There is an old saying among central bankers that credibility is earned in years of hard work, but can be lost overnight. On Sunday night, the European Central Bank may have said goodbye to its credibility when it agreed to buy the government bonds of euro nations in trouble.
This casts a dark shadow over the euro area’s 750 billion-euro ($980 billion) stability package, which was dressed to impress, and seems to have worked so far. Markets will probably advance in the near term as short positions need to be covered.
A major casualty of the emergency decisions was the ECB. With its move to prop up the failing bonds of governments in financial distress, it has allowed itself to be transformed into an agent of fiscal policy. The intention to sterilize bond purchases means, in effect, that it taxes euro-area private borrowers to support governments in difficulty. In the long run, this is likely to undermine confidence in the ECB and the euro.
Markets last week gave their thumbs down to the Greek rescue program led by the euro area and the International Monetary Fund, probably for two reasons: fears that Greece can’t implement the program, and that Greece wouldn’t return to solvency even if it did.
Here is what has scared investors (apart from the riots in Athens): Even if the IMF program were fully implemented, the Greek debt ratio is projected to rise to 150 percent of gross domestic product by 2013. Assuming an interest rate of 5 percent, Greece would pay 7.5 percent of its GDP to bondholders. With more than 80 percent of creditors being foreign by then, the country would transfer at least 6 percent of its GDP abroad.
How likely would it be that Greece can generate a structural current account surplus before having to make interest payments of this magnitude? Traders saw little likelihood of this and expected an eventual debt restructuring. And because they didn’t trust the package that the IMF and euro-area governments have offered Greece, they didn’t trust other euro-member countries in fiscal distress to find a viable solution. This, and not a conspiracy of speculators, was the brew that generated contagion.
The huge stability package has stopped that contagion for the time being, but to ensure lasting success of the coordinated effort, the European Stability Mechanism and the loan guarantee scheme have to be developed into a European Monetary Fund, capable of running adjustment programs and of managing orderly defaults of insolvent countries in the region.
Managing Debt Burdens
Earlier this year, we proposed the creation of such a fund designed to manage fiscal crises in the euro area, including a possible bond restructuring of a member country unable to cope with its debt burden. The fund could issue its own debt and create the nucleus of a common euro-bond market. The European stabilization mechanism agreed by the Council of Finance Ministers opens the door to such an instrument.
Whether the measures announced on the weekend will prove successful depends on whether governments follow up and construct this framework. Without it, the management of public finances will remain ad hoc and crisis-prone. Monetary union may degenerate into the feared “transfer union,” as discretionary bailouts would fuel moral hazard of weak governments.
The ECB has now joined the list of major central banks that have lost their innocence during this financial crisis by moving closer to fiscal policy than seemed possible not long ago. However, the descent of the ECB from the path of virtue has been the most dramatic. The Maastricht Treaty, on which monetary union was based, states that every country is responsible for its own finances and that the central bank is independent from governments. With its decision to buy failing sovereign debt, the ECB has undermined both principles.
To the extent that it does not sterilize the effects of its intervention, it monetizes government debt. To the extent that it does sterilize the purchases, it acts as a fiscal agent, taxing other euro-area borrowers to support a government in fiscal distress. The claim that intervention serves the purpose of creating orderly market conditions seems unconvincing when governments or the ECB decide which market movements are justified and which aren’t.
The ECB may now have years of hard work to restore the credibility that it put on the line on Sunday night.
(Daniel Gros is the director of the Centre for European Policy Studies in Brussels. Thomas Mayer is the chief economist of Deutsche Bank AG in Frankfurt. The opinions expressed are their own.)
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