The ECB talks tough on the euro

The president of the European Central Bank may superficially have little in common with Dirty Harry. But his statement to investors in London this week that the ECB would do everything within its mandate to keep the euro together – “and believe me, it will work” – was the financial equivalent of “go ahead, make my day”.

Investors were suitably impressed by this injection of machismo into a debt crisis made worse by eurozone indecisiveness. Italian and Spanish sovereign bond yields dropped immediately. Stock markets made up for losses earlier in the week. But Mr Draghi has stuck his neck out. If he is bluffing, his bluff will soon be called.

    Across town from the ECB, the Bundesbank on Friday poured cold water on the two policies that would be the most likely game-changers: relaunching ECB bond purchases or granting a banking licence to the European Stability Mechanism – the monetary union’s taxpayer-backed rescue fund. If Mr Draghi is to match his words with actions, he may have to face down Jens Weidmann, the Bundesbank’s man on the ECB governing council.

    There are signs that the council is indeed edging towards renewed activism. This week Ewald Nowotny, head of Austria’s central bank, expressed sympathy with the case for an ESM banking licence. If the support is shared by Mr Draghi, it would be very good news.

    A banking licence would enable the ESM to post the bonds it buys to obtain ECB liquidity – like any private bank. This could in principle give it unlimited firepower, as is the case for bond purchases by the ECB itself. Both would, if pursued with conviction, eliminate the markets’ worry that existing eurozone commitments to “do what it takes” will expire before the problem is solved. That in turn could reduce the need to use ECB funds, directly or as an ESM backstop.

    But the ESM is superior to direct ECB bond-buying along two critical political dimensions. One is vis a vis the beneficiary states whose bonds would be supported. The ESM is set up to impose conditions in return for aid in a way that the ECB cannot. The other is vis a vis the ECB itself. Putting the central bank’s balance sheet directly at risk threatens its independence. In contrast, the ESM is capitalised by member governments who take the credit risk on their shoulders.

    Opponents of an ESM banking licence consider it a covert form of illegal monetary financing. But the EU’s ban on credit lines to governments explicitly exempts state-owned credit institutions. And private banks are free to turn their sovereign bonds into ECB cash, even with capital ratios in the single-digit percentages. To stop a 100 per cent capitalised bank, backed by the collective political commitment of the monetary union, from doing the same is perverse.

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