May in August at the ECB

After the recent meeting at the ECB’s Governing Council, it was decided to keep the policy rate fixed at its record-low level of 0.75%. As the (bleak) economic outlook has not changed markedly since the last meeting, it seems a sensible decision given the ECB’s mandate.

Many, however, forget that the mandate of the ECB is to secure stable prices in the Euro area, which by the ECB is defined as a HICP inflation rate close to, but not above, 2%. It is currently at 2.4%, so it is difficult to accuse the ECB for being particularly hawkish. But the policy rate setting, and how it was aligned with the mandates of the ECB, were not what made the headlines.

Instead, most focus was on how the ECB could possible help saving the European debt crisis. To be clear, it is not the job of the ECB, and it is not within is legal mandates. It is supposed to act independent of fiscal matters. Nevertheless, many commentators and market participants criticized the ECB for not laying out any firm strategy for helping fiscally distressed countries (like, e.g., Spain). Well, I would say that the ECB itself is to blame for this de jure unwarranted focus on fiscal policy measures. It has earlier been running a Securities Markets Programme (SMP) where they have bought up public debt on a massive scale (thereby violating the intent of the Treaty on European Union). So the ECB has been acting in a way that clearly has undermined its credibility as a central bank independent of governmental preferences and pressure. (How this can generate excessive debt issuance and fiscal relaxation I have noted before.)

To make matters worse, Mario Draghi made a sequence of openings for fiscal action in his introductory statement to the press conference following the meeting of the council. Here are a couple of central passages (coming way before the analyses leading to the policy rate decision!):

“Exceptionally high risk premia are observed in government bond prices in several countries and financial fragmentation hinders the effective working of monetary policy. Risk premia that are related to fears of the reversibility of the euro are unacceptable, and they need to be addressed in a fundamental manner. The euro is irreversible. (…) The Governing Council, within its mandate to maintain price stability over the medium term and in observance of its independence in determining monetary policy, may undertake outright open market operations of a size adequate to reach its objective. In this context, the concerns of private investors about seniority will be addressed. Furthermore, the Governing Council may consider undertaking further non-standard monetary policy measures according to what is required to repair monetary policy transmission. Over the coming weeks, we will design the appropriate modalities for such policy measures.”

Not a very firm statement. “May” appears twice, so you can’t blame them for making commitments in this respect. Nevertheless, it doesn’t take much intelligence to acknowledge that when somebody has to emphasize that they contemplate actions that will actually satisfy the laws, then they are in the business of trying to bend the laws to the limit.

Under the SMP, the loophole that carried the ECB through was that they did not buy up government debt directly from governments, but on the secondary markets. In other areas of economic exchange such activity are sometimes referred to as money laundering. Now, the loophole seems to be that the financial markets are mispricing government bonds. It is interesting that an institution which otherwise operates under a free markets doctrine has the power to determine the “right” price on a bond. But since lots of the risk premia arise from investors’ putting a positive probability on a collapse of the Eurosystem, then the ECB can apparently deem the price wrong as “the euro is irreversible”.

Hence, conditional on its axiom that the euro is irreversible, the ECB has now opened the way for any action it desires in a fiscal direction, as this will be interpreted as consistent with central bank independence and attaining its objective of price stability.

It is an amazing play with words and an amazing way of toying around with letters of a Treaty. It appears that in Europe, no Treaty can withstand the shortsightedness of politicians and (some) central bankers.

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