hadn’t been for the monetary ease of 2003-2006 and then the panic provision of mega-liquidity in the following two years, there may not have been a sovereign-debt bubble.
Top ECB officials don’t admit past mistakes any more than their counterparts at the Federal Reserve do. That is a great pity. Instead, the ECB has made much over the years of the euro’s strength and rapid internationalization, maintaining that this demonstrates monetary success. Exchange rates, however, are determined by relativities, not absolutes. The euro is in competition not with a dollar administered by libertarian monetarist ideologues, but by a Fed packed with neo-Keynesians and officials with inflation targets.
Bernanke’s Time Bomb
Last year, the euro surged as Fed Chairman Ben Bernanke planted a giant monetary time bomb known as quantitative easing on the rails of the U.S. economy. Over the past few months, the Fed has been deliberating on whether to add to the size of the bomb, and so the euro has rebounded from its crisis low point.
The ECB claims that, unlike the Fed, it hasn’t resorted to mega money-printing. Yes, in the depths of the sovereign-debt crisis this year it went on a mini-buying spree to support periphery-country debt (and there may be more to follow as the crisis unfolds), but the funds employed were “sterilized” by money-market operations. The ECB issued short-term certificates of deposit at auction to banks with surplus liquidity. And the ECB has used similar means to offset much greater collateralized liquidity through cheap lending in recent years. The total sterilization operation, however, is of dubious quality.
Explosion of Reserves
As the euro-area economy rebounds, with Germany well in the lead among the large countries, banks will eschew such paper in favor of exploiting new high-margin lending opportunities. At that point, the ECB might consider selling its certificates to non-bank investors so as to prevent an explosion of excess reserves. But such investors may be scared off by the rotten condition of the ECB’s balance sheet. A further deterioration in the value of the bonds the ECB has bought to backstop markets might well sway the central bank toward monetary excess.
ECB officials could plausibly find some alternative method to mop up excess reserves -- for example, foreign-exchange swap transactions. But such operations on reserves, even if successful, don’t have the same significance for overall stability as in the days of the pre-euro Bundesbank.
The hardness of the deutsche mark was based on the Bundesbank of the 1970s opting for high reserve requirements, no interest paid on reserves, and tight monetary-base control. The ECB jettisoned all three at the start of monetary union.
Just maintaining excess reserves under control is no substitute for this recipe of stability. Instead there will be the continuing spectacle of the ECB’s giant policy-making committee deliberating each month, on the basis of its economic assessments, whether to make a quarter-point change in its benchmark rate. That departure from Bundesbank monetarist principles fed directly into the instability of the last decade and it will almost certainly do so in the next.
The biggest danger for European monetary stability is that the ECB pins interest rates near zero for too long. As the world economy rebounds, say, into 2011-12, the ECB will have its eyes on those mega-billions it lent to zombie banks and sovereigns. A significant increase in key money-market rates may be the trigger for an even more threatening round of credit quakes.
The attempt to keep Humpty Dumpty together by continuous monetary swamping also means a heightened danger of some new temperature increase in certain asset markets and a continuing sclerosis of the euro-area financial system.
Don’t count on skilful navigation by the ECB.
(Brendan Brown is the author of “Euro Crash: The Implications of Monetary Failure in Europe” and is chief economist at Mitsubishi UFJ Securities International Plc. The opinions expressed are his own.)
To contact the writer of this column: Brendan Brown at Brendan.Brown@int.sc.mufg.jp