Will the ECB ever act?

The above has nearly become a rhetorical question. Once again, the ECB has failed to act. As scores of economists have argued repeatedly, the ECB can and should have intervened in the bond markets long ago by committing itself explicitly to capping sovereign yields. A year ago, such an intervention would have been far cheaper than next month or next year. That the euro sovereign bond crisis is still with us reflects the deeply conservative nature of both its governing board and of the (mainly) northern European centre-right political class whose conventional wisdom still rules. And of course, even were the sovereign bond crisis resolved, this would not deal with the wider issue of Eurozone trade imbalances, but let us ignore that problem for the moment.

There are several strands of the centre–right’s argument about the ECB. The basic assumption of this group (which includes several prominent German SPD members) is that an explicit cap on sovereign spreads would leave the ECB bereft of power to control Eurozone (EZ) governments’ profligacy. Further assumptions include the alleged need for the ECB ‘to defend its balance sheet’, the notion that its only function is keeping inflation under control and the alleged refusal of bond markets to accept losses at the expense of sovereign member-states.

What’s wrong with these assumptions? As far as ‘profligacy’ is concerned, we know that the only Club-med government which can be so accused is Greece — most other countries had reasonable primary budget deficits or relatively low net debt/GDP ratios before the attack on their sovereigns. In any case, the true test of sustainability is a country’s long term net debt/GDP ratio. Even if a country’s net debt is constant, falling GDP will cause the ratio to rise. Troika-imposed austerity is not the answer since ‘rescued’ member-states are nearly all in deep recession. Japan and the USA are both judged ‘sustainable’ despite having high debt ratios because their economies are no longer in recession.

As for the ECB’s balance sheet, a central bank (unlike a private bank) generally need not fear for its equity position. This is true for two reasons: one is that its equity must include its future stream of earnings from seigniorage, currently thought to amount to 2-3 trillion euros in the case of the ECB. The most important reason, though, is that a central bank has the unique power to print money (what economists call ‘monetisation’).  Where the CB engages in QE, or prints money to keep banks solvent, this is what the two recent rounds of the ECB’s Long-Term Refinance Operation (LTRO), together amounting to just over €1tn, were about.

Has printing money been inflationary? Although much of the centre-right (and even some of the centre-left) still holds the Friedmanite view that ‘inflation is always and everywhere’ about printing money, the empirical evidence suggests that this view is simply wrong. The Swiss Central Bank successfully capped the exchange rate by printing money with negligible inflationary consequences. Neither massive QE by the Bank of England nor the ECB’s LTRO has produced any jump in inflation. Indeed, EZ (and UK) price levels at the moment are falling. Friedman himself admitted that the view depended on the non-bank public’s demand for money, and it is precisely because of lack of effective demand that most of Europe is in recession.

But regardless of inflation targeting, it can sensibly be argued that the ECB has an implicit mandate to maintain economic stability. Hence Mario Draghi’s much publicised remark that the ECB would do anything it takes to save the euro. What he also said at that meeting was that stabilisation falls within the ECB’s mandate:

To the extent that the size of the sovereign premia hamper the functioning of the monetary policy transmission channels, they come within our mandate

But the rise in the euro and the easing of Spanish and Italian bond prices lasted only a few days, and now the pressure is rising once more. Inter alia, this faltering rally reflects pessimism about the outcome of Thursday’s meeting of the ECB governing council, mainly because of the negative noises from Germany’s Bundesbank (although both Angela Merkel and Wolfgang Schäuble appeared to back Draghi); equally negative have been the reactions of smaller players like the Dutch and the Finns.

The ECB has a number of options: it can buy more member-state bonds on the secondary market through its Security Market Programme (SMP); it can extends its LTRO programme to provide more low-cost loans to troubled banks; it could give the newly formed European Security Mechanism (ESM) a banking licence, enabling the ECB to lend to the ESM directly and greatly increasing the ESM’s firepower, or it could cut its lending rate, currently 0.75%. All these options are problematic for those who want solid collateral for an extended SMP, who see the LTRO as inflationary, the granting of a banking licence to the ESM as illegal and the further easing of monetary policy as sending the wrong signal to Club-Med countries.

Perhaps the most relevant recent comment comes from Andrew Milligan, head of global strategy at Standard Life Investments:

The eurozone is falling into a Japanese-style trap by saying: let’s give ourselves more time and not take radical decisions that have to be taken, for instance on labour market reform in Italy or bank restructuring in Spain.

So despite the compelling economic logic of the positive noises from Signor Draghi, it was hardly surprising that no radical new steps were taken by the ECB on Thursday the 2^nd of August. How bad must things get before the ECB acts decisively to save the euro?