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Pietro Naj-Oleari/European Union 2011
When euro-zone partners meet next week for another summit, German Chancellor Angela Merkel will ask 17 member nations to sign on to fiscal union and sign away their budget sovereignty. But restive global investors have lost their appetite for yet another grand solution too distant to count on. They are deeply discounting profligate governments’ promises to mend their ways. What’s needed is the strong arm of the European Central Bank to remove catastrophic risk from the marketplace without risking the bank’s core mission of fighting inflation.
Most of Europe is whining for a quick fix. Finance ministers want the ECB to turn on the monetary printing press and disgorge two trillion fresh euros to soak up every weak government bond in sight until yields are driven down from a realistic 7% to a windfall 4%. Across the Atlantic, the Obama team—which has never met a country, bank, company or homeowner it didn’t want to bail out—is pushing to refashion the ECB as a carbon copy of the free-spending Federal Reserve. So far, a tentative 200-billion-euro foray into bond buying has bought only a transitory blip in prices and saddled the ECB balance sheet with a troublesome asset.
“The Obama team—which has never met a country, bank, company or homeowner it didn’t want to bail out—is pushing to refashion the ECB as a carbon copy of the free-spending Federal Reserve.” –Adam LerrickResorting to costless money simply trades short-term relief for long-term distress. It ignores the power of incentives and the speed with which expectations of the future are reflected on global financial screens today. Politicians, no longer constrained by borrowing costs, will once again overspend to court indulged voters accustomed to a standard of living that their productivity cannot deliver. An explosion in the money supply will feed a large inflation and, with it, a massive transfer of wealth from Europe’s ordered North to its easygoing South. Markets will precipitate a currency crisis where once a stable euro was a credit to ECB skills.
But on the continuum between total bailout and abandoning the market to chaos, there is a place where the ECB can properly step in and siphon panic out of the system: It can create a “floor of support” to underpin Europe’s progress toward fiscal union.
Clear rules of intervention do away with the uncertainty that stampedes markets. A public announcement of a floor of support would state a new rule: The ECB stands ready to buy all bonds of members with a proven—not just promised—commitment to fiscal reform at a 5% inflation-adjusted yield. Implementation would be instantaneous. If a government backslides or the euro zone slows its pursuit of fiscal union, ECB bond purchases would automatically end.
The floor would spare the ECB the conflict of choosing between stable markets and central bank integrity. It would set a bottom to the market that protects investors against panic-driven losses but not against all losses. It would pressure spendthrift politicians even as it helps weak economies on the road to recovery. And it would safeguard the key elements of euro-zone financial well-being: liquidity, solid collateral values and, for the euro itself, stable inflation and exchange rates.
The floor price would fall as inflation rises, leaning against monetary expansion. Each month, a rolling 12-month euro-zone inflation rate would reset the floor level for five-10 year bonds. At today’s euro-zone inflation rate of 3%, sovereign interest rates would be capped at 8%. For a seven-year bond with a 7% coupon, this would translate to an ECB-guaranteed price of 95% of nominal amount. If inflation falls to 2%, the guaranteed minimum value would be 100%.
At 6% inflation, the ECB cap would hit 11% and the price guarantee on the same bond would fall to 81%. Borrowing costs would be painful but sustainable for the coming three years, keeping pressure on politicians to restore solvency and move on to fiscal union.
Central banks are designed to stand up when markets fail to function. For purists on the governing council of the ECB, the floor of support should meet the criteria of a classic lender of last resort—lending in a crisis at a penalty interest rate against good collateral. The inability of a government with a sound fiscal program to obtain funds at 5% adjusted for inflation is a crisis. An interest rate of 5% above inflation is a penalty. The government’s execution—not mere promise—of credible fiscal policy, and the euro zone’s clear commitment to fiscal union, are good collateral.
What will happen if the ECB sits on the sidelines and there is no floor of support to arrest a downward spiral? Investors will refuse to buy bonds of sound issuers. Panicked markets will drive prices below rational valuation. Solvent but illiquid borrowers will be forced into default as financing costs spin out of control. Politicians and bankers will confuse the end of their world with the end of the world. The central bank will abandon its principles. And still another bailout will renew investor licenses to gamble with taxpayer money.
The founders of Europe’s monetary union promised to give a rigorous Bundesbank to the Italians. Instead, will the ECB be forced to reverse course and give the Banca d’Italia to the Germans? Europe must move out of the shadows of financial prehistory—when big banks and governments colluded to manage markets—and accept the realities of a rough and ready, profit-focused global trading room. It must learn to work with markets, not try to control them, and to use the ECB without corrupting it.
Adam Lerrick is a scholar at AEI.
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