The ECB: Using a Crisis to Maximize Leverage

Paraphrasing Donald Rumsfeld, the former Defense Secretary, you fight a financial crisis with the institutions you have, not the institutions you might want. No doubt Europe went into its current financial and sovereign debt crisis woefully under-institutionalized. In effect, Europe was flying on just one motor—the European Central Bank (ECB), the only institution able to respond powerfully and in real time.

But in exercising its responsibility, the ECB has made up for its lack of political power by seeking to push reluctant European leaders in certain directions, demonstrating a remarkable ability to leverage its authority in the political realm.

It is important to remember that the ECB is not a normal independent central bank in the mold of the Bank of England, the Bank of Japan, or even the Federal Reserve. Normative academic studies of what outcomes monetary policymaking should target and how to achieve them rarely apply to the ECB. It has no single government counterpart within Europe and thus enjoys far more political independence than any other large central bank.

This unique independence derives from Article 282 of the EU Treaty [pdf], which states that the bank “shall be independent in the exercise of its powers and in the management of its finances. Union institutions, bodies, offices and agencies, and the governments of the Member States shall respect that independence.” In other words, the ECB has no political masters. Even if it did, the treaty would bar them from criticizing its decisions. 1

Thus unaccountable to any democratically elected government,2 the ECB sees itself as answerable only to European publics directly, to whom it wants to be credible and trustworthy. As the bank president Jean Claude Trichet frequently states, “The ECB is credible, as we have delivered price stability for 332 million of our fellow citizens, a price stability better than even the German Bundesbank achieved.”

The Bank is no doubt chagrined by the recent decline in its public standing as reflected in public opinion polls.3 Despite this, the ECB knows that the first target of public anger over slow economic growth will always be the governments in Europe, although the bank did get some blame for price increases following the introduction of the euro more than a decade ago.4 Monetary policy scholars generally agree that focusing on core inflation is the more appropriate framework when taking forward-looking interest rate decisions. Public concern matters less when it comes to headline consumer inflation. But to placate its true constituency—the euro area public—and its concerns about price stability, the ECB adopted a low headline (HIPC) inflation target and has proven willing to risk economic growth prospects to achieve that goal.

Another unique feature of the ECB’s independence is the bank’s ability to engage in horse-trading with democratically elected governments behind closed doors, where it can quietly demand that government leaders implement far-reaching reforms.

This was clearly visible in May 2010, when the ECB agreed to begin buying peripheral government debt only after EU governments agreed to establish the European Financial Stability Facility (EFSF) bailout fund and accelerate their fiscal consolidation. It became even more explicit in early August 2011, just ahead of the ECB’s initiation of purchases of Italian government debt. The sitting and incoming presidents of the ECB wrote bluntly to Italian Prime Minister Silvio Berlusconi , stating that “the [ECB] Governing Council considers that pressing action by the Italian authorities is essential to restore the confidence of investors.” They then listed more than ten specific required reforms. Unlike the leaders of other central banks, unelected officials at the ECB can make such demands knowing that no European government leader can compromise its decisions or independence.

Put another way, the ECB will never be treated roughly by any European government. Nor does it fear that any national parliament can revoke its independence.

Ultimately, however, the success of the ECB’s demands for conditionality from Italy was less than fully successful. Berlusconi did push a new austerity budget through parliament in record time, but he was unwilling to launch the comprehensive economic overhaul called for by the ECB. On the other hand, a similar letter (not published) was sent to the Spanish government at the same time, soon after which the Spanish parliament voted to install a national constitutional debt restriction. With the accelerated adoption of a balanced budget in Italy, it is fair to say that the ECB got a lot of what it wanted from the Spanish and Italian governments.

Can such independence be a mixed blessing? Perhaps. In a sovereign and financial crisis, total central bank independence can also hinder a solution, because it might undermine market confidence in the solvency of a government that does not control its own central bank, lacks its own currency, and has no ultimate lender of last resort. The European Treaty’s Article 123 forbids the ECB to extend credit to member states, preventing it from issuing any blanket guarantees for their sovereign debt. The euro area thus lacks an important confidence boosting measure in the face of market turmoil.

