The last post looked at the Target2 system, which has facilitated massive net flows of bank deposits from the Euro area periphery to the core. With its unlimited capacity to issue currency and well defined rules governing how losses would be distributed, it was argued that ECB and its Target 2 clearing system was a source of strength and resilience, that was preventing a speculative attack that would effectively break the fixed rate of exchange between the value of one euro area member’s deposits (e.g. Spain’s) against another’s (e.g. Germany’s).
OK, great, but that takes us back to square 1. By maintaining the fixed rate of exchange between the nominal value of one country’s financial instruments against another’s, the common monetary area is delaying the real exchange rate adjustment that has to happen. More often than not, its speculative attacks, sudden stops in capital flows, and the associated current account crises that normally break fixed exchange rate regimes are simply accelerating that adjustment. In the Euro area’s case, the clever and well designed Target 2 system is slowing that adjustment, which should take place via other economic mechanisms such as wages adjustment and structural change.
Delayed adjustment could be a good thing, because typically current account crises are not good – just ask a Thai, Korean or Indonesian. But it could be bad too. Forestalling disorderly adjustment is fine if it buys time for orderly adjustment. But in Europe’s case, it may well be prolonging the agony. It just buys Europe’s Orphaned Annies (the political leadership) more time to hum and haw and wait and see as they wait for tomorrow. And while they wait, the economic condition in the eurozone seems to just get worse.
Simply put, why would any European government take measures for the benefit of the Euro area (or for that matter the world) as a whole that are likely to be domestically costly (e.g. cutting wages in the periphery or reducing demand growth in Germany). Why act today if the costs of action are high and the future is uncertain (and at present uncertain is an understatement) and you can exercise the option of waiting, even if the costs to the global economy are high? Why act today if you think your vision for the future of Europe will be fulfilled if you hold out another month in negotiations with countries that have a competing vision? Why act if a chunk of the costs of inaction can be pushed down on to the ECB and the Target system?
So here is the problem. The ECB has become not only the Euro area’s federal central bank and soon its banking supervisor. It has also become, by and large, the euro area’s crisis fighting institution. As such, it is also becoming the euro area’s federal fiscal institution (its treasury), by taking on expected future losses of the banking system and it will continue to happen as economic conditions deteriorate even more than they already have and the ECB is forced to implement a quantitative easing policy, because the heavily indebted periphery nations cannot, and Germany will not, take the necessary fiscal measures. It may even have to forego its hawkish inflation targets if the ECB ultimately becomes responsible for ensuring fiscal sustainability of the large economies of Spain, Italy and France, not to mention the small economies of Greece and Portugal (surely every euro area political has already been briefed that high sovereign debts are somewhat more sustainable at higher levels of inflation). Essentially, the sovereign debts of the Euro area members may well be coming back (back from the past and the future) to haunt the ECB: a problem referred to as fiscal dominance in the literature.
But the ECB simply lacks the tools to implement a proper federalist fiscal policy or structural reforms or pass federal laws or do many of the things that are required to make a monetary union successful. In short, the ECB has very successfully achieved its goal of maintaining a common currency and (so far) of achieving price stability. But as more and more of the burden of economic management is imperfectly pushed down on to this institution, it is likely that the ECB will find itself incapable of achieving one objective without compromising on the other. What is more, given that it doesn’t really have a clear unequivocal constitutional mandate to do what it is increasingly being asked to do, it may lose its legitimacy or face an erosion of its independence.
So the irony is that the ECB as the euro area’s pillar of strength, has become its crutch: during this time of crisis, the ECB is successfully impeding speculative attacks and disorderly euro exits (as it is designed to do), but its presence is also reducing the incentive for politicians to implement the necessary steps to facilitate adjustment through other avenues.