Proposals for the ECB

Fernando Fernández. Professor. IE Business School

7 February 2018

The European Central Bank should stop taking national quasi-fiscal decisions.

Once again, the tendency of Spain’s politicians to turn against their own trumps doing what is good for the country. A large part of Spain’s population and its politicians prefer to listen to the Vice President of the Central Bank of Ireland rather than to Spain’s Minister of Finance. I’m not sure they understand the scope of what the Governor of the Central Bank of Ireland proposes in an opinion piece that appeared recently in the Spanish press.

Interest Rates and Secular Stagnation

Philip Lane proposed performing some financial magic to create safe, risk-free European assets to replace the EU states’ public debt in the portfolios of European Banks, without sovereign risk-pooling or mutualisation of liabilities. He promises to make omelettes without breaking any eggs, or to put it in more technical terms, to create a virtual asset by combining the different top-rated national bonds. The idea is similar to that invented by banks with so-called CDOs, which ended up derailing global financial systems. As we all learnt something from that, rating agencies are now far more cautious, and warn against the enormous risks involved in such an approach. S&P warned that such a combined asset could only be given a rating equivalent to a BBB. It is highly likely that the public debt of some countries that is not rated at that level will be reduced to a junk bond, because according to the terms of the contract it would only be backed by its own treasury, without being able to resort to a EU bailout, nor would it be able to dilute its currency through inflation or by introducing more money into the system. 


This extremely dangerous proposal confuses the symptoms with the disease and risks killing the patient. It almost happened on a previous occasion when they wanted to interpret the flows of the European Central Banks’ liquidity distribution system (TARGET). Now they want to do the same thing with banks’ balance sheets. It’s true that they are very exposed (and in a highly uneven way) to the levels of public debt of their respective treasuries. This domestic bias is obviously greater in those banks whose countries have suffered problems with external funding and access to capital markets. But the solution does not lie in penalizing them with additional capital requirements. No other advanced finance system in the world has anything similar, and it would turn banks into vigilantes responsible for meting out discipline with regard to public debt and the fiscal system, the obvious risk being that the sheriff gets slapped with an arrest warrant. Given that the people who propose this are serious and experienced economists, there can only be two explanations for this outlandish proposal. Either they don’t trust the peripheral countries to be capable of meeting the demands of competitiveness and discipline of the Monetary Union and are looking for technical excuses to make them abandon it, or they have renounced all manner of fiscal discipline within the Union’s governance system. Neither of these two possibilities augurs well for the future.

The need to mutualise sovereign and banking debt in the EMU is well known. Without it there would be financial fragmentation, asymmetric crises would be exacerbated and would become systemic due to contagion, the sovereign banking risk nexus would worsen, it would be more difficult to execute monetary policy, and it would prevent the consolidation of the euro as an international reserve currency. This supposedly safe asset has been created to prevent the mutualisation of European sovereign debt. That is why it cannot work. It would mean that all national debts over a certain level would have no market or would be extremely expensive, which would limit the capacity to set economic policy in the weaker countries. If the Spanish government considers the debt of the autonomous region of Catalonia as a debt owed by the Kingdom of Spain, how can the EMU act any differently? There can be no sustainable monetary union without the mutualisation of sovereign debt. We should seek solutions to levels of baseline debt, and guarantee credible ex ante fiscal discipline mechanisms designed to avoid the unlimited growth of contingent liabilities for the European taxpayer. There is no mutualisation without discipline, and no solidarity without austerity. But let’s not pretend that we can solve real problems with financial alchemy. The Monetary Union demands the transfer of greater amounts of financial and fiscal sovereignty to institutions that fulfil the dual criteria of efficacy and democratic legitimacy. This is the challenge facing the Treasury and the European Finance Ministry. That is why Eurobonds are necessary and why we will need a new constitutional treaty. There will be no European asset insured against risk without a central European authority to issue it. The ECB will not be a normal central bank until it can issue European bonds and take quasi fiscal decisions. Everything else is pure fiction and a dangerous illusion.



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