The “E” and the “M” of the EMU

They say “do not believe anything until it’s been officially denied”. Just last Thursday, ECB President Jean-Claude Trichet categorically denied that the ECB had discussed buying government bonds of peripheral eurozone members.

A market sell-off and a hectic weekend later, it was time for a complete about-face… Per the ECB’s press release on Sunday night, “in view of the current exceptional circumstances prevailing in the market, the Governing Council decided [among other things]

To conduct interventions in the euro area public and private debt securities markets (Securities Markets Programme) to ensure depth and liquidity in those market segments which are dysfunctional. The objective of this programme is to address the malfunctioning of securities markets and restore an appropriate monetary policy transmission mechanism. […]

In making this decision we have taken note of the statement of the euro area governments that they “will take all measures needed to meet [their] fiscal targets this year and the years ahead in line with excessive deficit procedures” and of the precise additional commitments taken by some euro area governments to accelerate fiscal consolidation and ensure the sustainability of their public finances.”

The significance of this move is huge, as far as killing speculators goes, but here I want to focus on a key policy dilemma that has emerged since the subprime (and now the eurozone) crisis ever began: The need for a separation between monetary and fiscal policy—what Trichet referred to as the difference between the “E” and the “M” of the EMU (or Economic and Monetary Union) at the ECB’s press conference on May 6th.

In the US for example, this separation was all but blurred by the Fed’s decisions to put its own balance sheet at stake in the bailouts of Bear Stearns, Citi and AIG and, more bluntly, by its decision to buy US Treasuries, GSE debt and mortgage-backed securities. In the event, Congress’ disgruntlement with the AIG saga, monetarists’ concerns about “debt monetization” and valid criticisms about the Fed’s decision to favor a specific sector—housing—with cheap credit, have served to raise questions about the appropriate limits of the Fed’s independence.

Does the European/ECB approach offer an alternative/better(?) route? In my view yes, notwithstanding the latest decision to purchase government bonds.

Ignoring the bond purchases for the moment, recall first that, at the height of the financial crisis, all failed banks were “dealt with” by their corresponding national governments, without any participation from the ECB. To the extent that saving insolvent banks was deemed desirable form a social or financial-stability perspective, the burden was assumed by the elected governments, with ultimate responsibility going to the taxpayers (who voted for them).

Meanwhile, the ECB did not remain idle—on the contrary: It was the first central bank to flood financial institutions with liquidity right at the onset of the crisis in August 2007; and in June 2009, it decided to provide as much funding as demanded by European financial institutions at a low, fixed rate for a 12-month maturity (longer than the Fed’s liquidity operations). In other words, the ECB demonstrated full flexibility and creativity when it came to preserving financial stability and fulfilling its LoLR functions (to illiquid but solvent institutions).

Given the faithful delineation between fiscal and monetary responsibilities, Sunday's decision to step into the government bond market may be seen as an aberration—or worse: A betrayal to the spirit of its price-stability mandate, let alone an anathema to the Germans.

I actually don’t think so. First of all, the interventions are described as—effectively—liquidity operations, to improve the functioning of monetary transmission. This is not a b.s. excuse for back-door debt monetization. Repo transactions using peripheral-economy debt as collateral have been increasingly dysfunctional, undermining the ability of some European financial institutions to fund themselves in private markets.

Now, why is that so different from the Fed’s MBS purchases, which, ultimately, were also aimed to help improve conditions in financial markets? It is different in many ways. First, unlike the MBS purchases, the ECB’s operations will be sterilized—that is, the objective is not to loosen monetary policy further but to relax financial conditions from the currently tight levels by improving funding for financial institutions (and governments).

Importantly, the Fed’s MBS purchases were unconditional: No actions were demanded on the beneficiaries of these purchases (the mortgage borrowers). In contrast, the ECB *had* to extract commitments for further fiscal consolidation from the eurozone governments, so that it could claim that (by its own judgment, rather than the now discredited rating agencies) peripheral government bonds are “safe” enough for its portfolio. We yet have to see whether such pledges will be met, but they are at least a start.

Mind you, the point goes beyond the “narrow” objective of securing the safety of the ECB’s balance sheet. It is about securing a commitment by the eurozone governments that they still see the EMU as a desirable objective and one that is worth making sacrifices for: Namely, further fiscal measures in line with the spirit of the Stability and Growth Pact, and structural reforms to restore competitiveness.

Trichet’s tough talk on May 6th aimed at highlighting exactly that—the limits of monetary policy in preserving financial and economic stability, when the political will to do so is lacking:

“We cannot substitute for the governments. The governments have their decisions to take while we have our own role as an independent central bank, and of course we expect each authority to fulfill its own responsibilities.”

What are the lessons here, including for the U.S. of A.? The first is the realization that, unfortunately, politicians are unlikely to get their act together until things are at the brink of falling apart. And even then, political will may be hard to muster in the midst of the crisis. Trichet’s “bluff”(?) worked in finally stirring bold action. Bernanke had to step in and bail out the likes of AIG with Fed money. But once the emergency is over, any fiscal burdens must be transferred from the Fed’s books to of the US Treasury.

The second is that there was, in fact, an alternative to the MBS/Treasury purchases... which was to buy none! Instead, like the ECB, Fed operations could have focused solely on securing ample liquidity to the financial system, in line with its mandate of safeguarding financial stability. Indeed, as I argued here, the effectiveness of the so-called “portfolio balance” channel over and above the positive impact of the MBS purchases on bank liquidity is dubious. Let alone the hoped-for impact on inflation… has anybody seen the recent US inflation numbers?! (OK, OK, we can’t know the counterfactual!)

The third lesson is that monetary policy cannot be oblivious to fundamental imbalances in the economy, whether these take the form of fiscal imbalances, current account imbalances or large indebtedness in the household, corporate or financial sectors. This applies even to those central bankers fixated with (product price) stability. The reason is that the resolution of such imbalances is often “non-linear”—as in, abrupt and brutal and one that will tend to undermine the very price stability that the central bank claims to defend.

The eurozone came close to its "non-linear" experience by seeing the viability of the euro falling apart. The US (along with the rest of the world) felt it first hand, in the fourth quarter of 2008 and its ugly aftermath.

Both these instances suggest that Trichet may actually be wrong: The “M” and the “E” cannot be that separate after all.