27 February 2012

Paul N Goldschmidt: A Federal Europe (EMU) and a fully-empowered ECB - “Two interdependent facets of European solidarity”

Numerous voices are clamouring in order to allow the ECB to lend directly to EMU Member States. Their requests are based on two main arguments:

• Argument 1: the implementation, specifically in the US and the UK, of official programmes of “non-standard measures” (quantative easing) by Central Banks which result in market purchases of their domestic sovereign debt;
• Argument 2: the fact that the ECB is providing liquidity to the banking sector on terms that allow the latter to arbitrage profitably EMU sovereign debt. This situation seems crazy to the extent that the same Member States are supposed to guarantee the solvency of their respective banks.   

Let us, however, examine more closely the validity of these arguments. With regard to the first point, two remarks are in order:

1) One should not compare the position of a country that has kept full sovereignty over its monetary policy (including the capacity to monetise debt and intervene in the external value of its currency) and that of countries that have pooled their sovereignty (EMU Members), denying themselves the possibility of exercising fully all their sovereign prerogatives. An immediate corollary is that ownership of EMU sovereign debt obligations exposes the ECB to a “solvency” risk that other Central Banks do not run when they own their own Government’s debt securities denominated in their own currency.

2) The ECB has, also, implemented “non-standard” measures of monetary policy: the secondary market purchases (SMP) of sovereign debt obligations on the one hand and unlimited refinancing offers, now with maturities of up to three years (LTRO). If the justification for the SMP was “to smooth the transmission mechanism of monetary policy” – which was financially necessary, technically admissible, though semantically hypocritical – it has become apparent that, with the deterioration of the situation in Greece and of other peripheral countries, this excuse is no longer credible. Indeed, investors, and specifically banks short of primary capital, were using this “facility” to reduce their exposures by transferring their risk to the ECB despite incurring significant losses.

The accuracy of this analysis is confirmed by the polemic surrounding the treatment of the Greek debt held by the ECB within the framework of that country’s debt restructuring. It is also supported by the significant reduction in the scope of the SMP program after the initial LTRO last December. This first operation (to be followed on February 29th by another) fully accomplished its primary aim of underpinning the colossal refinancing needs of the banking sector throughout 2012. But it will not have escaped the attention of observers that, in addition to reassuring markets, these two huge refinancing operations (forecast to exceed a combined total of €1 trillion) may entice banks – or at least some of them – to reconsider the possibility of reinvesting profitably in sovereign debt obligations of EMU Members: indeed, the Greek rescue package appears to have – at least temporarily - removed the spectre of an imminent implosion of EMU; furthermore, the prospect of a recession, even a mild one, does not encourage or even allow banks to redeploy their assets in the real economy because of the lack of demand.

Thus, similarly to the FED and the BoE, the ECB has – indirectly – achieved comparable results as evidenced by the sharp drop in secondary market interest rates on Spanish, Italian and Irish debt, though Portuguese rates remain worrying. It follows that the premises, on which this first argument is based, appear significantly weakened.

Concerning the second argument one should note:

