We had to burn the euro to save it

An edited version of the following commentary on the eurozone debt crisis appears in the latest edition of a magazine for official monetary and financial institutions and the original is posted here by kind permission of the publishers.






















Faced with a sovereign debt crisis that threatened to spread from Greece to at least Portugal and Spain, between March 25^th and May 10^th of this year the eurozone authorities progressively relinquished various constraints designed to maintain the ECB's solvency and detachment from fiscal policy. While the authorities' aim was to avoid a collapse of EMU as members unable to remain competitive and service their debts in euros seceded from the monetary union to reintroduce their own national currencies, the adjustments threaten to undermine the real value of the euro by weakening the ECB's balance sheet and setting precedents for similar accommodation in future. After this U-turn, investor perceptions of the euro may never be the same again – the euro may remain the currency of most EU states, but as a unit diminished in value and reputation.

The euro was conceived as a hard currency. Part of the motivation for EMU was the desire of Germany's EU partners to emulate German post-war economic success, which owed much to a hard Deutschmark that drove German industry to seek real solutions to problems like the 1970s oil shocks, rather than the inflation and devaluation palliatives tried by other European countries; Germany itself would have refused to join any less rigorous monetary union. And until the present eurozone sovereign debt crisis, the ECB had largely followed the Deutschmark model. In its first few years, the ECB withstood scepticism about an initially weak euro, and resisted calls from politicians like Oskar Lafontaine to use (the short-run ability of) monetary easing to boost economic activity. Although the ECB did cut euro short-term interest rates in response to the early (US sub-prime) phase of the global financial crisis and offered eurosystem banks unlimited loans against private sector bond collateral for periods of up to a year, unlike the US Federal Reserve the ECB declined to drive inter-bank interest rates to practically zero or purchase such bonds outright for its own balance sheet. Indeed, until this year the euro was gaining ground as a reserve currency as the more accommodating stance of the Fed and the ongoing deterioration of the US net international investment position raised doubts about the future value of the dollar.

Unfortunately, the spreading of the financial crisis to the debt of eurozone governments, especially those of Greece, Ireland, Portugal and Spain, proved to be a sterner test of the ECB's resolve. These countries had got into trouble because, since adopting the euro, they had not taken advantage of its lower interest rates to reduce their borrowing while failing to reduce their labour cost increases in line with the lower inflation of the eurozone. Even countries like Spain which had not run increased public sector deficits during the good times came to face fiscal problems as their economies were depressed by private sector debt and uncompetitiveness. This situation poses an existential threat to EMU, because one way for a member of a monetary union to tackle such difficulties is to secede from the union and reintroduce a national currency that can be devalued to reduce the real value of domestic debt and restore the competitiveness of domestic output. Obviously, this is bad for the holders of that debt, and to the extent that secession of one country makes it seem more likely that others will follow, investors will demand higher interest rates to hold those countries' debt, encouraging them to secede and so on, collapsing the monetary union through a cascade of withdrawals. Understandably therefore, the ECB may have been more inclined to acquiesce to measures to hold down marginal countries' bond yields and to err on the easy side in monetary policy to minimise their incentive to secede from EMU.

The first concession made by the ECB was in the collateral requirements for its lending to eurosystem banks. These were set in terms of agency credit ratings, no doubt to distance the ECB from the task of differentiating between the creditworthiness of eurozone governments, with the inevitable consequence that a credit rating agency decision could render a country's debt ineligible as ECB collateral at an inconvenient time. In particular, the likelihood that that Greek government debt would be downgraded below the ECB's normal A- / A3 threshold threatened to restrict the ability of Greek banks to borrow from the ECB and would have removed a key benefit supporting the value of Greek government debt. On March 25^th, however, ECB President Trichet said that investment grade (ie down to BBB- / Baa3) debt would be accepted for an indefinite period. And then on May 3^rd, with the prospect looming that Greek government debt could even be downgraded to junk status, it was announced that Greek government debt specifically would be accepted regardless of its credit rating.

