Formally, the European Central Bank has but a single mandate – price stability. But as the debt crisis facing the Eurozone has evolved into an existential challenge, the ECB has been pushed into taking on responsibilities far beyond its original raison d’etre.
The ECB is now poised to become the supreme Eurozone banking supervisor, and it may soon make good on its pledge to do whatever it takes to save peripheral Europe from its credit crunch. If these plans come to fruition, the ECB will have become, in a very real sense, the founding father of a federal Europe.
As the financial crisis first engulfed Europe, the ECB stepped up to provide liquidity to the Eurozone’s banks. This was no great step – financial stability is in fact the original purpose of central banking, and the implicit promise to ‘lend freely against good collateral at a penalty rate’ has been around at least since Bagehot first formulated it in 1873.
But Mario Draghi’s plans for Outright Monetary Transactions (OMT) take the central bank into new territory. It is simultaneously a bold vision for the future of the Eurozone, and a means to get there. Draghi said the ECB will buy potentially unlimited amounts of sovereign bonds in countries facing financial stress – but only if they formally ask for help and agree to the conditionality that comes with aid.
Conditionality is the key. In the obligations to be negotiated under the auspices of a European Stability Mechanism (ESM) program lie the seeds of a federal Europe and sustainable monetary union. As the price for its support, the ECB will require three broad categories of reform: First, to address the concerns of the Eurozone’s creditors, the ECB will insist on long term fiscal responsibility. Second, in order to restore the competitiveness of unbalanced economies, the ECB will demand structural reforms that free up labor markets and increase competition. Finally, in order to ensure financial stability and break the vicious link between banks and sovereigns, the ECB will force national governments to give up their authority to regulate domestic banks, transferring authority to Frankfurt and Brussels.
Taken together, these measures amount to an ambitious vision for a federal Europe – or at least a federal Eurozone. Nor is the ECB alone in pushing this vision. The European Commission has come out strongly in favor of handing all prudential supervisory authority over the Eurozone’s 6,000 plus banks to the ECB. The Fiscal Compact, the Banking Union and the European Stability Mechanism are, in effect, the protean new institutions of a federal Europe.
Now, in the OMT, the central bank holds both carrot and stick as it attempts to cajole politicians to give up sovereign prerogatives and make tough, unpopular decisions. In order to succeed, the ECB will also need to midwife a grand bargain between Europe’s debtors and creditors. Banking Union is really about two big issues: On the one hand, it is about stability – ensuring that Europe’s financial sector has macro-prudential oversight and that the single market in financial services is repaired. On the other, it is about distributing the losses from bad debts.
Europe’s debt crisis is, after all, fundamentally about too many borrowers being unable to service their debts. But thus far the Eurozone has, with the partial exception of Greece, been unwilling to countenance large scale defaults or debt restructurings for fear that it would lead to contagion and the collapse of many banks.
Significantly, the idea of Banking Union – with a single set of rules, a regulator with the authority to shut down insolvent banks, and a common deposit insurance scheme to prevent bank runs – is controversial in certain quarters in Germany. In part, this is because it is a threat to the Landesbanks, which have traditionally enjoyed close relationships with state governments. But it is also because of fears that a common deposit insurance scheme and bank resolution fund could result in transfers from German taxpayers to the periphery.
And yet the vision for the Eurozone being laid out by the ECB and the European Commission are very much in line with what Angela Merkel has proposed. The Chancellor has consistently warned that solving Europe’s problems will take time, and that stronger European institutions – that bind the continent’s states into durable fiscal and political union – are prerequisites for any discussion of debt mutualization or relief. “Control and liability must go hand in hand,” Merkel told the Bundestag in June, “and shared liability cannot occur until sufficient control has been assured.”
Wiser heads in Berlin have always understood that Germany has benefitted enormously from the single currency, and that the country will indeed need to share in the burden of resolving bad debts. But they lack trust in many of their political counterparts in the periphery, and fear throwing good money down a bottomless pit if strict and enforceable conditions are not attached. Peripheral Europe must, in other words, improve its political governance and economic competitiveness, and agree to transfer sovereignty to Frankfurt and Brussels, before a final resolution of the crisis can be achieved. And though Berlin might recognize the need for Germany to eventually open its checkbook, it would of course prefer for the check to be as small as possible.
In this regard, the protestations of Bundesbank head Jens Weidmann and others should be seen as strengthening the German negotiating position. Germany has been, and will continue to, drive a hard bargain with the rest of Europe. And yet the fears expressed by Wiedmann – of the specter of inflation haunting the ECB’s purchases of sovereign bonds – also points to the leverage that the ECB holds over Germany.
Just as the OMT holds out the promise of unlimited support for bond markets in Spain and Italy in return for tough conditionality, so too does the prospect of open ended bond purchases restrain the Germans from driving too hard a bargain. If economic growth does not return to peripheral Europe, the political pressure on the ECB to further ease monetary policy to generate nominal growth and inflation will eventually prove too great to resist. Germany does not have the votes to impose its will on the ECB if the periphery remains mired in debt deflation – it too must compromise.
There are only three ways to resolve a debt crisis: default, where borrowers lose their collateral and lenders take principal losses; public bailouts, where governments transfer bad debts onto public balance sheets and taxpayers share in the losses; and financial repression, where the real value of bad debts are inflated away. If there is to be a federal Europe – or to put it another way – if the Eurozone is to survive, then Europeans must decide what combination of these treatments should be employed.
September has been a good month for the Eurozone: the German Constitutional Court signed off on the Fiscal Compact and ESM; the Dutch voted for centrist, pro-European parties; ambitious proposals for Banking Union were released; and Mario Draghi finally unveiled a firewall big enough to protect Spain and Italy. But many of the hardest decisions – the ones that can finally resolve the crisis – remain to be made. Neither Spain nor Italy is eager to sign up for the lending lifelines on offer, not least because they do not know what form the final resolution of their debt crises will take. But accepting conditionality is the necessary first step on the path towards resolution.
The ECB has a lot on its plate – and it is not yet meeting any of its mandates. The monetary transmission mechanism really has broken down in much of the periphery, and deflation remains the immediate threat to price stability. Bank depositors are still wary of keeping their money in Spanish banks, rendering Eurozone financial stability fragile. And Banking Union, to say nothing of fiscal and political union, remains but a glimmer in the eyes of European technocrats.
The ECB’s institutional capabilities and unique leverage make it the indispensable actor in the efforts to create a “federation of nation states,” in the words of Jose Manuel Barosso. For the ECB to fulfill its newfound responsibilities, it must succeed in restoring economic growth, cleaning up the continent’s financial sector, and institutionalizing new federal structures in the Eurozone. The central bank cannot achieve these goals by itself, but the carrots and sticks it wields are the means to those ends.
Ben Carliner is a fellow at the Economic Strategy Institute. Prior to joining ESI, Mr. Carliner worked as a financial journalist in New York for Project Finance International. The original article can be found on Ben Carliner’s blog.