• That there is a fundamental difference between the direct purchase (monetising) of EMU sovereign debt and the acceptance of the same securities as collateral for advances made to the banking sector. In the first instance, the ECB assumes directly the “credit risk” associated with the issuer, while in the second case, the primary obligors are the banks which are subject to the control of the ECB through the Regulatory/Supervisory framework, and in which the posted collateral (in particular sovereign debt securities) constitute a complementary guarantee.
• That outright purchases of sovereign debt raise a number of problems:
  • First a political problem: will the ECB be able to impose differentiated financial conditions (interest rates) and negotiate conditionality on a case by case basis or will it be requested to treat all of its “shareholders”  in the same way?
  • If the aim is to put the borrowers on an equal footing with the banking sector, then the ECB should request the posting of appropriate collateral which will mean penalising the weaker borrowers as the ECB applies “haircuts” according to its own internal risk assessment process (Mario Draghi dixit). This would substantially negate the purpose of the exercise.
  • Would the ECB enjoy “preferred creditor status”, as was discussed during the Greek debt restructuring process? If affirmative, the collateral requirements mentioned here above could be made more flexible but there would be negative consequences on the primary and secondary markets because other investors would be “subordinated”. In exchange, they will request higher interest rates which would cancel most if not all of the benefits anticipated from the lowering of debt service requirements.
  • Would the ECB be authorised to sell securities purchased directly from issuers or should this be prohibited? In the latter case, its ability to “facilitate the transmission of monetary policy” would be impaired to the extent that the situation would require withdrawing excess liquidity from the market.
• That assuming the sovereign credit risk on the ECB’s balance sheet is tantamount to granting an indirect “joint and several guarantee” over the sovereign debt portfolio by the shareholders, i.e. all the EMU Members; indeed, in case of overwhelming losses they are under the obligation to recapitalise the Bank. It is precisely this type of guarantee that has been denied by those countries who refuse any form of debt mutualisation, be it in the form of “eurobond” issuance or even within the financial stability mechanisms (EFSF and ESM) that have been - and still are being - so laboriously negotiated. If one wishes, nevertheless, to broaden the powers of the ECB to authorise purchases of sovereign debt, an additional “ratification” process is unavoidable and all indications point to a German rejection unless the current institutional framework of the EMU is significantly amended.

Most of the objections which interfere with a simple “extension” of the ECB’s mandate, in order to endow it with powers comparable to those enjoyed by its peers, would disappear if EMU Member States agreed to transform the existing “intergovernmental reinforced cooperation agreement” into a fully-fledged political and economic Federation. This implies new significant transfers of sovereignty (which are rejected by France) and the adoption of strengthened and enforceable budgetary discipline (well under way) that Germany demands as a prerequisite for its agreement to any form of debt mutualisation.

It is only within a “federal” framework that the EMU (which should ultimately merge into the EU itself), with the benefit of a common budget, specific “own resources” as well as a sufficient borrowing capacity to allow for internal financial transfers, that serious consideration can be given to extending the powers of the ECB. This would cover essentially giving it the powers to act as lender of last resort for EMU (not its individual Members) as well as mandating the management of the Eurozone’s foreign exchange policy, on an equal footing with other Central Banks.

Indeed, once an “EMU Federation” would have the capacity of borrowing under the “joint and several guarantee” of its Members (as is the case for the EU budget guaranteed by the 27 Member States), it would be fully appropriate for the ECB to assume the role of lender of last resort. In such a context, the ECB could consider, if necessary, the monetisation of the “federal debt”. This structure would be interpreted by markets as an iron cast guarantee of the “solvency” of all euro-denominated federal debt, even if its intrinsic “value” (purchasing power) would be subject – in a similar manner to the debt securities of other Sovereign States – to market fluctuations (interest rates), inflation and foreign exchange rates. These characteristics would significantly enhance the claims of the euro to become a fully-fledged “reserve currency” alongside the USD. Additional benefits would be a far greater flexibility in matters of budgetary options, allowing for more coherence between measures imposed by the need for austerity and those dictated by equally desirable growth policies, as well as taking better into account divergences prevailing within the EMU Members.

It is therefore appropriate to conclude that the extension of the mandate of the ECB is only conceivable within an effective “federal” framework and that both processes are intimately interdependent.

If it remains difficult to imagine a speedy implementation of such an ambitious programme, the declaration, in the near term, of the clear political will to succeed, together with a realistic calendar and a broad information campaign aimed at the European citizen, might prove sufficient to reassure markets providing the necessary timeframe for a smooth implementation of the process.

Focusing haphazardly on individual problems (stability mechanisms – budgetary discipline – growth policies etc.) which has been the hallmark of the current crisis management, further complicated by the fact that decisions are taken within different political settings according to the subject, does not augur well for the future of the EMU/EU, whose destinies are inseparable.

A future offering hope can, nevertheless, be proposed to the European citizen. To achieve this it is necessary to provide the EMU/EU with the correct structure and the appropriate tools in order to protect the shared values and the economic interests of the population. This implies necessarily a greater degree of solidarity among the 27 Member States and the creation of a Federal European Union which would constitute its emblematic symbol.

Paul N Goldschmidt, Director, European Commission (ret.); Member of the Advisory Board of the Thomas More Institute

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