An Analysis by Stefan Kaiser, Spiegel Online
The next taboo has already been broken in Europe, with the European Central Bank now buying up Italian bonds. With its interventionist policies, the ECB is becoming increasingly similar to the US Federal Reserve. It's a path fraught with serious risks.
The original sin occurred 15 months ago -- in May 2010, when the European Central Bank (ECB) caved in for the first time. After a dispute with politicians that lasted weeks, the central bank agreed to purchase bonds from euro-zone member countries that had been brought to the abyss by the crisis. By doing so, the ECB also lost its independence -- at least that's how critics of the central bank's policy see it.
Those same critics feel confirmed in their doubts now that the central bank in response to the debt crisis and market developments is not only buying up Greek, Portuguese and Irish bonds, but also those of Spain and Italy. "Back then, the claim was made that the bond purchasing was a one-time exception," said Joachim Scheide, head of the Forecasting Center at the Kiel Institute for the World Economy (IFW), an influential German economics think tank. "Now they are doing it again."
Furthermore, by expanding it to include a bond-buying program for Spain and Italy, the ECB is taking efforts to combat the crisis to an entirely new level. Up until last week, the ECB had around €76 billion ($108 billion) in government bonds on its books. With relatively small economies like Greece, Portugal or Ireland, that could actually make a dent on the bond markets. But in the case of Italy, it would require much greater dimensions if the action is expected to have any lasting success.
The entire volume of outstanding Italian government bonds is greater than €1 trillion. "If the ECB continues to operate with the kind of small amounts seen until now it will, at best, be able to quiet the markets in the short term, but it won't be able to change the (upward) trend in interest rates," Scheide said.
Independent ECB Driven By Politics
Critics see several problems in the ECB policy. One is that the central bank is seriously jeopardizing its independence. According to the European treaties, the ECB and national central banks are obliged to ensure price stability. In order to make them independent of political whims, the treaties hold that "neither the bank itself nor the national central banks or any member of their decision-making organs may request or accept instructions from Community organs or bodies, member state governments or any other organ."
Since the start of the crisis, however, those rules have reflected theory rather than practice. Indeed, the central bankers and ECB President Jean-Claude Trichet are now driven by politics. The governments of the euro zone frequently apply pressure on the central bank to intervene on the markets. And again and again, the central bankers in Frankfurt cave in.
During the baking crisis in 2008 the action was limited to providing unlimited liquidity to banks, where mutual distrust had grown so great that they stopped lending to each other, creating a credit crunch. Since the beginning of the debt crisis in early 2010, however, the ECB has also been expected to purchase government bonds in order to keep the interest rates on those bonds low.
By bending to pressure, the ECB is allowing itself to become a political central bank, making it look more and more like its American counterpart, the Fed.
The Fed has always had a different mandate than the ECB. In addition to ensuring monetary stability, the Fed is also expected to keep the unemployment rate and long-term interest rates low, which is why it has undertaken bond-buying programs that are far bigger than those in Europe. The last, which took place in June, had a volume of $600 billion. Fed Chairman Ben Bernanke has already hinted another may be in the offing.
"The Fed is no longer independent," said Scheide. "Monetary police and financial policy in the United States have been blurred. And that is exactly what Europe doesn't want because it would undermine trust in the ECB."
Expectations Could Fuel Inflation
The second problem inherent to the bond-purchasing program is the risk it poses to the central bank's balance sheet. Three years ago, European and American bonds were considered to be highly secure, but today there are doubts as to whether governments would actually be capable of making good on their debts -- and that is particularly true of the highly-indebted nations on the periphery of the euro zone. Some experts are already concerned that after rescuing banks and countries, the central bank itself will have to be bailed out at some point.
Critics' third argument against the current policies goes right to the core of the ECB's actual mandate: monetary stability. They argue that this, too, is threatened by bond purchases. "When the ECB purchases bonds on the capital market, it increases the base money supply," explained Thorsten Polleit, an economist at Britain's Barclays Capital. "If that money supply eventually reaches the private sector, experience has shown that, sooner or later, it will be offloaded through rising prices."
So far, this effect has been manageable in Europe because the volume of bond purchases has been limited. In addition, the ECB has always tried to neutralize the effects of the liquidity it creates by draining money from money markets or other places to compensate for it. But this "neutralization" will get increasingly difficult as the size of the bonds gets greater.
There is another way in which bond purchases can stoke inflation. "If the impression is created that the ECB is pursuing a weak monetary policy, then it will increase consumers' expectations of inflation -- and ultimately also the inflation rate," said IFW expert Scheide.
As so often is the case with the economy, that is attributable to psychology. If consumers anticipate a rise in prices, they then have a tendency to spend more of their money in order to prevent a devaluation. It is also possible that the unions will demand greater wages in order to offset the expected decline in income. Finally, companies can spot consumers' increasing demand and the higher wage demands of employees and respond by raising the prices of their products.
Despite all these risks, one must also ask what the alternative might be. So far, the governments of the euro-zone countries haven't found an answer that is acceptable to the markets. As long as they are unable to do so, the ECB will have to keep on resembling the Fed. The only consolation for the European currency guardians, it seems, is that the situation is no different for the proud Bank of England or the Japanese central bank. For some time now, both have been forced to purchase state bonds on a massive scale.