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Internal divisions blunt ECB's crisis response

In this May 18, 2011 file photo, ECB chief economist Juergen Stark speaks during a conference in Lagonisi, south of Athens.

Thanassis Stavrakis/AP

As it battles the euro zone debt crisis, the European Central Bank faces the most severe internal divisions over policy in its 13-year history – divisions that risk leaving the region vulnerable to any fresh market attacks.

The split on the ECB's 23-member Governing Council centres on its decision early this month to revive a controversial program of buying government bonds of weak states, in order to try to stabilize panicky financial markets.

Substantial differences over monetary policy among representatives from 17 euro zone nations are inevitable and were foreseen by the founders of the central bank.

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But because the current dispute involves much more than fine-tuning policy, and goes to the heart of how the central bank defines its mission, it has the potential to undermine the ECB's ability to contain the crisis, some analysts say.

"This probably is the biggest internal rift – or the most important internal rift – in ECB history, insofar as outsiders can say," said Berenberg bank economist Holger Schmieding.

"Any public suggestion that there is a split blunts, or has the potential to blunt, the ECB's message and the effectiveness of its bond-buying program."

Governing Council members from the euro zone's highly indebted states were believed to be strong supporters of the ECB's decision to resume bond-buying this month after a 19-week pause. The ECB's decision-making process stresses consensus but is based ultimately on the principle of one person, one vote.

The decision has succeeded in bringing 10-year Italian and Spanish government bond yields down to around 5.0 per cent, from danger levels above 6.0 per cent before the central bank stepped in.

But German central bank chief Jens Weidmann and Juergen Stark, another German ECB policy maker, led a four-man group in the Council who opposed the revival, central bank sources said. The hawks think the bond-buying risks fuelling inflation, encouraging irresponsible spending by governments and compromising conservative monetary principles.

Their influence shone through in the manner in which the ECB announced it was stepping up bond purchases. The central bank buried the news as the last of six points made in a statement on Aug. 7, and included the qualification that its decision aimed "to ensure price stability in the euro area."

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This has left investors with the firm impression that the ECB has little appetite for buying bonds and will do so only grudgingly until the euro zone bailout fund is empowered to take over, which seems unlikely before October at the earliest.

Since the ECB's decision, the hawks' views do not appear to have changed. Earlier this week the German central bank, the Bundesbank, publicly criticized official purchases of bonds from the secondary market as reducing incentives for "appropriate fiscal policy."

The split on the Council casts doubt on whether the ECB would have the stomach to boost its bond purchases in the event of a renewed market attack on Italy and Spain, or other states.

"It means that there is uncertainty as to the extent of their commitment," said portfolio manager Andrew Bosomworth at Pimco, the world's largest bond fund, when asked if the ECB could keep Italian and Spanish yields around 5.0 per cent.

"They are buying what is needed to keep it at that level but it's what happens when there is another capital outflow rush or when the primary supply restarts – will they still be committed to stabilize it at that 5-per-cent level?"

The ECB reduced its bond purchases last week to €14.3-billion from €22-billion a week earlier, showing a similar pattern to May, 2010, when it began the program with €16.5-billion worth of purchases before rapidly reducing their scale. Ultimately, the program did not prevent a sharp rise in Irish and Portuguese yields that pushed those countries into seeking international bailouts.

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The central bank tries to neutralize the monetary effect of the purchases and the inflationary pressure created by taking deposits from commercial banks.

But Nobel Prize-winning economist Myron Scholes said the ECB could not keep up its bond-buying for long before it had effectively to print money without sterilizing the purchases. "The ECB has about eight weeks left before they have to print money," Mr. Scholes told Reuters.

The split within the ECB is dangerous partly because it risks inflaming popular opinion in rich countries where skepticism about aiding the euro zone's weak states is rising.

Germany's largely ceremonial president, Christian Wulff, questioned the legality of the ECB's bond-buying program in a speech to economists on Wednesday. Mainstream media in Germany, which has a folk memory of hyperinflation in the 1920s, gave prominent coverage to the speech.

"If you get a mainstream backlash in these countries – the Netherlands, Germany in particular – then people will lose faith in the purchasing power of the euro," said Mr. Bosomworth.

"And when faith is lost, people vote with their savings. That is when you get capital flight out of the euro zone or into real assets. That's a bigger danger than disagreement in the Governing Council."

The rift promises to saddle incoming ECB president Mario Draghi, who will take over at the start of November after Jean-Claude Trichet's eight years in the post, with a tricky diplomatic challenge just as he is trying to assert his authority over the central bank.

It could also complicate the central bank's effort to send clear signals to the markets on interest rate policy, if the internal struggle over bond-buying influences the ECB's rhetoric on broader monetary policy.

At his monthly news conference in early August, Mr. Trichet struck a hawkish tone that surprised some analysts given the slowdown in the European and global economies. His remarks diverged unusually sharply from expectations in the markets, which no longer anticipate another rate hike this year and are even speculating about a cut early next year.

Meanwhile, the ECB has struggled to maintain a consistent public line on the consequences of a Greek debt default. Last month Austria's central bank chief Ewald Nowotny took a different stance than Mr. Trichet before, in an about-turn, insisting he shared the ECB view. This was reminiscent of an episode in June when the ECB issued a new version of comments on Greece by its vice-president Vitor Constancio.

Ultimately, a deeper economic slowdown in the euro zone may be required to restore unity within the ECB, by focusing all Governing Council members on avoiding a repeat of the 2008 recession.

Poor economic data in the past week from Germany, where business sentiment has posted its steepest monthly drop since the aftermath of the Lehman Brothers collapse in late 2008, may contribute to this process.

"The economy is now suffering from a confidence shock as a result of the European and U.S. debt crises … it's the escalating market turmoil, which is related to some extent to the European debt crisis," said Berenberg's Mr. Schmieding.

"Bundesbank opposition [to ECB bond-buying]may ease in the face of clear evidence that the financial crisis has at least to some extent affected the real economy."

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