Thu, Aug 02, 2012 - Page 9 News List

Debate continues on the appropriate limits for ECB policy

By Martin Feldstein

Recent statements by European Central Bank (ECB) President Mario Draghi and Governor Ewald Nowotny have reopened the debate about the desirable limits to ECB policy. The issue is not just the ECB’s 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.”

Draghi’s 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 euros (US$246 billion) had no lasting effect on these countries’ risk premia, the presumption is that the effort this time could be much larger. However, 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 country’s share in the basket determined by its share in the ECB’s 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 ECB’s bond purchases would become as similar to the open-market operations of the US Federal Reserve and the Bank of England as is possible in the absence of a sin gle 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. However, an ECB program to limit interest-rate differentials would eliminate this important signal.

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