The Legal Constraints that bind the ECB

23 Dec 2011

Pat McArdle

Some weeks after the first part of this article was published, the situation remains largely unchanged, at least in so far as major ECB intervention in the government bond markets is concerned. 

Prior to the December European Council, the ECB unveiled a more ambitious than expected range of monetary policy measures. These included a second, successive, quarter-point reduction in the key REPO interest rate but what caught the eye was the range of other measures that accompanied it.

These included major changes to the rules under which banks can borrow emergency funds (liquidity) from the ECB – via yet another easing of the types of collateral the ECB will accept in exchange for funds drawn – as well as a major extension, from one to three years, of the term of the facilities.

This is particularly welcome in Ireland. The quest for certainty of (medium-term) funding has long been a feature here given that Irish banks, with only minor exceptions, have been unable to tap the markets for several years and have had to rely on the ECB instead. However, like the demand for lower interest rates on the Programme loans, it went unheeded until the problem spread to the bigger member states. 

In any event, the ECB action has averted a major liquidity crisis as banks now have an additional €200 billion of funding and attention has shifted to the uses to which these funds may be put. Obviously, the EU authorities would like to see them used to extend loans to hard-pressed SMEs which rely on bank credit to a greater extent in Europe than elsewhere.

Another, more Machiavellian, possibility hinted at by President Sarkozy, is that they might purchase government bonds (thereby alleviating pressure on sovereigns). This seems unlikely given the bad experience a few years ago when ECB funds were used to buy bonds. Were this to happen, the ECB would indeed have come to the rescue of sovereigns, albeit in a way that is perfectly legitimate and legal. 

The final possibility is that the funds might end up back on deposit with the ECB, i.e. a continuation of the recent trend. This would be a manifestation of a broken, dysfunctional market, given that the rate of interest charged for loans is greater than that paid on deposits.

The European Council, for its part, laboured mightily to produce a troublesome mouse, marginalising the UK in the process. Its definition of a fiscal union is a very particular one which avoids any of the solidarity and fiscal transfers that one expects in a normal (political) union.

Instead, it placed total emphasis on implementing the existing treaties, including the expanded Stability and Growth Pact, which was recently signed into law as the “Six Pack”. To this end, it agreed on a new inter-governmental treaty which would give greater certainty by incorporating these provisions into national constitutional law or its equivalent. Though the new treaty will be rushed through, its relevance to the current crisis is tangential.

Measures aimed directly at the crisis were more limited. The previous Summit’s attempt to leverage the emergency bailout fund, the EFSF, failed because non-EU countries refused to provide finance when the EU itself was reluctant to do so. Accordingly, the December Council agreed to contribute an additional €200 billion to the IMF in the hope that this would prompt a response by non-EU countries. In the event, they had to scale this back to €170 billion as the UK will only stump up its €30 billion share in a Group of Twenty (G20) context, rather than an EU one.

So far, the impact on markets has been modest with only limited falls in bond yields in Spain and Ireland – see chart. Yields in Italy, Ireland, Portugal, and, above all, Greece remain at unsustainable levels – here I define sustainability as 5% or lower. Incidentally, Germany has been a major beneficiary of the crisis (with 10-year funding costs falling from over 3% to around 2%) as has the UK though France has seen its relative position eroded and its funding costs are now a full percentage point above Germany. 

 

As we head into the new year, the crisis is unresolved and attempts to boost the size of the EFSF have yet to bear fruit. This leaves governments vulnerable to renewed funding problems given the large volume of debt that must be refinanced next year. 

The ultimate solution, central issuance of euro bonds with joint and several liabilities, has been ruled out pending much greater European integration and the ceding of fiscal autonomy by national parliaments.

The only other option is the “big bazooka” approach, i.e. to convince the markets that the official firepower to purchase bonds is greater than their ability to sell them. A few months ago, a €2 trillion EFSF might have sufficed; now even that is doubtful and, in any event, looks unlikely to be secured.

This leaves the ECB as the only institution with potentially unlimited firepower, given that it can print money.

The ECB’s position is now better understood following the 8 December press conference where President Draghi elaborated on its thinking. Basically, he pointed to the need to respect the spirit as well as the letter of the Treaty where monetary financing of governments is concerned.

The counter argument to this is that the money transmission mechanism is broken given the unprecedented spread of bond yields and notwithstanding ECB bond purchases of €200 billion or so to smooth the markets. ECB signals regarding long-term interest rates are, thus, not being transmitted, in contrast to the situation in the US and the UK where yields are much lower. 

In the end, it boils down to a question of scale. Purchasing €200 billion of member states’ bonds may be lawful but would a Court rule that purchasing 10 times that amount was market smoothing or (unlawful) monetary financing of governments? In my view, there is a decent chance that it would take the latter view.

Still, many people believe that the ECB will come to the rescue in the end, primarily because the consequences of a euro break up are so awful and so much worse than any conceivable alternative.

The question thus arises: under what circumstances might the ECB act? Clearly, the answer has to be political. Given that it would quite likely be breaking the law, it could only contemplate such a course of action in response to a unanimous request from all 27 governments. For good measure, it might take a leaf out of the IMF’s book and get the German opposition to sign up as well. Personally, I would insist that some of the signatures be in blood.

This content forms part of the E View project, which is part-funded by DG Communication of the European Parliament. 

 

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