Last week’s failed auction of German debt showed that none would be immune from a blow-up of the Eurozone, and that normal central banks act as lenders of last resort to their governments. This column argues that unless the ECB starts to care explicitly about financial stability, the troubles will only get worse.
As many had expected, the decisions made at the last European summit a few weeks ago were totally inadequate to halt the crisis. What can now be done to stop the spread of distrust?
The official response of German politicians is that leaders must reorder public finances and reform the economy. There is no doubt that this should be done, as it is unthinkable that the countries of southern Europe can get out of the crisis if they cannot recover the capacity for growth and restore public finances. But will this be enough? It is now increasingly clear that the answer is no.
National reforms are necessary but not sufficient to stop the crisis. The trouble is that the distrust is no longer aimed at individual countries; it is now aimed at the entire Eurozone. There is now a widespread belief that the very foundations of the euro are weakened by a defective foundation – an ‘original sin’.
- In all advanced countries, the central bank’s task is to safeguard financial stability by acting as a lender of last resort.
- The ECB can only perform this task in the middle. It can provide liquidity to banks in difficulty, but it cannot do so for Eurozone governments.
The result is that countries with high debt are left at the mercy of the changing mood of the markets. If for some reason confidence falters, the debt burden quickly becomes unsustainable.
This problem is compounded by a second major flaw in the foundations of the euro.
- Monetary policy has been centralised, but banking supervision has remained a national competence.
- And today the supervisory authorities do not trust each other.
The distrust is so widespread that the national supervisors require banks not to transfer cash out of their country so as not to be exposed in the event that the crisis degenerates.
We have arrived at the paradox of having a single currency with 17 bank and public debt markets segmented by national borders, charging their customers different interest rates. Such a situation cannot last long.
It is hard to imagine a return of confidence if these defects are not corrected. Admittedly, we made mistakes in the Eurozone’s design. The monetary institutions of advanced countries are the result of a slow and gradual process of trial and error, littered with lessons and mistakes such as the recessions of the 1930s and the 1970s inflationary shocks. The founding fathers of the euro were too ambitious. They have designed a highly ambitious endeavor and then armored against change with an international treaty. Now we are finding that, in extreme circumstances triggered by the financial crisis of 2008, the system no longer works. It is time to admit it. It is time to openly declaring that the Treaty should be revised.
At the time of writing, last week’s auction of German government bonds remains unsold. This is the latest confirmation of what is now widespread distrust. Yet, paradoxically, this could also help to unblock the situation, for two reasons:
- First, it has made clear to everyone that, despite its rhetoric, the Bundesbank actually continues to act as lender of last resort, at least temporarily, to the German state. The securities sold at auction because they were absorbed by the Bundesbank, which always plays this role to ensure the liquidity of German securities.
- Second, this event could bring forward the point where even the ECB is convinced that financial stability comes before even price stability. If the German central bank is forced to keep unsold debt on the balance sheet of its state, it means that it is time for a change in monetary policy. Not only cutting interest rates more decisively, but facilitating the purchase of government bonds in a policy of quantitative easing similar to that adopted long ago by the US Federal Reserve to support the economy and provide liquidity.
The next few months (and perhaps the next few weeks) will be crucial to see if there will be a breakthrough in the formulation and in the foundations of European monetary policy. Unless this happens, the crisis is likely to grow.