Why the European Central Bank is Right to Be Stubborn

An ECB bailout of Italy and Spain would create a political monster that Europe is unequipped to face.
Politicians and commentators alike have been pleading for months with the European Central Bank (ECB) to ride to Europe’s rescue and buy up the bonds of troubled governments in southern Europe. The hope is that the ECB’s unlimited ability to print money to purchase bonds would push down the interest rates of countries like Spain and Italy, thereby reassuring investors that these countries will not be forced to default. Without the imminent threat of a market panic, governments in the eurozone will be able to calmly address the source of their problems, or so the argument goes. The only problem is that the ECB refuses to play along.There are several reasons why the ECB is being so stubborn. First, the ECB views large-scale bond buying, and the large-scale printing of money that this would entail, as inconsistent with its mandate to preserve price stability. Unlike the Federal Reserve Bank of the United States, which has a dual mandate to both keep prices stable and unemployment low, the ECB was created with the sole mission of maintaining price stability. This was no mere technicality, nor was it an accident. The German Central Bank, the Bundesbank, has a long history of price stability that was not shared by its counterparts in southern Europe. The ECB’s single mandate was the price Germans demanded for parting with their beloved deutschmark and adopting the euro. The second reason for the ECB’s reluctance is that preferential direct purchases of government debt are expressly forbidden by the Lisbon Treaty, the document that provides the constitutional basis for the European Union.Proponents of an ECB bailout downplay these issues, arguing that in a recessionary environment inflation is not a concern and that the ECB could sidestep the Lisbon Treaty’s prohibition on direct purchases by buying Italian and Spanish debt in the secondary market. They claim that it is the ECB’s duty to act as a “lender-of-last resort” for Italy and Spain, pointing to the Fed’s massive lending to financial firms during the financial crisis. However, there is a fundamental difference between the Fed’s interventions and the proposed ECB actions: the Fed lent to companies, not governments. For the Fed to do something comparable, it would have to agree to backstop Californian debt, something that would be completely unprecedented. What the ECB is being asked to do is unlike anything the Fed—or any other central bank in the developed world—has done. As ECB officials point out , it is being asked to cross into the realm of fiscal policy and effectively forfeit its independence.Central bank independence is not just an academic concept; it has underpinned the stability of prices in the advanced economies for decades. The reason independence has been so fiercely guarded by central banks is that once a government is able to rely on the printing press to finance its debts, spending tends to get out of control. Without the markets, there is no longer a check on deficits. This creates a multitude of problems.To illustrate, let’s say the ECB does agree to buy Italian and Spanish debt. How much do they buy? What interest rates do they charge? Suddenly, an unelected institution in a position to decide which member states default and which do not. After all, the ECB never came to Greece’s rescue, nor Portugal’s, nor Ireland’s—their access to funds was subject to the whim of the International Monetary Fund (IMF). An ECB bailout will create a situation where some countries can get unlimited financing, and others need to appeal to the IMF for funds. This would institutionalize a two-tier eurozone and create a political monster.Voters in Greece, Portugal, and Ireland would understandably be furious. The move would also create enormous incentive problems. Optimists argue that Italy just needs the breathing room to implement reform, but this logic contradicts itself. If Italy knows what reforms it needs to implement, why didn’t it enact them sooner? If the answer is that politicians needed market pressure to push through painful reforms, what reason would there be to expect that they would implement these reforms once the pressure is lifted? Even with the constant threat of default, Greece has struggled to implement even modest cuts, managing to reduce its 2011 budget by a mere €2 billion . With a blank check, what hope would there be for austerity and reform in Italy and Spain? Worse, once the ECB bends, it loses all credibility to make an about-face, making the move irreversible. Europe simply does not have the institutional framework to deal with the incentive problems like the ones that an ECB bailout would create.The EU summit in December produced a treaty intended to address this issue, but it is a far cry from what is needed. Without a plan to address the inevitable consequences of a bailout, the ECB is right to refuse to take the plunge. Do not blame the ECB for “refusing to save” Italy and Spain. It is the only institution thinking about the inevitable consequences of its actions. European politicians, who got themselves into this mess in the first place by failing to do exactly that, should take notes, not criticize.

Photo courtesy of eisenrah via Flickr.