The most shocking climb-down by the ECB, however, occurred on the night of May 9/10^th, when in association with the creation by EU finance ministers of a €750bn emergency funding mechanism available to any eurozone country, which added to a €110bn conditional loan facility for Greece agreed on May 2^nd, the ECB announced an outright bond purchase programme. Since the ECB had previously consistently resisted appeals to follow the Federal Reserve, Bank of England and Bank of Japan in buying bonds to enhance monetary policy easing, this change raised questions about both the ECB's commitment to inflation and its political independence.

Although the ECB presented this Securities Markets Programme (SMP) as a technical initiative "to ensure depth and liquidity in those market segments which are dysfunctional.....to address the malfunctioning of securities markets and restore an appropriate monetary policy transmission mechanism", the SMP does potentially compromise the ECB's ability to hold down inflation in future. The concern is not so much the money-creating effect of government debt purchases, as the ECB undertook to sterilise this by introducing a week-long deposit facility (actually, given an unchanged interest rate target, routine open market operations effectively provide automatic sterilisation anyway), but rather that the SMP effectively represents an additional source of funding for eurozone governments. It is normally undesirable for a central bank to lend to its government partly because that government may be tempted to borrow and spend more than otherwise in the knowledge that, if the volume of its debt sales disturbs the market, the central bank provides a backstop, and partly because the accumulation of potentially depreciating assets on the central bank's balance sheet may restrict the central bank's ability to sell enough assets to absorb excess money to counter an inflationary threat. For these reasons, Article 123 of (the updated version of) the Maastricht Treaty specifically prohibits the ECB from purchasing debt directly from eurozone governments, and buying government debt from the market to relieve a surfeit that is impeding sales of new debt arguably violates the spirit of this rule.

The fact that Trichet had denied that the ECB governing council had even discussed government bond purchases when questioned about this at the press conference following their monetary policy meeting on the Thursday preceding the EU finance ministers' weekend summit gives the impression that the ECB was influenced by the inter-governmental negotiation. Given that these discussions were apparently fraught, with French President Sarkozy reportedly threatening to withdraw France from EMU if an agreement including a sceptical Germany represented by Chancellor Merkel could not be reached, it is not hard to imagine that the ECB was pressurised to support the package.

The retreat by the ECB is particularly disappointing because it represents a missed opportunity for Europe to interrupt the sequence of bailouts that have characterised the financial crisis since the demise of Lehman Brothers in September 2008 and to differentiate the euro as a reliably hard currency even in adverse circumstances.

Allowing at least Greece to be driven to default or restructure its government debt – assuming that Greece could not adjust its finances to service that debt – before compromising the ECB's standards would have established the principle that, in the eurozone, an individual state can run out of money like a corporation, and that the risk premium on debt should be regarded as advance compensation for genuine risk of default. With Greece's reputation for misreporting economics statistics, tax evasion and generous public sector remuneration, there was relatively little support in the rest of the eurozone for a bailout of Greece, and given the size of the fiscal adjustment that Greece must make to avoid default even with the support of its €110bn conditional loan facility, Greece may yet default anyway. It would have been better for the EU to draw the line before, say, Portugal rather than Greece.

Many commentators claim that the eurozone authorities' real reason to bail out Greece was that so much Greek debt was held by eurozone banks that even restructuring was likely to impose sufficiently large losses to bankrupt those banks and reduce Europe's banking capacity enough to cripple its economy. If so, this was an unwise decision. First, bailing out a country means saving all its creditors, making it an inefficient way to protect banks. Second, unless banks are formally bankrupted, it is difficult to make full use of their shareholders' and junior creditors' money to absorb losses, making bank failure more costly for the taxpayer. And in Europe especially, bankrupting a bank need not involve disruptive closure and complete liquidation; it is easier to nationalise a failing bank in Europe compared with America where the public are more hostile to state ownership. As it is, the danger is that bank losses on sovereign debt are offloaded to the eurozone states, increasing their indebtedness and intensifying the pressure on the ECB for further accommodation. Ironically, in making concessions to abet the eurozone bailout of Greece to avoid a mythical banking meltdown, the ECB may find that it has opened a Pandora's Box.