Connecting the dots in Euroland

Today’s Financial Times article: ECB: trick or Trichet (Dec 2)

After the Irish bailout, markets were starting to turn their attention to Portugal and Spain when ECB president Jean-Claude Trichet launched a program of outright purchase of sovereign bonds from these states. From one point of view, this is inappropriate use of monetary means for a fundamentally fiscal operation. If Portugal or Spain cannot make good on their debts, then the only question is who bears the loss: the holders of the debt, the taxpayers of Portugal and Spain, or the taxpayers of the European Union more broadly. Central bank purchase has the effect of shifting the loss to the EU taxpayer, but in a backdoor way that disguises what is being done.

From another point of view, however, this is wholly appropriate use of monetary means to stabilize markets. In the face of uncertainty, the effect was to provide an escape hatch for nervous investors wanting out, so preventing a destabilizing run for the exits, hence nipping in the bud a speculative attack in anticipation of that run. No losses were socialized; rather temporary liquidity was provided as a way of preventing a destabilizing deviation of bond prices from their fundamental value.

Which is the correct point of view? Time will eventually tell, as the bonds will either be paid or not. Meanwhile, however, the narrow economist’s debate misses the more important political economic dimension of the problem, which we can best enter by placing ourselves in Trichet’s shoes.

Let it be stipulated that Trichet is a central banker, and central bankers abhor credit risk. From this point of view, the ECB can be understood as in effect betting that fiscal solutions will be found to the fiscal problems of Europe’s periphery; in that event, its bond purchases entail no credit risk. Buying sovereign debt, the ECB was in effect expressing confidence that policymakers will choose among all possible futures that path along which Europe’s periphery is solvent.

But it was not just passively placing a bet and hoping for the best. It also chose the same moment to recapitalize its balance sheet with contributions from its member national central banks, more that 5 billion Euros worth, which more than doubled its capital. By this mechanism, the first loss piece of any default on its bond purchases will be spread among the member states of the EU in proportion to their stake in the central bank. Now all member state central banks have a self-interest in making the ECB’s bet work out.

That is the background against which to understand all the talk about expanding the European Financial Stability Facility, or introducing a joint Eurobond. Both of these proposals are the first steps toward a common treasury. The ECB is leading the way by its own loss-sharing mechanism, even as it offers up its own balance sheet to buy time.

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