Understandably the element of my talk at the Royal Irish Academy
which generated most discussion was the role of the ECB. (Here
is a media report, but ignore the last two paragraphs which are
confused/wrong. Abstract for the talk is here.
Paper will follow.) The proposition I put forward was that the ECB’s
OMT
programme should have been put in place in 2010, and if it had been
countries outside Greece could have implemented a more efficient
austerity programme (one that produced less unemployment) and might
have retained market access (interest rates on government debt would
have remained reasonable). [1]
There are two serious and related arguments against this view. The
first is that it is unrealistic for the ECB to act as a sovereign
lender of last resort because of the transfers between countries that
this might lead to. (A sovereign lender of last resort is a central
bank that is always willing to buy its government’s debt.) [2] The
second is that in practice OMT is bound to be coupled with a
requirement for austerity programmes that might have simply
duplicated what was actually put into place by national governments.
Both arguments speak to a real problem that remains unresolved within
the Eurozone, but do not nullify the argument that things should have
been done much better.
Government debt in advanced economies is regarded as a safe asset for
two reasons. The first is that most governments that borrow in their
own currency rarely default. The second is that an individual
investor does not need to worry about market beliefs, because if the
market panics and refuses to buy the government’s debt the central
bank will step in (hence sovereign lender of last resort). If the
central bank did not do this, the government might be forced to
default because it cannot roll over its existing debt.
It makes sense for the central bank to act as a sovereign lender of
last resort, because it avoids self-fulfilling market panics. Doubly
so because such panics will be more likely to occur after a large
recession when the social value of government borrowing is
particularly high. The complication in the case of the ECB is the
following. If the market panic is so great that the ECB was forced to
actually buy a ‘distressed’ government’s debt (normally the
threat to do so is enough), it is possible that this government might
choose to default even with ECB support. If it did that, the ECB
would make losses which would be born by the Eurozone as a whole (the
transfer risk).
Partly for this reason, the ECB has to have the ability not to act as
a sovereign lender of last resort, or withdraw support if
circumstances change. If that ability exists (a point I will come
back to), then the transfer risk associated with the ECB acting as a
sovereign lender of last resort are tiny. It represents the kind of
minimal risk that should always be offset by the trust and solidarity
that comes with the territory of being in a monetary union. I suspect
those that suggest otherwise are often trying to hide other motives.
A government that is receiving ECB support of this kind will
naturally want to know what it has to do to maintain it, because the
threat of its withdrawal is so great. It would be unreasonable to
withhold that information. Does that in practice amount to nothing
more than the kind of conditions that have in practice been imposed
on Ireland and Portugal anyway? Absolutely not. Just as the market
does not worry about the build up of debt in a recession in countries
like the UK or Japan, a rational ECB would have no reason to impose
fiscal consolidation at the time it would do most damage. The time a
rational ECB might withdraw its support is once a recovery is
complete and the government refuses to embark on fiscal
consolidation.
So a sovereign lender of last resort in a monetary union must have
the ability not to provide that support. In other words it has to
sort Greece from Ireland. That decision is a huge one, because in
effect it is a decision about whether the country will be forced to
default. It is natural that the ECB wants to share that
responsibility with member governments, but as we have seen with
Greece member governments are hopeless at making that decision
(particularly when their own banks may be compromised by any
default). We have also seen that European central bankers are far
from rational on issues
involving government debt (compared with at least one of their
anglo-saxon counterparts),
so giving the decision to someone else other than the current ECB
would seem like a good idea. However at present there is no
institution that seems capable of doing this job.
In this post
I suggested contracting out this task to the IMF, although that
presumed a reduction in the political influence of European
governments on that institution. I have also wondered about whether a
body like the newly created network
of European fiscal councils could play this role. Another possibility
is to reform the ECB so that it is not subject to deficit phobia, and is more accountable. It
seems to me that this is where current research and analysis should
be going, rather than into schemes involving greater political union.
The existence of various alternatives here means that we should not
take what has actually happened in the Eurozone as some kind of
immutable political constraint beyond which economics cannot go.
There is no intrinsic reason why the OMT that was introduced in
September 2012 could not have been introduced in 2010. There is no
intrinsic reason why any conditionality that went with that could not
have been much more efficient in terms of unemployment costs. Beyond Greece, the Eurozone crisis happened because the ECB thought it could avoid undertaking one of the
essential functions of a central bank. This was perhaps the most important of the many errors it has made.
[1] For a country within a monetary union which needs to reduce debt
more rapidly than does the union as a whole, a gain in
competitiveness relative to the rest of the union is required
to offset the deflationary impact of fiscal consolidation. That
‘internal devaluation’ probably requires some increase in
unemployment, but it is much more efficient
to obtain that increase in competitiveness gradually.
[2] It could be argued that the Fed does not provide lender of last
resort services to individual member states. But state debt is
typically
lower relative to GDP and income than for Eurozone governments.
Before 2000, Eurozone governments were able to borrow more because
they were backed by their central bank. That means that they are
inevitably subject to a greater risk of suffering from a
self-fulfilling market panic. The architects of the Eurozone might
have initially believed that the SGP might avoid the need for a
sovereign lender of last resort, but after the Great Recession they
would have known otherwise.
