The European Central Bank on May 17 said that it will invite banks in member countries to deposit cash with it for one week to prevent its purchases of government bonds from swelling the money supply and fuelling inflation. In the last month, the sovereign bond prices of its member states fell drastically and the ECB stepped in to buy the bonds so that the prices did not plummet. This created additional liquidity in the system because to purchase the bonds, the ECB had to pay cash to the seller of bonds, which were the European banks. The ECB on May 18 mentioned that it would soon begin to issue term deposits to drain the extra liquidity. This process, called sterilisation, is done to limit inflationary effects due to excess money in the system. Revealing details of its sterilisation plan, the ECB said on May 17 that it will take term deposits for the first time starting May 18 to mop up 16.5 billion euros of bond purchases settled up to May 14. The ECB?s unprecedented buying of government and corporate debt is aimed at stabilising financial markets after Greece?s fiscal crisis spread to Portugal and Spain, driving up bond yields and threatening the euro. The measure has now raised concern that it could weaken the ECB?s independence and inflation-fighting focus.
The ECB emphasises that it makes sure to sterilise the effects of intervention in the market for tumbling sovereign bonds. It stresses that the process of sterilisation ensures that there is no increase in overall liquidity and will not have any impact on inflation. The ECB underscores this aspect of sterilisation to fend off accusations that it is monetising government deficits. However, it is true that through its interventions the ECB deliberately lowers the interest costs of ailing countries. This obviously comes at a cost that is borne by the healthy countries in the form of higher borrowing costs. So the ECB is implicitly granting subsidies to the ailing countries and taxing the healthier ones and is slipping into the role of a fiscal agent. This will inevitably lead to conflicts of interest between various countries in the fold of the euro system. A member country with fiscal problems will always claim that the market for its government paper needs to be supported by the ECB. On the other hand, the countries that do not have fiscal problems wouldn?t want to subsidise the fiscally imprudent states. They will want answers to questions like, who bears the losses if Greece is ultimately unable to service its sovereign debt?
Two principles were key to the establishment of the Economic and Monetary Union of the EU: 1) every member country is responsible for its own finances and 2) the ECB is not to be an agent of fiscal policy. These two principles have been violated in the last one month. The first was violated by the provision of emergency aid to Greece and the second was breached as the European System of Central Banks started to intervene in weak markets to prop up the bonds of countries in financial straits.
When the EMU was formed, the member countries signed a promise called the Stability and Growth Pact (SGP). The pact was intended to ensure that the member states maintain budgetary discipline after the single currency was introduced. It was needed to facilitate and maintain the stability of the economic and monetary union.
Perhaps it was naive to believe that the SGP would ensure that every state assumed responsibility for its own finances. It was inevitable that SGP would require fine-tuning, something that we are currently seeing. What is undeniable is that the pact failed to prevent a member state to get on the verge of bankruptcy. And it has gotten to a stage where the long shadows of other debt-stricken states are looming large over the fate of the monetary union. The architects of SGP need to do something credible to restore faith in the rules governing the monetary union.
People will argue that the crisis required extraordinary measures, that the interventions were minor in volume and thus will have more or less symbolic value, and that the Federal Reserve has conducted similar operations before and is therefore unlikely to cause any major problems in the future. In my opinion, the people who argue that the current bailout, intervention and sterilisation will not have any problems, forget that the EU is just a monetary union unlike the US. They underestimate the vulnerability of monetary unions. In the past, all monetary unions between sovereign states have failed because national fiscal policy eventually gained dominance over common monetary policy. The idea of the ECB?s strict abstention from participation in all fiscal operations was meant to prevent EMU from suffering the same fate as its predecessors. With the ECB?s involvement in rescuing sovereigns in distress, the door has now been opened a wee bit for the bug to enter that proved so lethal for past monetary unions.
The author, formerly with JPMorganChase, is CEO, Quantum Phinance