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Is King Euro Naked?



Europeans may find several historical and theoretical reasons why a political government for the euro area would be desirable. But after the global crisis there are technical reasons why it is more than desirable. That conclusion is a necessity in light of three increasingly important aspects of current monetary developments in Europe: (1) the lack of an exchange rate policy; (2) the absence of a European fiscal authority guaranteeing the stability of sovereign bonds; and (3) the collusive relationship developing between the European Central Bank (ECB), the banks, and the national governments hiding the costs to the taxpayers.

(1) In a world where the exchange rate of the dollar and the renminbi are "governed" for domestic purposes, Europe risks being caught as a scapegoat for other countries' imbalances. The lack of a proper currency policy is the most intuitive argument in favor of establishing a political governing authority in the eurozone. The ECB cannot pursue currency objectives beyond its statutory mandate of inflation control. Trying to achieve the two different objectives of price control and setting the right exchange rate with only one available instrument, interest rates, would set up two conflicting goals and price control in the euro area would lose credibility. So under the pressure of the other countries' depreciations eurozone economies have to adjust internally and more painfully through deflation or unemployment.

(2) But new and more subtle reasons are emerging for establishing a political head on top of the eurozone economic shoulders. The ECB cannot buy bonds issued directly by governments or directly finance national government debts. There are two reasons for this. One is that the ECB must be free to pursue its only statutory objective, low inflation, which means that it should avoid increasing the monetary base through the purchase of government bonds under political pressure. The second reason is that (some) eurozone member states do not want to share a common fiscal responsibility. Nor do they want to issue common bonds. As a consequence, euro-denominated bonds lack the guarantee of a central bank that in a crisis situation could be able to print money and buy euros even if only for stabilization purposes.

The lack of a political guarantee hinders the development of a fully fledged bond market denominated in euros. This is a problem that goes beyond Europe. For instance, it would reinforce the credibility of Washington's oft-proclaimed support for a strong dollar if the United States were to issue bonds in euros or yen. After all, such an action would only be taken if the United States were confident that the dollar was not going to depreciate against these other currencies. But in the absence of a fully fledged euro bond market, this remains in the realm of the hypothetical. Actually the global financial crisis has silently broken a few barriers to the ECB's restrictions on use of monetary policy. The central bank has increased—through repurchase operations—its holdings in European government bonds for an equivalent of approximately 90 billion euros between August 2008 and July 2009. How does the bank determine which bonds to hold? This remains uncertain. The lack of a fiscal backup, i.e., a fiscal authority behind the eurozone, makes it difficult for the ECB to cover the potential losses from its securities investments. Inevitably it will feel compelled to invest in the most secure bonds, even though this can increase the yield differential among government bonds in the eurozone, tarnishing the objective of monetary and fiscal convergence and making monetary policy more difficult to manage. In theory the bank could arbitrarily buy bonds issued by governments whose economies are diverging, but in doing so it would assume a political role.

(3) An even more interesting development has occurred in the relation between the ECB and regular banks. The ECB is granting low-cost money to the European banking system, which reinvests it in government securities, reaping a financial gain that comes at the cost of the taxpayer and ensuring governments the financial breathing room to engage in fiscal deficits without being accountable to political authorities. One could dispute whether this is the most efficient way to manage risks of financial instability. And one could find the circumvention of democracy irritating. But can we really expect banks and governments not to collude in pursuit of their interests behind the scenes? Which government is in the position to let any bank fail when the alternative is this collective and reciprocal bail out?

In the last 12 months, the ECB has increased by 60 percent the supply of liquidity in its open market operations. The effect on the economy has been subdued. Loans to firms tend to lag in economic cycles, so the credit demand is clearly still far from the normal level, not necessarily because of banks placidity. At first banks hoarded the liquidity at the ECB deposit facility, earning a sure and safe differential. More recently they are using low-cost funding (at a 1-percent rate) to invest in government securities, not only earning on the rate differential but improving the quality of their battered balance sheets. Some estimates reckon that half of the government securities issued from the start of the crisis is directly absorbed by banks being financed by the ECB.

In this situation, the problem is that the ECB finds it much more painful to raise interest rates because doing so would reduce the advantage for banks in purchasing government securities. If the ECB were to increase the interest rates that it charges the banks, for fully understandable reasons, government bond rates would have to increase as well to attract investors and compensate for the thinning of the spread between the ECB's funding facility and government bond rates. The consequences of an excessive rise in short- and long-term interest rates would be an exaggerated appreciation of the euro and a likely recession—unless the ECB and the Fed coordinate an increase in rates. But because such a coordination would likely occur on a broad scale as part of an "exit strategy" from the current crisis, it is inconceivable for the central banks to cooperate in the absence of an agreed strategy between political authorities.

If the ECB for the above reasons delays increasing the interest rates, than the excess liquidity provided to the European banks will, sooner or later, find a way to inflate some kind of new bubble, inviting a new crisis starting from square one….

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