Ironically, the ECB’s inability to a priori “go big” in supporting member states’ government debt is what gives it negotiating leverage. Since the bank is immune to government orders, it can only act by bending its Treaty-described mandate and engaging in emergency support purchases of government debt in response to requests from governments.

Take the bank’s purchases of Italian government bonds. The ECB has justified these purchases as “ensuring the appropriate monetary policy transmission mechanism.” But it can turn the tap on and off as it sees fit. Immediately after its first intervention in early August 2011, Italian 10-year rates fell from 6.2 percent to below 5 percent. Subsequently, as Berlusconi’s lack of full compliance with ECB reform demands became apparent, 10-year rates rose again to about 5.5 percent, where they have been roughly stable since mid-September 2011. The ECB thus clearly possesses the means to drive Italian spreads further down than where they are today, but will only do so when the Italian government does what is requested.

Trying to oust an incumbent prime minister is hardly a standard central banking target. But while 5.5 percent 10-year rates and spreads of more than 350 basis points compared to Germany are not catastrophic in the short run, they are too high for a country the size of Italy. Consequently, the ECB’s de facto decision on long-term Italian interest rates looks likely to increase the pressure by the business sector on the reform-resistant Berlusconi government to leave office.

But while the central bank acts forcefully, it does so only when it gets most of what it wants in return.

The ECB’s overarching goal is for the euro area’s politicians to establish credible European institutions working alongside the bank. It seeks, for example, bulletproof fiscal constraints on euro area members (something more credible than the Stability Growth Pact, which was widely ignored). It also wants a common euro area crisis fund to relieve the bank of the primary bailout responsibility. In addition, the ECB wants individual member states to accelerate structural reforms in their national economies.

This is an ambitious wish list. Under normal circumstances, it would be inconceivable for sovereign governments to agree to strict and binding fiscal rules, or use their taxpayers money to bail out other countries and antagonize domestic interests by pushing through structural reforms. But the turmoil in Europe has left the ECB as the only European institution able to act.

The slowness of Europe and of the ECB to act in the current crisis is frustrating to citizens and markets alike. But it is actually not in the bank’s interest to move decisively—for example, by standing behind all of Italy’s debt. A sweeping preemptive safety net would be seen as counterproductive, relieving pressure on governments to reform. The ECB’s game is thus not to end the crisis at all costs as soon as possible, but to act deliberatively to preserve its leverage. Market volatility becomes something not to be avoided but to be used as a club.

It is not that the ECB cannot step in. There is no asset it cannot buy, if the governing council agrees. 5 The strategy of allowing financial market mayhem to pressure European governments is less risky than it seems. Ultimately, the ECB has the means to calm markets down but its intention is to do so only to avoid absolute disaster.

This is bad news for those who want a swift end to Europe’s crisis. The ECB’s agenda wish list of institutional change and structural reforms will inevitably take a long time to implement, as these require democratic legitimacy and a sustained political consensus. On the other hand, the ECB’s “maximum leverage on politicians strategy” is probably the best possible news for those who wish to see a more institutionalized and economically integrated Europe emerge. A sustained crisis not ended “prematurely” and even one with occasional financial panic attacks, is the only environment in which Europe can be forged into a closer economic union.

Trichet should be seen as not playing to end the crisis right away, but to allow new European institutions to emerge.

What then can be expected from the next EU Summit on October 23rd?

Since European leaders cannot credibly commit to fulfilling the ECB’s wish list, Trichet will reject an arrangement to end the financial market uncertainty in Europe. The ECB will further refuse to participate directly in leveraging the EFSF into an expanded funding entity providing politicians access to the ECB’s unlimited balance sheet. Nominally, it will cite the need to protect its institutional independence, adhere to the European Treaty, and prevent moral hazard. In reality, it will be motivated by not wanting to give up its leverage.

