25 October 2011

Martin Wolf: Be bold, Mario, put out that fire

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.

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