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2012-06-26 11:35:32
The European Central Bank has unlimited firepower and limited inclination to
use it. The first of two articles on central banks explains the ECB s thinking
Jun 23rd 2012 | Frankfurt | from the print edition
IN 2008 and 2009, policymakers impressed markets with decisive action. Central
banks moved swiftly to slash interest rates and extend liquidity, beefing up
balance-sheets in the process (see chart). Governments launched big stimulus
programmes. The G20 meetings were a signal of a concerted determination to act.
Things are different now. At this week s G20 summit in Mexico, more fingers
were pointed than backs slapped. Many governments are intent on tightening
policy, not loosening it. Central banks retain the capacity to act: the Bank of
England announced new liquidity programmes on June 14th, and on June 20th the
Federal Reserve decided to extend a programme to hold more longer-term bonds
(see article). But, maddeningly, the institution that needs to do most the
European Central Bank is hanging back even as the pressure on countries like
Spain, whose sovereign-bond yields rose to euro-era highs this week,
intensifies.
The politicians are casting around for solutions of their own. One approach,
mooted in Mexico, would be for the zone s bail-out funds either the permanent
European rescue fund, the European Stability Mechanism (ESM) due to start in
July, or the temporary European Financial Stability Facility to purchase the
bonds of struggling countries like Spain and Italy, driving down their yields.
Such intervention has previously been conducted by the ECB via its Securities
Markets Programme (SMP), which now holds over 200 billion ($250 billion) in
government bonds.
The snag with using the ESM is that its firepower is limited to 500 billion
(of which up to 100 billion is already earmarked for Spanish banks). By
contrast the ECB s resources are potentially unlimited. Yet Mario Draghi, the
ECB s president, has made clear that any use of the SMP should be temporary and
limited. No purchases have been made over the past three months. Mr Draghi
knows that bond-buying alarms the Germans, who regard it as close to monetary
financing of states, which is banned by the European treaty establishing the
euro.
And even if the ECB did start buying bonds again, the intervention might be
less effective than its proponents hope. Financial markets are now gripped by
fears of subordination being pushed down the pecking order of creditors. The
ECB s insistence on being excluded from the Greek sovereign-debt restructuring
in March, which resulted in bigger losses for private bondholders, has set a
worrying precedent. Investors now worry that any official rescue, whether by
the ECB or the ESM, will claim a similar privilege.
Another way in which the ECB could calm things down would be to prime its Big
Bertha again and to fire off a third round of long-term funding for European
banks, maybe providing loans for even longer than the three-year term on those
made in December and February. Those two LTROs (longer-term refinancing
operations) were successful in cowing the markets, at least for a time. And the
ECB feels on much safer ground when it lends to banks (even if they then lend
to governments) than when it steps into the swamp of sovereign-bond markets.
Yet the case for another LTRO is less compelling than before. The funding
drought that prompted the first two has largely been quenched thanks to the big
take-up of those earlier offers, which amounted to just over 1 trillion of
three-year money. Mr Draghi said on June 15th that constraints on the supply of
bank credit had been removed. As with the policy of quantitative easing pursued
in America and Britain, there may be diminishing returns to unorthodox
policies: having banks load up on even more domestic government debt is not
ideal, for example.
That leaves more orthodox approaches. There are certainly compelling reasons
for the ECB to ease monetary policy. The euro area may have managed to dodge
recession in early 2012 (when output remained flat after declining by 0.3% in
late 2011), but GDP seems to have slipped back in the second quarter. A clutch
of business surveys, including the latest ZEW indicator of confidence among
German investors, paint a dismal picture of the rot spreading from the
periphery to the German core. The second quarter started wretchedly: euro-zone
industrial output contracted by 0.8% in April from March; the monthly fall in
Germany was 2%.
To counter this weakening, the ECB looks likely to cut interest rates when its
governing council meets on July 5th. Its benchmark rate has stood at 1% since
December. If it were to be cut to 0.5% (similar to the rate in Britain), this
would affect not just new lending by the ECB but the rate charged on the LTROs
(for which banks will be charged the average interest rate over the three
years). Any reduction would probably occur in two quarter-point steps, as
happened late last year when the ECB brought down the rate from 1.5% to 1%.
Such a move may bolster Germany and other solid northern economies, but it will
do little to help the euro area s foundering southern economies. The
fundamental problem that Mr Draghi faces is the acute divergence within the
euro zone as capital flight sucks funds out of the periphery and into the core,
making monetary conditions simultaneously tight and loose. In Germany, despite
recent gloom, businesses and households can borrow readily at cheap rates. In
southern Europe, banks are restricting the supply of credit; those loans that
are available are expensive.
Mr Draghi has long argued that the solution to the euro crisis lies in the
hands of politicians. If European leaders fail to deliver when they meet for
yet another summit in Brussels at the end of June, the ECB will remain in a
quandary. Trying to implement a common monetary policy for the euro zone was
always a tough task. But in a rapidly fragmenting currency area, it is
well-nigh impossible.
from the print edition | Finance and economics