Across Europe, reactions to the latest signals that the European Central Bank (ECB) might play a larger role in battling the euro crisis have been very different. While markets have rejoiced and spreads of periphery government bonds have come down significantly, the German public has been outraged. Not only have populist politicians from both the government and opposition parties denounced the ECB's plans, editorials in important media have also warned of a slippery slope towards financing governments with the printing press.
In spite of the German outcry, however, the economic argument for ECB action is extremely sound. There are signs that we are observing something which is known among economists as a “self-fulfilling fiscal crisis”. The set-up of such a crisis is simple. If government debt has reached a certain level, the country's solvency depends on investors' expectations. If investors believe that a government can continue to service its debt, they will demand low interest rates and the country in question remains solvent. If investors start doubting the government's ability to fulfill its payment obligations, they will demand higher interest rates and these higher interest rates themselves will cause insolvency.
The catch of such a set-up is that one can stabilise expectations (and hence the situation) by promising ample credit to a government in distress. If the country in question can tap decently priced loans from a multilateral institution in case private investors withdraw, there is no reason for private investors to call into question the solvency of the government and the self-fulfilling crisis is defused.
Alternatively, if the central bank would explicitly or implicitly guarantee to buy enough bonds in the secondary market to keep interest rates from rising above a certain threshold, expectations would also be stabilised in the “good” equilibrium. This mechanism is also the reason why countries with their own central bank and debt in their own currency such as the US or the UK have so far not been victim of market panic, even though their debt-to-GDP ratio has been higher than in some of the euro crisis countries.
What is central to stabilise investors' expectations is that there is no doubt that a sufficient amount of loans can be provided. As the European Financial Stability Facility (EFSF) and the European Stability Mechanism (ESM) rescue funds are too small to promise such unlimited support, the ECB is the only actor to really prevent the self-fulfilling crisis.
Moreover, in contrast to popular German fears, there is little doubt that the ECB could do so without creating inflation. The European economy is extremely weak at the moment. Additional money supply is not used for transactions, but is saved, mainly in central bank accounts. In such a situation, there is little danger of higher price increases due to bond purchases. In addition, the ECB would have sufficient time to sell bonds again and thus mop up liquidity, should the crisis submerge and the euro area economy recover.
Of course there are political complications. In some of the countries of the euro area – such as Greece and to a certain extent Italy – excessive public spending or insufficient taxation were elements that contributed to the current crisis. In these cases, one should not give unlimited and unconditional loans at low interest rates.
Last summer, the ECB thus dictated conditions in terms of fiscal and structural reforms to the Italian government before it started buying Italian bonds. However, such a set-up creates a lot of problems: for one, the ECB does not really have the expertise on the fiscal and economic reforms required to make public debt sustainable and kickstart growth. Moreover, it clearly does not have the legitimacy to dictate such wide-ranging policies. It has been given independence for a closely defined realm of maintaining price stability. Giving it the additional power to control economic and fiscal policy across Europe would turn the democratic principle on its head.
A much cleaner solution would thus be to grant a banking licence to the ESM. The ESM, which is controlled by democratically elected national governments, could then set conditions under which it guarantees low interest rates to crisis countries. Such low interest rates could easily be enforced if the firepower of the ESM were increased, by allowing it to borrow from the ECB against its holdings of government bonds.
The pressure on member states to reform would remain in place, yet a self-fulfilling solvency crisis could be averted. Instead of crying wolf about any possible ECB intervention, Germany should also push for such a solution: a rule-bound ESM with a banking licence would be much closer to Germany's approach of rule-based policy-making than an ECB that intervenes in bond markets at its own discretion
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