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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