August 2 marked the first anniversary of the European Central Bank’s “outright monetary transactions” program, under which it stands ready to purchase government bonds on the secondary market. The ECB announced OMT in response to last summer’s panicked sales of southern European sovereign debt, which threatened to blow apart the eurozone.
At one level, the anniversary was a happy one. Yields on Spanish and Italian bonds, which had risen to unsustainable heights over fears of a eurozone breakup, fell sharply after the announcement. They have remained at lower levels ever since, despite little visible improvement in the European economy. Perhaps best of all, the ECB has never had to activate the facility. It has not actually bought any bonds under the program. Its promise to act was enough to calm markets.
But the OMT scheme is also condemned for exceeding the ECB’s mandate. Critics view it as a devious attempt to circumvent the prohibition on the ECB’s direct purchases of eurozone governments’ bonds. It is thus a source of moral hazard, for it relieves pressure on spendthrift politicians to balance budgets and push ahead with reforms. In addition, it is seen as exposing the ECB’s principal shareholders, notably Germany, to the risk of losses on their holdings of southern European bonds.
Earlier this summer, these issues were the subject of two days of hearings before Germany’s Constitutional Court, which will issue its ruling shortly. If it finds that the OMT program is inconsistent with the German Constitution, it could force the Bundesbank to withhold its participation. It might even force the ECB to abandon OMT.
Now, more than 100 economists, half from Germany, half from abroad, have signed a letter in support of the program. (Full disclosure: I am among them.) It might seem odd for foreigners to weigh in on a question of German law. But the stakes are too high to remain on the sidelines.
A normal monetary union, which is what the eurozone aspires to be, requires a normal central bank to carry out the entire range of central-banking functions. This starts with ensuring price stability. But, as is acknowledged in the ECB’s statute, it also means ensuring the “smooth operation of payment systems.”
Moreover, it means preserving financial stability. Recent experience has provided a harsh reminder of the consequences of neglecting this responsibility. Specifically, the central bank must be ready to act as a lender of last resort when investor panic threatens financial markets.
Americans learned these lessons the hard way. The founding governors of the Federal Reserve System interpreted their mandate narrowly, viewing the Fed as responsible for maintaining gold convertibility and a stable dollar. Embracing the “real bills doctrine,” they regarded their role as being to provide as much money and credit as was required for retail and wholesale transactions, and no more. In particular, they did not see the Fed as a lender of last resort. Emergency lending to distressed financial institutions and markets, they warned, would only encourage excessive risk taking and create bubbles, while exposing the Fed to losses on its investment portfolio.
The result was a series of escalating banking and financial crises in 1930, 1931, and 1933, the last of which shut down the entire US financial system. Obviously, this was no way to manage what was already the world’s largest economy. The result was the Banking Act of 1933, which expanded the Fed’s powers to discount and purchase notes, drafts, and bills, thereby ensuring that retail banks would have the liquidity required to meet depositors’ needs. The Banking Act – and the experience that prompted it – made clear that the Fed had an obligation to use those powers.
It is no coincidence that the US has not had a 1933-style financial crisis ever since. The financial crisis of 2008 came close, but it was precisely the Fed’s readiness to step in as an emergency lender that prevented the worst.
The lesson of this US experience is unambiguous. The eurozone will never be a normal, well-functioning monetary union until it has a normal, well-functioning central bank prepared to act as a lender of last resort. The OMT program is a step in this direction. The ECB has recently signaled that it is similarly prepared to take the other steps expected of a normal central bank, publishing its board’s minutes, for example, so that the public can understand its deliberations and hold its members accountable for their actions.
The ECB statute was not engraved on stone tablets and handed down on Mount Sinai. It is a man-made charter, and it should be treated – by the German Constitutional Court and others – as a living document that is to be interpreted in light of current events. The rest of us should encourage this approach. The euro’s fate could well depend on it.
Read more blogs on the ECB.
The opinions expressed here are those of the author, not necessarily those of the World Economic Forum. Published in collaboration with Project Syndicate.
Author: Barry Eichengreen is Professor of Economics and Political Science at the University of California, Berkeley.
Image: The headquarters of the European Central Bank in Frankfurt REUTERS/Ralph Orlowski.