I thought you would be interested in my new Project-Syndicate column on the
recent proposals to have the ECB buy bonds of Italy and Spain.
I have copied it below
Marty
Dos and Donts for the European Central Bank Page 1 of 2
Project Syndicate
*Dos and Donts for the European Central Bank *
July 2012
By MARTIN FELDSTEIN
CAMBRIDGE Recent statements by European Central Bank President Mario
Draghi and Bank Governor Ewald Nowotny have reopened the debate about the
desirable limits to ECB policy. The issue is not just the ECBs legal
authority under the Maastricht Treaty, but, more importantly, the
appropriateness of alternative measures.
Nowotny, the president of the National Bank of Austria, suggested that the
European Stability Mechanism (ESM) might (if the German Constitutional
Court allows it to come into existence) be given a banking license, which
would allow it to borrow from the ECB and greatly expand its ability to
purchase eurozone sovereign bonds. Draghi later declared that the ECB can
and will do whatever is necessary to prevent high sovereign-risk premia
from hampering the functioning of monetary policy.
Draghis statement reprised the rationale used by his predecessor,
Jean-Claude Trichet, to justify ECB purchases of eurozone members
sovereign debt. Not surprisingly, financial markets interpreted his
declaration to mean that the ECB would buy Spanish and Italian government
bonds again under its Securities Markets Program, as it did earlier this
year. Although the previous purchase of more than 200 billion ($246
billion) had no lasting effect on these countries risk premia, the
presumption is that the effort this time could be much larger. But is that
what the ECB should be doing?
*While any central bank must be able to conduct open-market operations to
manage liquidity in financial markets, selective purchases of individual
country bonds that bear high interest rates because of current and past
fiscal profligacy is both unnecessary and dangerous. A better rule for the
ECB would be to conduct open-market operations by buying and selling a
neutral basket of sovereign bonds, with each countrys share in the
basket determined by its share in the ECBs capital. *
*This neutral basket approach would permit the ECB to purchase
substantial volumes of Italian and Spanish bonds, but only if it was also
buying even larger amounts of French and German bonds. The ECBs bond
purchases would become as similar to the open-market operations of the
United States Federal Reserve and the Bank of England as is possible in the
absence of a single eurozone sovereign government*.
By contrast, focusing potential ECB purchases on the sovereign debt of
those countries with high interest rates would have serious adverse
effects. It would reduce pressure on the governments of Italy, Spain, and
other high-interest countries to make the politically difficult decisions
that are needed to cut long-term fiscal deficits. Spain needs to exercise
greater control over its regional governments budgets, while Italy needs
to shrink the size of its public sector. An ECB policy that artificially
reduces their sovereign borrowing costs would make these steps even more
politically difficult.
Indeed, when the ECB controls interest rates on long-term bonds, it is hard
for political leaders, parliaments, and voters to know whether they have
achieved significant fiscal improvement. The peripheral eurozone countries
became over-indebted in the last decade because the bond market failed to
provide a signal that debts were too high. That has now ended, because bond
investors no longer treat all eurozone sovereign debt as equal. But an ECB
program to limit interest-rate differentials would eliminate this important
signal.
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Dos and Donts for the European Central Bank Page 2 of 2
Moreover, because the ECB cannot simply buy sovereign bonds without regard
for individual governments fiscal policies, it risks finding itself in the
politically dangerous position of deciding whether a countrys fiscal
actions are tough enough to be rewarded with lower interest rates. The ECB
would thus cross the threshold from monetary policy to fiscal policy. Would
it put a common ceiling on well-performing governments interest rates,
as Italys Prime Minister Mario Monti suggested not long ago? Or would it
set and revise sovereign interest rates according to its current evaluation
of each countrys fiscal efforts?
Finally, Germany might not continue to accept the default risks implied by
large ECB purchases of high- risk sovereign bonds. Germany already faces
large financial risks, owing to the ECBs balance sheet and the Target2
balances at the Bundesbank that are generated by international flows of
deposits to German commercial banks.
While German political leaders now declare their allegiance to the
eurozone, opinion polls in Germany show that public support for the euro is
very weak. As the risks accumulate, it is not inconceivable that Germany
might conclude that, despite the potential impact on its exchange rate, it
would be better off returning to the Deutsche Mark.
For all of these reasons, the ECBs direct purchase of high-yield sovereign
bonds to limit their interest rates would be a mistake. It would also be a
mistake to do this indirectly by another trillion-euro long- term
refinancing operation aimed at encouraging commercial banks to buy those
bonds. And it would be a mistake to allow the ESM to have a banking license
so that it can borrow from the ECB, greatly increasing its purchase of
peripheral countries bonds.
Individual governments should take the tough political steps needed to
reduce the risk of a eurozone breakup, which would have very substantial
financial costs for all and not only its members. Unfortunately, ECB
officials recent statements may have reduced the pressure on governments
to do those things, and, by reversing the decline of the euros value, may
have blocked the market response that is needed to shrink current-account
imbalances and boost GDP in the eurozone. Sooner or later, the ECB will
have to clarify the limits of its policy.
Martin Feldstein, Professor of Economics at Harvard, was Chairman of
President Ronald Reagan's Council of Economic Advisers and is former
President of the National Bureau for Economic Research.
Copyright: Project Syndicate, 2012
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Received on Mon Jul 30 2012 - 11:25:45 EDT