Instead, EU leaders will probably try to turn the EFSF partly into some sort of insurance mechanism for new primary euro area sovereign debt.6 Such a step should help boost the nominal firepower of the EFSF and reduce the primary market funding costs for euro area governments. Access to such euro area bond insurance will be conditional on benefitting governments implementing reforms, a functional equivalent of an International Monetary Fund (IMF) Flexible Line of Credit, available to solvent countries with strong economic fundamentals.

A bond insurance program financed via the EFSF will strengthen the Stability and Growth Pact (SGP), enhancing incentives for all governments on the euro area council to keep the issuance of new debt in the periphery under control. This is just another way of strengthening the enforcement of the SGP’s deficit rules.

In return, the ECB will give up essentially nothing, but merely leave its bazooka—the Securities Market Program (SMP), through which it purchases bonds directly—on the table. Despite the ECB’s repeated statements that these are “temporary measures,” the SMP cannot be truly put away. Having once been added to the tool kit, the SMP will remain an option for the Governing Council in an emergency. The ECB has de facto committed to supporting the euro area secondary debt markets in another future acute crisis. The separation of labor between the EFSF (primary markets) and the ECB (secondary markets) has been established.

The ECB is not omnipotent and won’t obviously get everything it wants on October 23rd. A larger private creditor haircut on Greek government debts will likely be imposed against the central bank’s wishes. However, the Private Sector Involvement (PSI) battle over enforced losses for creditors was lost in July. Whether the next haircut is a little higher or not means that the ECB will demand and get higher financial guarantees in order to continue acceptance of Greek collateral, even if default rated.

The expected recapitalization of EU banks should of course reduce any contagion from a larger Greek haircut. EU leaders will likely devise further guarantees to show markets that after Greece, no other instances of PSI-burden sharing will be instituted.7 Both will be acceptable to the ECB, which will lastly ensure that it plays a direct role in any longer-term initiative to craft a new Treaty outlining Europe’s required fiscal and economic integration.

The ECB is Europe’s indispensable institution in this crisis, but it also has learned how to use a crisis. As Henry Kissinger once quipped [pdf]: “The illegal we do immediately; the unconstitutional takes a little longer.” This is true in Frankfurt, too.


1. Any change the EU Treaty of any substantial magnitude requires ratification in each member state, invariably including national referenda in some countries. As such a minimum five-year process, from initiation to final ratification, of any new EU Treaty should be expected. Moreover, it seems implausible that any restrictions in the independent role of the ECB could ever be part of a new EU Treaty, as such a move would quite likely be against the German constitutions and in any case be vehemently opposed in several EU member states.

2. The fact that the ECB president testifies regularly before the EU Parliament does not equal accountability, as the EU Parliament has no oversight or any influence over the ECB, except that it has to approve of member states’ selection the five-person ECB Executive Board.

3. In the latest Spring 2011 Eurobarometer 75, the share of EU citizens expressing trust in the ECB fell to an average of 40 percent, just 2 percent higher than the share that did not trust the ECB (the remaining 22 percent answered “don’t know”). In Germany, public trust in the ECB fell below 50 percent for the first time.

4. The one-off shift to the euro provided many retailers with the opportunity to top up prices in the transition, especially of small high-frequency consumer goods with “round convenience prices” easily visible to the public. A candy bar that was 1,000Lira (about €0.5) before 2001 suddenly “doubled in price” to cost €1.

5. Normal national independent central banks must take into consideration that they could lose their independence if they overstep in such purchases. It cannot for instance avoid restraining the actions of for instance the Federal Reserve, when it chooses how many and which assets to purchase in quantitative easing that the U.S. Congress is likely to be all Republican after 2012 (with the power to change the Federal Reserve mandate) and that Congressional GOP leaders have already called upon it to refrain from any such purchases. See letter from Boehner and McConnell to Ben Bernanke.

6. See for instance the Allianz proposal in this regard.

7. Note that the collective action clauses foreseen in the European Stability Management (ESM) Treaty works only post facto after official sector help has been tried, an IMF support program attempted, and a debt sustainability analysis found a country insolvent.

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