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Jean-Claude Trichet, European Central Bank president, takes great pride in his institution’s single mandate of European prices stability. However, the ECB’s next president-likely to be Italy’s Mario Draghi, now backed by French president Nicolas Sarkozy at a press conference in Rome on Tuesday-should reverse Mr Trichet’s stealthy adoption of a second mandate: keeping the eurozone’s periphery afloat.
When set up in 1998, the ECB’s statute said the bank’s objective “shall be to maintain price stability”. The ECB’s founding document also could not have been more explicit in stating its main tasks were the implementation of euro area monetary policy, the conduct of foreign exchange operations, the management of foreign exchange reserves, and promoting the smooth operation of payment systems.
Yet despite these limited provisions and years of professing that it would never engage in bail-out operations, the ECB has of late used its little discussed rediscount window to put more than $550bn at risk to the periphery. This is all too likely to cost the European taxpayer dearly. Worse, it has done this without the explicit approval of European national parliaments.
In the process, the ECB has steadily relaxed its collateral requirements, exposing the bank to large losses in the event of default in the periphery. And it has done so without any assurance that the periphery’s problems are really ones of liquidity, rather than those of solvency. In so doing, the ECB has stretched to the limit the catch-all clause of its founding charter, which provides that the bank “shall support the general economic policies” in the European Union.
Ireland is the most egregious case of throwing caution to the wind and allowing the rediscount window to be used recklessly. More than €180bn ($263bn) of ECB money is currently at risk to the banks there, or the equivalent of about 100 per cent of that country’s gross domestic product. This ECB lending has also shown no sign of letting up, even after the agreement in December of an €85bn International Monetary Fund-EU bail-out for Ireland.
The ECB’s motivation in lending to the periphery with such abandon is not so much to support those member states as to forestall a full-blown banking crisis in Europe’s core countries. For although Mr Trichet dismisses the relative importance of the periphery’s contribution to Europe’s overall GDP, he knows how exposed European banks are to the $2,000bn outstanding in the periphery’s sovereign debt. According to IMF estimates, European banks’ exposure to the periphery constitutes about 10 per cent of Europe’s GDP and 80 per cent of European banks’ capital.
It is ironic how little public discussion there has been of the ECB’s gargantuan rediscount operations to the periphery considering their importance and close public scrutiny of the European financial stability facility. It took months of political wrangling finally to set up the EFSF in May 2010 and there is now even more wrangling to ensure that the facility can effectively draw on the full €440bn that it was initially authorised to lend.
It is fair to note that the ECB’s €75bn purchase of peripheral country debt in the secondary market has been subject to ample public debate. However, its considerably larger rediscount operations have remained well below the public radar. This is all the more surprising considering that the ECB’s capital cushion is no more than €10bn, which exposes the European taxpayer to considerable risk should peripheral debt indeed be eventually subject to a large haircut.
One can understand why, in the heat of the sovereign debt crisis, Mr Trichet avoided a public debate on these issues. Such a discussion could have undermined the flexibility he needed to keep the periphery afloat. However, the ECB is now running an inordinate risk to its longer-run credibility by being less than frank with the public about its rediscount operations. Mr Draghi, if indeed he takes over from Mr Trichet, should think carefully about a change of course. Judging by the political winds now blowing through Europe, if he does not do so he may face a backlash against the ECB’s political independence. If European taxpayers are presented with a hefty bill for the bank’s recent largesse, such a backlash is only a matter of time.
Desmond Lachman is a resident fellow at AEI.
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