Martin Feldstein: Dos and don'ts for the ECB

The European Central Bank should not allow itself to pick and choose what sovereign debt to buy

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 euro 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 long-term 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 “well-performing” 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 long-term 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 euro-zone 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.

 

The writer is an economics professor at Harvard