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Be bold, Mario, put out that fire
By Martin Wolf
Dear Mario,

Congratulations and commiserations: next week, you will take up one of the most important central banking jobs in the world; but you will also bear a frightful responsibility. The European Central Bank alone has the power to quell the eurozone crisis. You must choose between two paths: the orthodox one leads towards failure; the unorthodox one should lead towards success.

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The eurozone confronts a set of complex longer-term challenges. But the members will not get the chance to make needed adjustments and implement required reforms if it does not survive. The immediate requirements include putting Greece on a sustainable path; avoiding a meltdown in public debt markets of several large countries; and preventing a collapse of banks. Of these, it is the last two that matter.

The economist who has best explained the role of the ECB is Paul De Grauwe of Leuven university.* Why, he has asked, do rates of interest on the debt of several big eurozone member countries exceed the UK’s, even though the latter’s fiscal position is far from superior: Spain’s deficits and net public debt are lower than the UK’s; Italy’s debt ratio is higher but its deficit far smaller; and the French deficit is smaller, though its debt is slightly larger (see charts).

It is surely surprising that markets view UK debt less sceptically than those of the others. It is not because Anglophones have devised a cunning plot to destroy the euro; they are not that clever. To put Prof De Grauwe’s alternative explanation starkly, it is the central bank, stupid.

What, after all, determines the price of sovereign debt? Governments offer no collateral, while claims on tax revenue offer illusory security.

Consider the example of Italy: the net public debt is 120 per cent of gross domestic product; average maturity is seven years; and the fiscal deficit is 4 per cent of GDP. So its government needs to raise a fifth of GDP each year. Every creditor knows this. Suppose creditors feared that the government might be unable to borrow such vast sums. Could Italy survive by slashing spending? No. If the country tried to redeem its debt out of revenue, it would need to slash spending by far more than a fifth of GDP, overnight, since the very attempt would tip the country into a depression. No sane creditor imagines that a country could roll over its debt in this situation.

Government debt markets are lifted by their own bootstraps: the willingness to lend depends on the perceived willingness of others to do so, now and in future. Such markets are exposed to self-fulfilling runs and so need a credible buyer of last resort: the central bank. The UK has one. Your members do not. In effect, they borrow in foreign currency.

Of course, members can reduce the risks. They can have lower debts and deficits, though Spain actually began the crisis with less of both than Germany. They can borrow long: in the 19th century, much UK debt was irredeemable. They can promise fiscal austerity, though whether that helps depends on the expected outcome: a promise of endless austerity rarely breeds credibility.

Any effort by the ECB to be the lender of last resort that members need will start a firestorm of protest. People will argue that the central bank may lose money, exacerbate moral hazard and stoke inflation.

To the first of these objections, the right response is: so what? The central bank’s aim is to stabilise economies, not make money. Indeed, it is far more likely to lose money through half-hearted interventions than through forceful interventions that succeed. On the second, a clear understanding of the rules governing fiscal and economic policy is needed. You also need to decide whether a country is credibly solvent. Surely, Italy and Spain are. On the third, no good reason exists to expect an out-of-control inflationary process as a result of central bank monetary operations. The expansion of base money does not lead automatically to an expansion in the overall money supply, as you know well. Indeed, during the current crisis, the monetary base has become disconnected from the money supply in all big economies. That is what a financial crisis means.

Suppose the ECB did succeed in stabilising government bond markets in this way. It would also automatically stabilise the banks, since it is fears of sovereign defaults that are driving worries over banking insolvency. The capital to protect the European banking system from big defaults by important sovereigns simply does not exist. It is particularly ridiculous to suppose that sovereigns can provide effective insurance against their own default. Yet since there is no good reason for a well-managed eurozone to suffer such defaults in the first place, the answer is to stop them – at source.

The qualification is deliberate. A well-managed eurozone is one in which growth is sustained and adjustment promoted. Again, the ECB has the central role to play.

The eurozone as a whole did not suffer huge asset bubbles and consequent financial crises: these were limited to a few peripheral members. No good reason existed for a big recession and subsequent weak growth. Yet the ECB has permitted nominal GDP and the money supply (supposedly, the “second pillar” of its policies) to stagnate. In the second quarter of 2011, nominal eurozone GDP was a mere 1.4 per cent higher than three years before. Broad money grew at a compound annual rate of just over 2 per cent in the three years to the end of August. Again, core inflation – the only relevant target when commodity prices are so erratic – has run at a compound rate of 1.4 per cent a year in the three years to September. To any sensible observer, all this screams that ECB policy has been far too tight. If the eurozone is to enjoy any hope of adjustment with growth this must change, and now.

The eurozone risks a tidal wave of fiscal and banking crises. The European financial stability facility cannot stop this. Only the ECB can. As the sole eurozone-wide institution, it has the responsibility. It also has the power. I am sorry, Mario. But you face a choice between pleasing the monetary hawks and saving the eurozone. Choose the latter. Explain why you are making the choice. And remember: fortune favours the bold.

Yours,

Martin

* Only a more active ECB can solve the euro crisis, Centre for European Policy Studies, August 2011, www.ceps.be/book/only-more-active-ecb-can-solve-euro-crisis

martin.wolf@ft.com