Dear Mario,
Congratulations and commiserations: next week, you will take up one of the most important central banking jobs in the world; but you will also bear a frightful responsibility. The European Central Bank alone has the power to quell the euro zone crisis. You must choose between two paths: the orthodox one leads towards failure; the unorthodox one should lead towards success.
The euro zone confronts a set of complex longer-term challenges. But the members will not get the chance to make needed adjustments and implement required reforms if it does not survive. The immediate requirements include putting Greece on a sustainable path; avoiding a meltdown in public debt markets of several large countries; and preventing a collapse of banks. Of these, it is the last two that matter.
The economist who has best explained the role of the ECB is Paul De Grauwe of Leuven university. Why, he has asked, do rates of interest on the debt of several big euro zone member countries exceed the UK’s, even though the latter’s fiscal position is far from superior: Spain’s deficits and net public debt are lower than the UK’s; Italy’s debt ratio is higher but its deficit far smaller; and the French deficit is smaller, though its debt is slightly larger.
It is surely surprising that markets view UK debt less sceptically than those of the others. It is not because Anglophones have devised a cunning plot to destroy the euro; they are not that clever. To put Prof. De Grauwe’s alternative explanation starkly, it is the central bank, stupid.
What, after all, determines the price of sovereign debt? Governments offer no collateral, while claims on tax revenue offer illusory security.
Consider the example of Italy: the net public debt is 120 per cent of gross domestic product; average maturity is seven years; and the fiscal deficit is 4 per cent of GDP. So its government needs to raise a fifth of GDP each year. Every creditor knows this. Suppose creditors feared that the government might be unable to borrow such vast sums. Could Italy survive by slashing spending? No. If the country tried to redeem its debt out of revenue, it would need to slash spending by far more than a fifth of GDP, overnight, since the very attempt would tip the country into a depression. No sane creditor imagines that a country could roll over its debt in this situation.
Government debt markets are lifted by their own bootstraps: the willingness to lend depends on the perceived willingness of others to do so, now and in the future. Such markets are exposed to self-fulfilling runs and so need a credible buyer of last resort: the central bank. The UK has one. Your members do not. In effect, they borrow in foreign currency.
Of course, members can reduce the risks. They can have lower debts and deficits, though Spain actually began the crisis with less of both than Germany. They can borrow long: in the 19th century, much UK debt was irredeemable. They can promise fiscal austerity, though whether that helps depends on the expected outcome: a promise of endless austerity rarely breeds credibility.
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.
