The agreement that eurozone leaders reached last week has succeeded in engaging the private sector in the Greek rescue. The package represents a sensible compromise: eurozone countries will provide some sort of guarantee for the collateral provided by Greek banks, which has been downgraded to default status. In turn, this will allow the European Central Bank (ECB) to continue to refinance the Greek banking system, in keeping with its de facto role as lender of last resort which has led it to fill an institutional and political vacuum since the onset of the crisis.
But the wrangling between eurozone member states and the ECB that preceded the summit reflects a fundamental misunderstanding on the part of these countries about their central bank. It is, in fact, impossible to reconcile the imperatives of fighting inflation, the objective mandated to the ECB, with a lender of last resort role in a setting where fiscal management is heavily decentralized.
The current, narrow mandate enabled the ECB to build solid anti-inflationary credibility over the course of the first decade after the introduction of the euro. Then came the global financial crisis and the ECB proactively provided unlimited liquidity to the European financial system, some say even more aggressively than the Federal Reserve did in the US. But it is with the unfolding of the European crisis that the ECB has stepped definitively into the fray by filling an extraordinary institutional vacuum in the euro architecture, one only widened by the lack of political leadership.
However, the recent hawkish turn taken by the ECB with its latest interest rate increase is not credible in a context in which substantial intervention may still be required to underpin the financial stability of the peripheral economies in distress, not to mention Italy or Spain, should their bond markets start to melt down.
If, on the other hand, there were a centralized fiscal authority, it would reduce the pressure on the ECB. A centralised fiscal authority does not necessarily imply a euro-area-wide finance ministry or anything like that. Were, for instance, the European Financial Stability Facility(EFSF) simply given the mandate to credibly fund itself on an adequate scale, to deploy its resources in a flexible way, and with a proper pan-euro—as opposed to an inter-governmental—governance framework, a lot could be accomplished.
At the Brussels summit last week, eurozone leaders did finally decide to increase flexibility in the deployment of EFSF resources, enabling its funding to prop up primary and secondary markets. However, they have not yet decided on a sound provisioning and expansion of the resource envelope or on the strengthening of the EFSF’s own governance arrangements.
The EFSF will still have to rely on and wait for bond issuances to fund its operations, which is plainly inconsistent with its emergency rescue role. Its current governance arrangements foresee it under a tight inter-governmental grip, rather than as a pan-eurozone decision-making mechanism.
The next step should be for the facility to be endowed with a proper resource base, coupled with a provisioning-system that would swiftly expand resources in accordance with the challenges at hand. For instance, the International Monetary Fund derives its resource base from the quotas paid by its members, but it may, if necessary, swiftly activate a contingent credit line – the New Arrangements to Borrow – which it did last April.
Lastly, the governance framework of the EFSF will need to evolve towards a pan-euro system, whereby its board of directors will take decisions based on an assessment of spillover effects on the stability of the euro area as a whole, and not merely based on a straight reflection of national political temperatures. The quality and quantity of the conditionality applying to its interventions should be de-politicized and be determined on technical grounds only.
This would go a long way—to start. It would not resolve the need to coordinate macroeconomic and fiscal policies in the European monetary union but would relieve the ECB of its unwanted “fiscal” responsibilities.