Tom McDonnell: Eurointelligence is reporting that Wolfgang Franz, chairperson of the group of economic counsellors to the German government, is warning that...further ECB purchases of government bonds from the crisis countries would be “a deadly sin".
At a time when rational technocratic responses to the crisis are required, it is disturbing that this is the type of language being used by senior advisers. It may well be a sin to impose tens of billions of private banking debt on a workforce of 1.8 million people. And it may well be a sin to unleash chaos by allowing the Euro to fall because of a dogmatic and intransigent interpretation of the role of the ECB. But changing the mechanisms and protocols of the broken machine that is the currency union is not a sin.
The ECB is now the most important institution in the EU. Its ‘discretion‘ over when and how much it will buy sovereign bonds in the secondary market provides it with the power to topple democratic Governments. Its foolish decisions to increase interest rates earlier this year increased instability, and showed a willingness to put narrow price stability concerns above the wider health of the Euro zone economy and the well being of its citizens. The interest rate increases betrayed a breathtaking failure to understand the seriousness and systemic nature of the debt crisis. The bank has consistently blocked the write down of Irish banking debt. It argues against creating moral hazard and 'dangerous precedents'. Yet it refuses to acknowledge the moral hazard it itself is engendering, by dogmatically insisting reckless lenders escape the consequences of their own actions in contravention of the basic rules of the market. ECB policy effectively reduces the expected ‘cost’ of bad lending and therefore encourages less prudent lending in the future. It is one thing to have an independent central bank. It is quite another to have an incompetent central bank with the power and willingness to threaten and take down Governments it dislikes.
Turning the ECB into a guaranteed lender of last resort for sovereigns would greatly erode its discretionary power and would help end the short-term crisis by ensuring a guaranteed supply of affordable funding for troubled sovereigns. While this could arguably be accomplished through the express wish of the European Council in the short-run (under certain provisions of the Lisbon Treaty), it would almost certainly require treaty change in the medium to long term. Even in the short-run it is clear there is immense hostility to the idea. Jens Weidmann of the Bundesbank gives the German position here, and it is reflective of the view of many core countries. There is little appetite for a changed ECB mandate in the core.
This has existential implications for the Euro because the whole make-up of the Euro zone as it is currently designed is incoherent, fundamentally flawed, and ultimately unsustainable. Even if the ECB was transformed into a normal central bank tomorrow, that in itself would be insufficient to end the crisis. We would still require mechanisms to ensure the survival of systemically important financial institutions, while in the medium term we would need centralised and tighter regulation of the financial sector as well as protocols for winding up insolvent financial institutions.
If the currency union is to work successfully for all member countries in the long term there has to be mechanisms in place for the Europeanization of banking debt, as well as mechanisms for a centralised counter cyclical fiscal mechanism funded from a Euro zone wide tax, for example a Financial Transaction Tax. In a non-optimal currency area such as the Euro zone there must also be a mechanism for compensating less competitive economies for enduring the millstone of a too-strong currency they cannot devalue. This means fiscal transfers. These necessary changes are deeply unpalatable for many in Europe.
The quid pro quo to all these changes would be deeper fiscal integration, more intrusive fiscal oversight for all 17 countries and the creation of a Euro zone finance ministry. Governments could still, as they saw fit, retain the freedom to pursue a low tax/low spend agenda or a high tax/high spend agenda. However they would be required to refrain from running structural deficits. Sustainable fiscal policy should be a goal of Government in any case. Thus as long as a centralised fiscal mechanism is securely in place at the Euro zone level, both to counter-cyclically combat recessions and to provide funding for strategic investment, these fiscal constraints ought not be a major burden for a responsible Government.
Of course deeper integration within the Euro zone will force us to finally address head on the fraught political issue of the trilemma. That issue is beyond the scope of this particular blog post, but for an excellent discussion of the trilemma facing Europe you can read Kevin O'Rourke here and here.