What does the new ECB Commitment to the Euro imply?

The ECB has now committed to purchasing unlimited amounts of sovereign debt from Southern Europe. The structure of conditionality proposed by the ECB in return for this new entitlement to unlimited borrowing is, however, unusual. While the ECB will provide the funds that underpin continued membership of the Euro by Southern Europe, the ECB itself will not set the conditions by which its money will be released. That role is reserved for the European Commission in collaboration with the IMF. Since the Commission has neither the political authority nor the technical prestige to take the lead in setting these conditions, in practice they will be set by the IMF. As long as the IMF remains satisfied, the ECB will underwrite sovereign debt, and the continued membership of Southern Europe in the Euro will be guaranteed, unless its leaders decide, of their own volition, to withdraw. Since no politician will be willing to incur the abrupt costs of personal responsibility for withdrawal, the prospect appears to be that Southern Europe will be subjected to a standard IMF Program, minus the exchange rate adjustment that the IMF normally requires.

Were this scenario to come about, it would imply deflation without the expenditure switching policies that induce the redeployment of the resources released by deflation. The nearest the IMF came to such a strategy was in the Franc Zone during the decade 1984-94. Exchange rate adjustment was ruled out politically because the key regional leader, President Houphouet-Boigny of Cote d’Ivoire, would not countenance it. The result was a prolonged agony of contraction across the zone. The contraction might have continued for a further decade had not his death in December 1993 enabled a swift, massive and coordinated devaluation across all thirteen countries of the zone. The political leaders of Southern Europe fear exchange rate adjustment as much as President Houphouet-Boigny, but unlike the Franc Zone no one of them is sufficiently hegemonic for a change of leadership to make a difference. Not only does this political difference imply that deflation in Southern Europe would persist longer than in the Franc Zone, Southern Europe has far less price flexibility than West Africa since its informal sector is far smaller. I find the prospect of prolonged deflation alarming: not only are the social costs high, but the political response may not be the emergence of Germanic standards of government probity, but rather the rise of populism.

Fortunately, the structure of the ECB plan is likely to avoid this scenario. While the IMF is required to sign off on the programs the governments of Southern Europe adopt, it is not going to be financing them to any significant extent: its own money is not going to be at stake. The decision whether to sign off, and more importantly whether to grant waivers in the event of slippage, will ultimately be taken not by IMF staff but by its Board. Consider the likely voting pattern on the Board. First, the Euro Zone is heavily over-represented and we can presume that it will always vote as a bloc in favour of granting a waiver. Second, each of the member countries has allies who are themselves represented on the Board. While in a real IMF Program such countries would vote according to their own interest since IMF money would be at stake, now it will be a costless favour for which some little quid pro quo may be extracted. If slippage in an austerity program is forgiven, the ultimate paymaster will be Germany, but Germany no longer has the power to veto it because it has already been overruled on the Board of the ECB, and, if necessary, it can also be overruled on the Board of the Fund. Germany’s only range of choice will be between funding the deficits of others, or matching their large deficits with its own, thereby accepting the inflation which would enable Southern Europe to achieve expenditure switching without exchange rate adjustment. In these circumstances governments in Southern Europe will be unlikely actually to implement stringent austerity programs even if they appear to agree to them.

If Southern Europe is to be denied the expenditure switching that either exchange rate adjustment or German inflation would enable, then it is indeed better that fiscal retrenchment should be less severe. A large and sustained transfer from Germany is the lesser evil. The ECB will find that the major asset on its balance sheet is Southern European sovereign debt that cannot be paid, but it will be valued at parity with the corresponding liability to Germany. Unlike other banks, central banks can still operate even if the true value of their liabilities substantially exceeds their assets.