The European Central Bank has been the savior of the euro zone over the past 18 months. While the politicians have dithered, it has used its status as the one European institution with the ability to act decisively to respond quickly to events. Without its interventions during the earlier stages of the crisis the euro zone would now be in even worse shape and may even have already collapsed. But over the past few months, the crisis has moved into a new and far more dangerous phase for which the ECB is not well-equipped. Indeed, it may now present the biggest threat to the currency's survival.
Both the ECB's strength and its weakness stems from its independence. The ECB is different from other central banks; it's not directly accountable to a single government but acts on behalf of 17 member states. To guarantee its independence, Europe's founding fathers set strict limits to the ECB's remit: there was to be a strict separation between monetary and fiscal responsibilities. The ECB was given one target—price stability—and excluded from responsibility for financial stability, which might have blurred boundaries, led to pressure to expand its balance sheet and created moral hazard.
These limitations to its mandate didn't stop the ECB intervening during the early stages of the crisis. It acted as a traditional lender of last resort to Europe's stressed banking system, offering unlimited liquidity of up to one year—all in the name of preserving price stability. When the crisis spread to Europe's sovereign debt markets, the ECB again intervened with its Secondary Market Program, buying government bonds to stabilize yields—justifying this as fixing a vital component of the monetary policy transmission mechanism. For a long time, this worked: the ECB only expanded its balance sheet by 71% compared to 229% at the U.S. Federal Reserve and 193% at the Bank of England. The euro-zone economy grew and inflation remained close to its target of 2%.
But the ECB's approach to crisis management was always controversial. Aware of the deficiencies in its mandate and the difficulties it would face responding to a serious outbreak of contagion, the ECB was adamant European policy makers shouldn't do anything to undermine confidence in the euro-zone financial system. When Ireland's banking system collapsed, the ECB insisted Dublin bail out all creditors even though its previous deposit guarantee had lapsed. Similarly, when the scale of Greece's sovereign-debt crisis became clear, the ECB insisted Greece must avoid a default at all costs.
This approach may have made intellectual sense, but it also appeared unjust. The Irish people paid a very heavy price for the ECB's determination to preserve confidence in bank-debt markets, while Greek taxpayers paid a similar price to maintain the integrity of sovereign-debt markets. Bondholders were being repaid in full while losses were being socialized—and would ultimately be borne by rich-country taxpayers. Meanwhile the collapse in peripheral countries was forcing the ECB to take over funding of both banks and governments, exposing its balance sheet to growing credit risk. Read more. (Subscription required.)
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