Credibility and the ECB

Includes: EWG, EWU, FXB, FXE, IEV
by: Joseph Trevisani

It has been a long road for the European Central Bank and its head Jean Claude Trichet. In less than a year, the most anti-inflationary of the world’s central banks has moved from strict monetary conservatism to the verge of sub 1.0% interest rates and to serious consideration of quantitative easing, leaving many principles in its wake.

It is not the fact that the ECB has followed the rest of the world’s central banks in pouring liquidity into the banking and monetary systems of Europe that is surprising but that at almost every step of the road they have either denied that such actions were contemplated or indicated that the end to these policies could be imminent. Their rhetoric has proved a far less than perfect guide to their actions.

The unexpected rebound in the German ZEW and Ifo Surveys and the surge in world equity markets have given the ECB bankers the latest hope that the recession may be reaching a bottom and that they may be able to break off their uncomfortable flirtation with accommodative American style central bank policy.

But the history of ECB policy, particularly since last July, tells us that it is not the stated and principled limits of policy that foretell bank actions but the economic and political conditions of the European Monetary Union that matter most.

Or to put it more plainly, sub 1.0% rates which at one time were anathema are now the very likely next step. Quantitative easing may still be unlikely, but can anyone doubt that if the European economies continue to deteriorate that the ECB will emulate the Federal Reserve and the Bank of England and intervene directly in the financial system by purchasing debt. Even a zero rate policy, firmly ruled out by board members and Mr. Trichet himself cannot be considered wholly impossible.

The correct guide to future ECB policy is not the limits of what the Bank promulgates as sound monetary and interest rate policy but what is politically and economically necessary. The influence of the Federal Reserve and the Bank of England is preponderant. In many ways Ben Bernanke is a better guide to ECB policy than Mr. Trichet, Axel Weber or Peer Steinbruck the German Finance minister.

In considering future ECB policy it is important to keep in mind the recent history of the Bank’s reaction to the financial crisis. It was the Bank’s inability to correctly assess the impact of the American sub-prime problem and its worldwide manifestation through asset-backed securities on European economies that put the Bank into the box where it was forced to cut rates while publicly downplaying the need for its doing so.

Shorn of accurate economic banking and fiscal foresight, the ECB’s first response to the crisis was denial. The US Federal Reserve began reducing rates in the fall of 2007. The ECB did not move until almost a year later. The 0.25% rate increase that the ECB enacted in July 2007 must rank as one of the most egregious misreading of an economy in central bank history.

The recession and its attendant economic problems have forced the ECB to follow the same policies as the Fed and the Bank of England, but with the burden of starting much later and with much weaker tools.

The response of the British and American institutions to the financial crisis began with standard interest rate and policy tools but quickly metamorphosed into an almost unlimited intervention into capital markets and many parts of the economic system itself.

In Europe it has been the national governments not the central bank that have taken most of the burden of economic rescue. In Germany and France, it was national governments alone, largely without the direct help of the central bank that rescued bankrupt banks and lending institutions.

The political makeup of the European Monetary Union, 16 separate governments, and the distinction that the ECB was created with any supervisory responsibilities has permitted the central bank to maintain a veneer of rhetoric about its policy and future intentions.

The blind spot of the ECB is that it has mistaken rhetoric for action because it does not have to shoulder the same responsibility as the other central banks. It is not the primary banking institution in the constituent countries of the EMU. The primary regulator remains the national government. This is the main reason why the ECB appeared to be blindsided when the banking crisis reached Europe. How could the central bank not have known the extent of the asset-backed infection of the continental banking system? The only conclusion possible is that the national central banks who should have known did not tell them.

But despite its different construction, the ECB has in essence the same policy as the Fed and the BOE, though they cannot make the same forthright case for it. The Bank will do whatever is effective and needed within their legal limits to mitigate the financial and economic effects of this recession and to prevent the meltdown of the financial system.

The upshot of the limited responsibility and imperfect information of the ECB is that its credibility, so carefully cultivated since its inception has crumbled under the weight of its first true crisis. The ECB may say that zero rates are unacceptable, but are they really? Should we give credence to the rhetoric of the Bank, or as the phrase goes, ‘who are you going to trust me or your own lying eyes’? In judging future ECB policy it is probably safe to disregard what they say unless it jibes with the dictates of economic conditions. To put it another way, the ECB will not have a zero rate policy or adopt quantitative easing until economic necessity demands it.