ECB DO n DOnots Martin Feldstein article

Recent statements by European Central Bank
President Mario Draghi and Bank Governor
Ewald Nowotny have reopened the debate
about the desirable limits to ECB policy. The issue is
not just the ECB’s legal authority under the Maastricht
Treaty, but, more importantly, the appropriateness of
alternative measures.
Nowotny, the president of the National Bank of
Austria, suggested that the European Stability
Mechanism (ESM) might (if the German
Constitutional Court allows it to come into existence)
be given a banking licence, which would allow it to
borrow from the ECB and greatly expand its ability to
purchase euro-zone sovereign bonds. Draghi later
declared that the ECB can and will do whatever is
necessary to prevent high sovereign-risk premia from
“hampering the functioning of monetary policy.”
Draghi’s statement reprised the rationale used by
his predecessor, Jean-Claude Trichet, to justify ECB
purchases of euro-zone members’ sovereign debt.
Not surprisingly, financial markets interpreted his
declaration to mean that the ECB would buy Spanish
and Italian government bonds again under its
Securities Markets Programme, as it did earlier this
year. Although the previous purchase of more than
^200 billion ($246 billion) had no lasting effect on
these countries’ risk premia, the presumption is that
the effort this time could be much larger. But is that
what the ECB should be doing?
While any central bank must be able to conduct
open-market operations to manage liquidity in financial
markets, selective purchases of individual country
bonds that bear high interest rates because of current
and past fiscal profligacy is both unnecessary and
dangerous. A better rule for the ECB would be to conduct
open-market operations by buying and selling a
“neutral basket” of sovereign bonds, with each country’s
share in the basket determined by its share in the
ECB’s capital.
This “neutral basket” approach would permit the
ECB to purchase substantial volumes of Italian and
Spanish bonds, but only if it was also buying even
larger amounts of French and German bonds. The
ECB’s bond purchases would become as similar to the
open-market operations of the United States Federal
Reserve and the Bank of England as is possible in the
absence of a single euro zone sovereign government.
By contrast, focusing potential ECB purchases on
the sovereign debt of those countries with high interest
rates would have serious adverse effects. It would
reduce pressure on the governments of Italy, Spain,
and other high-interest countries to make the politically
difficult decisions that are needed to cut longterm
fiscal deficits. Spain needs to exercise greater
control over its regional governments’ budgets, while
Italy needs to shrink the size of its public sector. An
ECB policy that artificially reduces their sovereign
borrowing costs would make these steps even more
politically difficult.
Indeed, when the ECB controls interest rates on
long-term bonds, it is hard for political leaders, parliaments,
and voters to know whether they have
achieved significant fiscal improvement. The peripheral
euro-zone countries became over-indebted in
the last decade because the bond market failed to
provide a signal that debts were too high. That has
now ended, because bond investors no longer treat all
euro-zone sovereign debt as equal. But an ECB programme
to limit interest-rate differentials would eliminate
this important signal.
Moreover, because the ECB cannot simply buy
sovereign bonds without regard for individual governments’
fiscal policies, it risks finding itself in the
politically dangerous position of deciding whether a
country’s fiscal actions are tough enough to be
rewarded with lower interest rates. The ECB would
thus cross the threshold from monetary policy to fiscal
policy. Would it put a common ceiling on “wellperforming”
governments’ interest rates, as Italy’s
Prime Minister Mario Monti suggested not long ago?
Or would it set and revise sovereign interest rates
according to its current evaluation of each country’s
fiscal efforts?
Finally, Germany might not continue to accept
the default risks implied by large ECB purchases of
high-risk sovereign bonds. Germany already faces
large financial risks, owing to the ECB’s balance sheet
and the Target2 balances at the Bundesbank that are
generated by international flows of deposits to
German commercial banks.
While German political leaders now declare their
allegiance to the euro zone, opinion polls in Germany
show that public support for the euro is very weak. As
the risks accumulate, it is not inconceivable that
Germany might conclude that, despite the potential
impact on its exchange rate, it would be better off
returning to the Deutsche Mark.
For all of these reasons, the ECB’s direct purchase
of high-yield sovereign bonds to limit their interest
rates would be a mistake. It would also be a mistake
to do this indirectly by another trillion-euro longterm
refinancing operation aimed at encouraging
commercial banks to buy those bonds. And it would
be a mistake to allow the ESM to have a banking
licence so that it can borrow from the ECB, greatly
increasing its purchase of peripheral countries’ bonds.
Individual governments should take the tough
political steps needed to reduce the risk of a eurozone
breakup, which would have very substantial
financial costs for all — and not only its members.
Unfortunately, ECB officials’ recent statements may
have reduced the pressure on governments to do those
things, and, by reversing the decline of the euro’s value,
may have blocked the market response that is
needed to shrink current-account imbalances and
boost GDP in the euro zone. Sooner or later, the ECB
will have to clarify the limits of its policy.