Henry Kissinger once said that while "the illegal we do immediately, the unconstitutional takes a little longer."1 Perhaps this is why it took the European Central Bank (ECB) until this week to begin buying up Italian and Spanish bonds in the euro area secondary bond markets. The ECB’s initial hesitation stemmed from its understandable reluctance to get even further involved in European fiscal policy making. Only the ECB has the firepower to affect financial markets in the euro area, and it was essentially forced to intervene on Monday because of market selling and political paralysis. But the ECB always extracts concessions for its nonconventional rescue operations.
Not until this week were the central bank’s Governing Council’s two criteria met for "nonconventional mandate expanding interventions." The first requirement is that, just as in May 2010, the crisis in euro area financial markets must be acute. Second the ECB must be given a fat and juicy set of policy concessions from the appropriate euro area leaders. Only then is the ECB willing to step in to become the euro area’s conditional lender of last resort.
It is instructive to compare the ECB’s situation to that of the US Federal Reserve, which announced its second round of quantitative easing (QE2) last November with the simple aim and justification "to promote a stronger pace of economic recovery and to help ensure that inflation, over time, is at levels consistent with its mandate." This week’s ECB statement, by contrast, is testimony to the remarkable independence of the bank derived not only by the status conferred under the European Union treaty but also its unique role as a supranational central bank unbeholden to any single democratic government. These attributes make the bank the sole operational and muscular euro area institution. Rather than responding like the Fed by simply trying to boost growth (in the absence of Congressional fiscal stimulus), the various euro area central bankers from the different European countries have a list of demands to make of elected European leaders in return for their actions.
The ECB also acted on the basis of Spain and Italy swiftly and decisively implementing new measures and reforms of fiscal and structural policies "in order to substantially enhance the competitiveness and flexibility of their economies, and to rapidly reduce public deficits." The bank further stated that all euro area members must "adhere strictly to the agreed fiscal targets" and ensure "prompt implementation of all the decisions taken at the euro area summit." Based on the details in a leaked letter from the ECB leadership to Italian Premier Silvio Berlusconi,2 it is evident that Frankfurt’s demands are far-reaching: In addition to accelerated austerity and a balanced budget by 2013, they include things like privatizations, product market liberalizations by decree, and labor market reforms. It is therefore wrong to characterize the ECB as merely demanding ever more austerity by the euro area. Frankfurt now goes considerably further, insisting on structural reforms to boost long-term growth.
While it still remains unclear what more the Spanish government will be asked to do, the recent week’s events in Italy in some ways mark a de facto return to the technocratic Italian governments of the early 1990s. It was then that Carlo Azeglio Ciampi moved from being governor of the Bank of Italy to the job of prime minister. Given the reluctance of the Berlusconi government to embrace serious growth enhancing structural reforms in Italy, a similar move would be welcome. Or put in another way, while Mario Draghi may soon be moving from the Bank of Italy in Rome to head of the ECB in Frankfurt, he looks set to dictate much of Italian economic policy nonetheless.3
Also interesting is the statement that the ECB Governing Council "attaches decisive importance to the declaration of the Heads of State or Government of the euro area in the inflexible determination to fully honor their own individual sovereign signature as a key element in ensuring financial stability in the euro area as a whole." In other words, as stated by euro area leaders on July 21 , there will be no sovereign bond restructurings for countries in the euro area other than Greece.
Considering the current underfinancing of both the Irish and Portuguese International Monetary Fund (IMF) programs, this must mean that the euro area sovereigns and the European Financial Stability Facility (EFSF) will fully fund the current Irish and Portuguese IMF programs in the future without any new use of haircuts on debt held by the banks, known as private sector involvement (PSI). The ECB thus seems to be defining the "division of labor in the euro area" by telling euro area leaders that the central bank will deal with illiquidity problems in Spain and Italy, but that the banks must deal with any future solvency related issues in Greece, Ireland, and Portugal through the EFSF.
Recent events should help dispel the fears that the euro area is a currency union without a lender of last resort. The precedents from May 2010 and this week show how the ECB will fulfill that role, but only as a last resort—and in return for policy concessions from relevant elected leaders along the lines usually demanded by the IMF. The ability of Europe’s top central bankers to press for longer-term solutions is encouraging, especially in the absence of political leadership from the continent’s elected officials.
Several concerns still surround the ECB’s recent actions, however. First is the question of whether bond purchases are a one-off action addressed to the volatile and thinly traded markets of August, or part of a sustained policy shift. Given the likely internal disagreements on the ECB Governing Council about this, as well as the vague strategy outlined for the Securities Market Program (SMP) to help in "restoring a better transmission of our monetary policy decisions—taking account of dysfunctional market segments—and therefore to ensure price stability in the euro area." Probably only time will tell. Yet, as both Italy and Spain remain simply too large to bailout by an EFSF/ESM (European Stabilization Mechanism) of any realistic size, continued ECB purchases should be expected if required. (A tripling of its size would probably jeopardize the remaining national AAA-ratings in the euro area, and especially that of second-largest France.) This is especially so, because both Spain and Italy look far more like instances of illiquidity than do Greece, Ireland, and Portugal. The scope of any credit risk from these countries transferred to the ECB’s balance sheet is accordingly limited.
Second, there is the technical issue about whether the ECB will be able to (almost) wholly sterilize these purchases if it continues to buy up Italian and Spanish bonds. If not, and faced with an associated increase in euro area base money, perhaps the ECB would choose to stop purchases. Sustained purchases would at a minimum likely require "nonconventional sterilization methods."
Third, there is the concern over whether lame duck Prime Ministers Berlusconi and José Luis Rodriguez Zapatero of Spain will actually implement any of their new alleged promises to the ECB. Perhaps they will not. On the other hand, the politics in Greece, Ireland, and Portugal suggest that when pressed to the wall, euro area governments act decisively to secure continued financial assistance—and only the ECB is able to provide this to Spain and Italy.
In summary, employing the famous if ill-chosen metaphor of former Treasury Secretary Henry M. Paulson, there is no guarantee that the ECB’s bazooka will work. That is true especially in a period of acute trans-Atlantic economic stress. But the fact that it is now being fired and can be reloaded adds important tools to Europe’s crisis fighting arsenal.
1. Cited in the New York Times, October 28, 1973.
3. Johnson and Boone (2011) at fear that Mario Draghi’s ECB presidency will usher in an "inflationary majority" on the ECB Governing Council. I believe recent events suggest once again that such concerns are unwarranted.