13 December 2011

FT: Debate over role of ECB hits wrong note

Erik Nielsen, chief economist at UniCredit, writes that the discussion of the European crisis and the appropriate policy responses have gone off track. He argues that governments need to address the long-term issue of sustainability of the eurozone, and says work is in progress to that effect.

As the pressure on the ECB has built up in recent months, its president Mario Draghi felt obliged last week to state that the ECB will act only within its legal mandate and that it will obey the spirit of the treaty.

For a central bank to secure price stability, it needs a well-functioning transmission mechanism, and – since the transmission mechanism tends to break down during financial crises – the ECB, like other central banks, is granted a wide degree of freedom to introduce extraordinary measures to restore this vital mechanism when necessary.

In line with this basic idea, on May 10 last year the ECB announced the Securities Markets Programme (SMP) with which it would intervene in public and private debt markets “to ensure depth and liquidity in those market segments which are dysfunctional. This was a clear case of the ECB doing its job, namely to implement a policy aimed at restoring the poorly-functioning transmission mechanism.

Clearly, the ECB’s job would be facilitated by good fiscal and structural policies, but the treaty does not give it a free pass with respect to its mandate in situations where other policymakers fail to meet their commitments in full.

The good news is that finally last week the ECB took more decisive steps. Unfortunately, it did not take the direct road of stepping up the SMP (still apparently blocked by a confused legal argument). Instead it took “the long way around” by making unlimited longer-term liquidity available to the banks against collateral now defined more broadly. This is a good second-best way of doing it; the effect should be the same as if it had taken the direct road – but it’ll take a bit longer and include a few more risks. With a little luck we’ll get there – eventually.

Full article (FT subscription required)

© Financial Times