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Is the bazooka bust?

17 November 2011 By Hugo Dixon

The European Central Bank holds many of the cards that could solve the euro crisis. But it has been reluctant to play them. Although it is hemmed in by law, ideology and past positions, it does have wiggle room.

Calls for the ECB to fire its “bazooka” and act more freely as a lender of last resort are reaching fever pitch as the crisis has moved from small peripheral euro zone countries to Italy and now to core states such as France. The United States, France and numerous pundits have pleaded with the independent central bank to turn on its printing presses.

Cheap money from the ECB might be able to head off three problems: a double-dip recession; an imminent credit crunch as banks face a tightening liquidity squeeze; and the possibility that countries such as Italy and Spain could be shut out of the bond markets. It is the latter problem which has garnered most attention in recent days. The current favourite solution is to turn the European Financial Stability Facility, the zone’s bailout fund, into a bank and let it borrow from the ECB. The EFSF would then have enough firepower to lend to big countries and keep their borrowing costs down.

The ECB, for its part, has been reluctant to do anything which undermines its independence from political interference or contravenes the Treaty of Lisbon’s provision which prevents it from lending directly to governments. It is also anxious to maintain its inflation-fighting reputation. The central bank has taken the view that governments need to solve the problem of excessive debts themselves rather than relying on easy money from the ECB.

There is also a strong suspicion in the markets that, despite being independent, the central bank doesn’t wish to anger Germany, the euro zone’s largest economy. And Berlin, which was traumatised by hyperinflation in the 1920s, has tended to take the orthodox line that the ECB shouldn’t either engage in loose monetary policy or help finance governments’ deficits. It has also opposed turning the EFSF into a bank.

But there are several reasons why the ECB might not be quite as hard as it looks. First, the Treaty only forbids direct lending to governments. Lending indirectly via the EFSF might therefore be OK, although lawyers could no doubt spend many years arguing the toss.

Second, Germany has no formal control over what the independent ECB does. Only two of the 23 members of the ECB’s governing council are German. One of these, Juergen Stark, is due to step down by the end of the year. His replacement will be Joerg Asmussen, Germany’s deputy finance minister, who is considered to be less of a hard-liner. However, this does not mean the other members of the governing council are soft – central bankers rarely are.

Third, although the ECB’s primary objective is to ensure price stability, a secondary objective is to contribute to the stability of the financial system. Arguably, the financial system is now in danger. A French government spokesperson, Valerie Pecresse, referred to this on Nov. 16 when she said that her government trusted the ECB would take the “necessary measures” to ensure financial stability. Even some Germans seem to be coming round to this view. Peter Bofinger, a government advisor, said on Nov. 15 that the ECB should act as a lender of last resort if politics failed to halt the crisis.

Fourth, the ECB has seemingly performed U-turns in the past. For example, in May 2010 it started buying government bonds in the secondary market under the Securities Markets Programme. A few days earlier, Jean-Claude Trichet, then the ECB’s president, said the governing council hadn’t discussed such bond-buying.

Finally, many of the ECB’s supposed red lines were drawn by Trichet. His successor, Mario Draghi, is thought to have supported these views. But he doesn’t appear to have gone on the record to oppose turning the EFSF into a bank. This means that, if the ECB has to perform another U-turn, he personally wouldn’t have so much egg on his face.


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