The European Central Bank’s recent decision to be a lender of last resort in government bond markets is a turning point in the governance of the eurozone. By committing itself to unlimited government bond purchases, the ECB prevented a panic that would have pushed governments into liquidity and solvency crises, destroying the eurozone.
Key to the success of the Outright Monetary Transactions programme, however, is its credibility. Investors must be convinced that the ECB is fully committed to the programme, or they will hesitate to step into the peripheral countries’ sovereign bond markets and the ECB will have to make unsustainably large purchases.
The trouble is that the credibility of the OMT programme is not guaranteed, mainly because of the opposition of the Bundesbank and its president, who is taking every opportunity to campaign against it. The Bundesbank is seen by most Germans as the guardian of monetary and financial stability. When its head mounts the barricades to tell the German public that the ECB is on a path that will destroy Germany’s stability, he is organising German hostility to the ECB and the euro. Sooner or later, this hostility will be unstoppable and may lead to German exit from the eurozone.
The spectre of such a German exit will paralyse the ECB when action is necessary. Investors will sense this, making the OMT ineffective.
This guerrilla warfare by the Bundesbank president is based on a failure to understand the role of a central bank in a modern economy. Central banks were created to deal with the endemic problem of financial capitalism: its instability and the impact this has on the banking system. This has led to the consensus that the central bank should be a lender of last resort in the banking system to ensure that the bubbles and crashes that are part and parcel of capitalism do not bring down the banking system.
Should this role of lender of last resort also be extended to the government? It must be, if financial stability is to be maintained, because the sovereign and the banks hold each other in a deadly embrace. When the banking system collapses, this threatens the solvency of the sovereign. When the sovereign defaults on its debt, it pulls the banks into default. This means that the banking sector cannot be stabilised if the sovereign is unstable. A central bank that wishes to stabilise the banking sector is condemned to also stabilise the government bond market. Failure to do so leads to a banking crisis, forcing the central bank to provide huge amounts of liquidity to banks that it refuses to provide to the sovereign.
Standalone countries such as the US and the UK understand this and have an implicit contract between the government and the central bank, whereby the latter will always provide liquidity to the government in times of crisis. Without such a contract, financial stability cannot be guaranteed.
The eurozone did not have such a contract between the sovereigns and the common central bank, explaining its fragility. It now has one with the OMT programme. Without such a contract, the eurozone cannot be stabilised. Of course, many other institutional changes will have to be introduced to make the eurozone sustainable. The fact that this contract is not sufficient, however, does not reduce its necessity.
Intelligent people such as the president of the Bundesbank certainly understand this logic. Why, then, has he decided to wage war on the ECB, thereby threatening the future of the euro? Here is my hypothesis. The Bundesbank has been an enemy of the eurozone right from the start, for understandable reasons. Before the eurozone’s creation, the Bundesbank reigned supreme in Europe, dictating monetary conditions not only in Germany but also in all the European countries that pegged their currencies to the Deutschmark. With the introduction of the euro, the Bundesbank lost its hegemonic power and became a central bank like all the others.
The eurozone crisis has created a window of opportunity for nostalgic souls in the Bundesbank to restore its hegemonic position in Europe. This opportunity can be realised by a German exit from the eurozone, which now appears possible. If the Bundesbank wishes to precipitate such an exit, a campaign to convince the German public that the ECB’s OMT programme will lead to monetary instability could prove to be a lethal weapon.
I hope that my hypothesis is wrong, and that the Bundesbank has buried its nostalgic dreams of recovering its past hegemony. In that case, it will have to accept that there is no other path to financial stability in the eurozone than one in which the ECB maintains its role of lender of last resort in the government bond markets.
The writer is John Paulson chair in European political economy at the London School of Economics