As the Eurozone debt crisis took a decidedly alarming turn in past weeks, the European Central Bank responded with resumption of their bond-purchasing program that had begun originally in May 2010. This measure had been intended to solve the debt crisis in Greece, though with the benefit of hindsight we can see that it failed to achieve that aim, not to mention preventing contagion to other Eurozone members. One question, then, is why it would work now. If the markets were not convinced by ECB purchases of Greek bonds, why would they be convinced by purchases of Spanish and Italian bonds, especially considering that far larger amounts will be required to make an impact in the latter cases? Given the short-lived reprieve for stock prices on Spanish and Italian banks, following the announcement of the bond-purchasing plan, it would appear that the markets are not convinced, and it is relatively easy to see why. Market skepticism about this latest attempt to combat the debt crisis is based in part on the fact that the ECB has, in past, grown weary of such measures and stopped short of making a decisive impact. There are a number of reasons to doubt their ability to follow through this time as well.
One reason is that the ECB is not the US Federal Reserve, but an independent institution with the central goal of maintaining price stability. Or at least that’s what the ECB is supposed to be. Some question the extent to which it can remain so as long as it purchases the bonds of indebted member states. It is not only onlookers, many of them based in Germany, who question this policy, but also national central bankers who sit on the governing council of the ECB. Although he has defended the decision to purchase Spanish and Italian bonds, ECB president Jean-Claude Trichet has stated publicly that it would be preferable if politicians could approve the legislation allowing the revamped European Financial Stability Facility (EFSF) to take on that role. In the meanwhile, the ECB appears to have bowed to political pressure in recommencing bond purchases last week. This is something that onlookers are equally concerned about, namely, that the ECB is no longer independent of political influence.
The requirements that the new central bank be independent and that all member states signing up to the common currency also have independent central banks were instrumental in reaching agreement on Economic and Monetary Union (EMU), so any movement away from that status is not taken lightly. Yet it would be difficult to argue that the ECB maintains political independence while pursuing a policy that its head is unsure of and the heads of Germany and France support openly. This situation may be allowed to continue for some time, but not indefinitely, as German opposition, already strong in the Bundesbank, economic circles and German media, hardens and widens. Thus, the markets are wise to question whether the ECB can stay the course, i.e. purchase enough Spanish and Italian bonds to maintain interest rates at a level that will permit those countries to finance their debt burdens.
This is not only because of questions over ECB independence, but also the primary goal of monetary stability. As long as the ECB is purchasing the bonds of Eurozone member states, it is injecting liquidity into the economy, which means prices may ultimately need to increase to absorb that excess liquidity. Wary of this, the bank has been sterilising its bond purchases, drawing an equivalent amount of liquidity out of the markets as is put in, by taking one-week deposits from banks at an interest rate of up to 1 percent, rather than the .25 percent offered on daily deposits. However, there is some question as to the effectiveness of such a measure, as well as whether this can continue alongside the massive increase in purchases that will be necessary to affect interest rates for Spanish and Italian bonds. It is safe to assume, given the historical commitment of the ECB to observing their price stability mandate, and not to mention those German onlookers, that this bond-purchasing program will cease if inflation takes hold.
Add to these factors the uncertainty caused by an upcoming change of leadership at the ECB and the political difficulties facing German Chancellor Angela Merkel in supporting more money for indebted Eurozone states and it would seem that skepticism about the ECB bond-purchasing program is in order for us all. With regard to the first point, Mario Draghi, who will soon takeover from Jean-Claude Trichet as ECB President, is known to have opposed past bond-purchasing programs as emergency help to Eurozone members, and there is no reason to expect his position has since changed. This may not matter, to the extent that political pressure to maintain the program is overwhelming, but neither that nor the former point augur well for its staying power in the long term. The second point is related, insofar as domestic opposition in Germany to any signs that ECB independence is being compromised should boost the capacity of the new central bank head to withstand political pressure. In addition to this, the German public, notably the powerful labour unions, will demand a policy response if inflation starts to eat away at their wages, putting the German government in a difficult position if it has encouraged the ECB to pursue looser monetary policy than it would have otherwise.
Taking into consideration all of these issues, it is unlikely that the ECB will stay the course with this latest round of bond purchases. Unfortunately for indebted Eurozone members, it seems equally questionable whether the much-vaunted EFSF will be able to take on that task, even after the necessary legislation is in place. The shortfalls of the EFSF are a topic for another time, but it is worth concluding with the point that, for all the complications raised by the ECB bond-purchasing program, the ECB is far more independent and far less cumbersome in its decision-making process than a fund administered by seventeen sovereign states.