The Onion famously announced the election of Barack Obama to the Presidency in 2008 with the headline: Black Man Given Nation’s Worst Job. The Onion noted that the position “comes with such intense scrutiny and so certain a guarantee of failure that only one other person even bothered applying for it.”
On November 1 an Italian, Mario Draghi, will assume the mantle of President of the European Central Bank, a job so terrible that the only other candidate for the position – Germany’s Axel Weber – had to resign his position as head of the Bundesbank in order to avoid being appointed the ECB’s new boss.
How did this job – the most powerful central banking position in the world alongside the Chairman of the Federal Reserve – become such a hot potato? The ECB is, by far, the most competent and professional institution in the EU. At a time when investors have lost confidence in many Eurozone borrowers, the ECB has the ability, with little more effort than a snap of its figurative fingers and a pledge to backstop sovereign borrowers, to halt contagion in its tracks.
The Eurozone is experiencing a classic run. The Greek debt crisis was a shock to the capital markets. Doubts began to grow about other borrowers, and investors began to run for the exits, hoping to preserve their capital. These fears were compounded by a design flaw at the heart of the monetary union. Eurozone members all suffer from Original Sin – they borrow in what is effectively a foreign currency – leaving governments, and not just banks, vulnerable to runs.
Solvent but illiquid borrowers – both financial institutions and sovereign governments – are now at risk of collapse simply because investors are scared. They are not sure which banks are hiding large losses on their balance sheets, or whether Italy will be able to grow its way out of its debt burden. Such doubts can become a self-fulfilling prophecy. Neither Italy nor Spain is insolvent so long as they can keep borrowing at modest spreads over German bonds. But if their borrowing costs keep rising, illiquidity could lead to default. Runs are not a new phenomenon. They are as old as banking itself. We know how to stop them. It requires a lender of last resort – which is the raison d’etre of central banking.
The ECB has, in fact, done its duty for Europe’s financial sector. It has provided unlimited liquidity to Eurozone banks since 2008. It has even, amid much controversy, stepped in and purchased sovereign debt on the secondary markets. But it has been unwilling to explicitly acknowledge its role as the lender of last resort for sovereign governments. So what is the problem? Why is the ECB so reluctant to do its job? Enquiring minds want to know.
One possibility is that the ECB’s Board of Governors really doesn’t believe that it is their job to guarantee the stability of Eurozone capital markets. Paul de Grauwe has alleged as much. The ECB was, after all, given but a single mandate – price stability – in its founding charter. Another possibility is the old canard – which has a kernel of truth – that Germans have such an historical aversion to inflation that any course of action that could conflict with the ECB’s monetary policy goals must be ruled out.
But these are dubious explanations. The first requires us to believe that the Eurozone’s central bankers are mindless ideologues, while the second ignores the fact that austerity measures and debt deleveraging among European households and financial institutions reduces the velocity of money and makes deflation, as opposed to inflation, the great risk to price stability.
There is a more substantive objection to allowing the ECB to act as the lender of last resort to sovereign governments. It is the risk of moral hazard: the risk that, by coming to their rescue in their hour of need, the ECB will let politicians off the hook and allow them to continue borrowing too much. This risk is real.
Once again, the crux of the issue is confidence. Not only have investors lost faith in sovereign borrowers, so too, it seems, has the ECB. Perhaps the real reason the ECB has been so reluctant to backstop sovereigns is because they don’t trust Europe’s politicians.
In a monetary union, countries that lose competitiveness cannot rely on a currency devaluation to bring down the prices of their goods on world markets. They must devalue internally – by cutting wages and making structural reforms that free up labor markets. Politicians who hope to be reelected are often reluctant to take such harsh medicine.
Take the case of Italy. Earlier this summer, yields on Italian bonds began to rise as contagion from Greece, Portugal and Spain spread to the world’s third largest bond market. This increased Italy’s (and its banks) borrowing costs, and intensified pressure on the Italian government to enact a broad package of economic reforms and austerity measures.
In the meantime, however, liquidity began drying up for many European banks, forcing the ECB to take decisive action by stepping into the secondary markets and purchasing Italian and Spanish sovereign bonds. Although Berlusconi did force an austerity budget through Italy’s fractious parliament, more fundamental structural reforms were put off after the ECB’s intervention in the sovereign bond markets succeeded in (temporarily) driving down yields.
Jacob Kirkegaard at the Peterson Institute has suggested that this experience convinced the ECB that whatever negotiating leverage they had over national governments would be lost as soon as it credibly committed to backstopping sovereign debt.
“The slowness of Europe and of the ECB to act in the current crisis is frustrating to citizens and markets alike. But it is actually not in the bank’s interest to move decisively—for example, by standing behind all of Italy’s debt. A sweeping preemptive safety net would be seen as counterproductive, relieving pressure on governments to reform. The ECB’s game is thus not to end the crisis at all costs as soon as possible, but to act deliberatively to preserve its leverage. Market volatility becomes something not to be avoided but to be used as a club.”
If Kirkegaard is right, this is a dangerous and cynical game the ECB is playing. The Eurozone is already at a disadvantage from having a monetary union without a corresponding fiscal union. Seventeen different governments cannot act quickly or decisively enough during times of crisis, and the lack of any mechanism for large scale fiscal transfers makes the burden of adjustment (through internal devaluations) all the more onerous. If the citizens of Europe lose faith in European institutions, then the grand experiment that is the European Union could unravel.
What Europe needs now is confidence, not confidence games. It is true that there is an inherent conflict between acting as the lender of last resort for solvent but illiquid sovereigns and the moral hazard of allowing governments and fiscal authorities to go on behaving irresponsibly. But there is a word to describe the ECB’s negotiating tactic of threatening to allow financial mayhem: it is a bluff.
In the end, maybe this is why the job of heading up the ECB became such a hot potato. Any threat to allow EU capital markets to disintegrate in a systemic financial crisis is no threat at all. Axel Weber is a smart guy, he probably saw this coming and preferred to escape into the gnomic comforts of Zurich rather than go down in history as the enabler of moral hazard.
So congratulations, er, my condolences, Mr. Draghi. It’s up to you to save the Eurozone. The latest farcical rescue plan hatched in Brussels only underscores the central role of the ECB in halting the crisis. You have very little negotiating leverage, and your bluffs will be called. You’re going to have to step in and buy massive amounts of sovereign bonds, and you will surely come in for harsh criticism for doing what is necessary. Good luck.
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. Mr. Carliner has also worked for Barron’s Business and Financial Weekly and WBAI Radio in New York. He holds a B.A. from the University of Wisconsin-Madison and an M.A. in International Political Economy and Public Policy from the University of Texas-Austin. The original article can be found on Ben Carliner’s blog.