An Open Letter to Dr Jens Weidmann
This article first appeared at VoxEU
By Charles Wyplosz, Professor of International Economics at the Graduate Institute, Geneva; Director of the International Centre for Money and Banking Studies. CEPR Research Fellow
The EZ crisis is approaching a tipping point beyond which market panic and slow government reaction threaten to create a generation-defining loss of jobs, savings, and pensions. This open letter to the president of the German central bank presents arguments that counter German objections to using the Eurozone’s last remaining defence against economic calamity – the ECB.
A growing number of competent economists have come to the conclusion that the debt crisis will not come to an end until the ECB intervenes as lender of last resort. You have taken the opposite view. The question, for me, is why?
As I see it, your objection rests on three points:
- Legality of bailouts;
- moral hazard; and
- independence of the ECB.
These are important issues, but the answer cannot be simply: “No, never.”
You read Art.123 as preventing support to governments. That is also my reading, but the ECB already violated this all-important article in May 2010. That was a historical mistake, but with no legal consequences so far. By deciding to buy outright Greek public debt instruments, the ECB has not just violated the spirit of the Treaty, it also changed the Eurozone regime.
We agree, I am sure, that a monetary union requires fiscal discipline in every member country. The unfortunate solution that was chosen more than a decade ago was the Stability and Growth Pact. This pact could never work, not just because it was ill designed, but also because its implementation requires that national sovereignty in fiscal policy matters be lifted, in contradiction with the Treaty prescription that governments and their parliaments retain full authority.
The Treaty was flawed, but not fatally, because the no-bailout clauses (Art.123 and 125) implied that a country that did not respect fiscal discipline would eventually face the consequences alone. It was reasonable to believe that this would happen one day – that a delinquent but sovereign country would be left to default and that, henceforth, a lesson would have been learned and discipline would be adhered to.
By removing the only effective instrument available to enforce discipline, the Eurozone governments and the ECB effectively Europeanised national public debts. I know that your predecessor disagreed publicly, as I did, but the harm has been done and cannot be undone.
Now the ECB must move down that path, to its bitter end. Legalities will not change this fact. I understand how hard it is for you and the Bundesbank to swallow this reality, but the alternative is a breakup of the Eurozone. This is a solution that is potentially so destructive that you cannot choose it over your justified rancor. At least, I hope. A reassurance from you would be a very positive contribution.
Of course, the May 2010 decisions have created a massive moral hazard. We will have to deal with that disastrous consequence. Now, however, is not the time. We have a crisis on our hands which requires urgent treatment.
Punishing undisciplined countries is apparently popular in your country, but it will not work. Forcing austerity programs on countries in recession, or about to enter into recession, will not reduce the budget deficits, as the Greek example abundantly illustrates.
The proper response is to carefully design a new regime that will deliver fiscal discipline while respecting national sovereignty. There are various possible solutions, many of which rely on the ECB. For instance, before the crisis, the ECB had long complained that the spreads on government bonds were far too small. But the ECB holds a big responsibility there.
By accepting all bonds as collateral for its repo operations, the ECB effectively guaranteed their values. We need no Treaty change for the ECB to decide that it will only accept repo bonds from governments with established adequate national arrangements that enforce fiscal discipline.
At the last summit, European leaders agreed that all countries would adopt a version of the German constitutional debt brake arrangement and establish independent fiscal countries. Once the crisis is over, the ECB can simply take good note of that commitment and act accordingly in its repo operations.
That would go a long way towards redressing the moral hazard problem. It should also reassure the ECB that its remonstrations will be taken to heart in the future.
Several other ideas should be considered — like ESBies or blue-red bonds – but only after the crisis is over. They are not ways to solve the crisis. If you think that none of these arrangements will work, please tell us precisely why.
Finally, you are rightfully concerned that the ECB’s independence should be preserved. Making the Eurozone’s central banks independent is arguably one of the main European achievements of the last two decades. The importance of central bank independence is a lesson that the Bundesbank can be proud to have taught all of us.
With its independence guaranteed by the Treaty, the ECB is undoubtedly the most independent central bank in the world. This is de jure true, but is it so de facto?
The May 2010 decision to contribute to the Greek bailout is worrisome, but not fatal. Why has the ECB taken that step? While not an excuse, there is a good, fundamental reason.
- The border between fiscal and monetary policy cannot, unfortunately, be clear-cut.
This is a consequence of the policy dominance issue.
- It is a fact that there exists a unique public-sector budget constraint that combines public debts, fiscal balances and seigniorage.
- Monetary independence exists when seigniorage is exogenous and budget balances are endogenous under all circumstances.
The residual is the real value of the public debt.
In May 2010, implicitly at least, the ECB must have concluded that public debts cannot be defaulted upon. In the end, as we now know, defaults will happen. This was a misjudgment, but also a very general warning that situations are not always black or white.
German history has shown how disastrous monetary financing of public debts can be, but that lesson is more subtle than just saying “no”. Hyperinflation was the consequence of continuing monetary financing of the budget deficit, with no end in sight. Today we are talking about dealing with the existing stock of debts that cannot be refinanced on the market anymore. We need a one-off guarantee by the ECB that sets a floor on these bond prices, and of course defaults to eventually regain market access. A guarantee does not mean actual purchases; most likely very little will be needed, and that can be sterilised. The German precedent simply does not apply to the current situation. If you agree, please say so. If not, please explain.
More generally, we need to recognise that there are situations when a central bank cannot disentangle itself from the public-sector budget constraint and must be the lender of last resort.
Rather than denying that this possibility exists, we need to anticipate the situation.
- The first thing to do is to adopt institutions that enforce discipline.
- The second thing is to accept that disasters may happen, and plan accordingly.
Within a country, it is indeed understood that central banks may have to act as lender of last resort for their governments, as we now see in the US and the UK, for instance. You may infer from Germany’s interwar experience that this will ultimately be inflationary, but this is not what many believe will happen this time around. Are they obviously wrong? We need to investigate this issue with an open mind.
Within a monetary union, things are even more complicated, if only because distributional issues arise. With adequate disciplining institutions in place in each country, the situation may still arise because of large-scale bank failures. Proper micro and macro surveillance should make such an event unlikely.
In the Eurozone, the solution is to keep improving the system that has been put in place, by making the European Banking Authority independent and building a strong European Systemic Risk Board. But we must also admit that mistakes can be made, much as natural disasters can occur.
We need a sort of Bagehot Rule for emergency central bank support to governments. This time around, we have tried to invent rules as events have arisen. Hopefully, we will draw the lessons of this crisis. This seems a better way to proceed than to deny that such things can happen and to then be unprepared when they do.
These are all complex issues that require considerable thought. The answers will not be black or white. Your task is to balance daunting trade-offs. One possibility is that the ECB refuses to intervene as lender of last resort and the Eurozone breaks up. The other is that the ECB acts as lender of last resort and some of your fears are realised.
You may have a better plan, but we have not heard it yet.