One Bank To Rule Them All

by: Frances Coppola

The ECB has released this letter from its former President, Jean-Claude Trichet, to the Spanish Prime Minister in August 2011. It is excruciating reading.

The letter starts with a reminder about the Spanish government's responsibilities:

We recall that the Euro area Heads of State or Government summit of 21 July 2011 concluded that "all Euro countries solemnly affirm their inflexible commitment to honour fully their own individual sovereign signature....."

Well, ok, this letter is about the threat to the Euro caused by spiking Spanish bond yields and the fear of default and redenomination at that time, so it is probably reasonable of the ECB to ask for assurance that the Spanish government intends to honour its debt obligations. But that's not all:

...and all their commitments to sustainable fiscal conditions and structural reforms.

And the letter then goes on to explain in some detail exactly what "structural reforms" the ECB expects Spain to undertake. There are three groups of changes:

  • changes to the labour market, including decentralising wage bargaining, ending indexation of wages and "reviewing other regulations" in order to make it easier for the unemployed to find jobs. Apparently making it cheaper for firms to sack people and eliminating restrictions on the rollover of temporary contracts makes it easier for the unemployed to find jobs. I am not quite sure how this logic works.
  • additional "structural fiscal consolidation" (i.e. permanent spending cuts and/or tax rises) of 0.5% of GDP, apparently to "convince markets" that the 6% deficit target could be met. This was to be coupled with strict control of sub-sovereign budgets, new rules enforcing transparency in sub-sovereign accounts and a "spending rule" restricting spending increases to the trend growth of GDP.
  • product market reforms, mainly to improve competition in key sectors and promote housing rentals.

I am not in this post going to discuss the wisdom or otherwise of these proposals. I am interested in the fact that it was the ECB that made them. In what insane world is fiscal policy the responsibility of a central bank? Which EU treaty gives the ECB the right to dictate policy to a sovereign government, even one subject to the "excessive deficit procedure"? It is very hard not to conclude that the ECB strayed far beyond its mandate. But why did it do this?

The final paragraph gives the game away:

Overall, we trust that the Spanish government is aware of its very high responsibility for the smooth functioning of the Euro area at the current juncture and will decisively undertake all necessary measures to regain market confidence in the sustainability of its policies again.

The impression that this gives is that restoring market confidence in the Euro was the responsibility of the Spanish government, not the ECB. An emasculated ECB was desperately trying to persuade the Spanish government to do whatever was necessary to prevent a disorderly breakup of the Euro. Poor thing.

We now know that this is total nonsense. What markets really needed to restore confidence was not Spanish structural reforms or fiscal consolidation. It was a guarantee from the ECB that it would stand as "buyer of last resort" for Eurozone sovereign debt. And when the ECB finally gave that guarantee - though admittedly hedged around with conditions - calm was restored to the markets and bond yields fell to normal levels.

So it was not the Spanish government that needed to act. It was the ECB.

In this letter, the ECB attempted to evade its own responsibility for ensuring the stability of the Euro. Nor was this the first time it had tried this trick. The Irish letters also include instructions to the Irish government about "fiscal reforms", though not in such detail. But in the Irish case, the ECB threatened to withdraw liquidity from the Irish banking system if the Irish government did not comply. It is a total mystery to me why the Irish government did not call the ECB's bluff. There was no way the ECB could possibly have done any such thing. It would have brought down the European banking system and caused a disorderly breakup of the Euro.

The Spanish letter does not include overt threats. But the message is clear. The ECB believed it had the right to dictate fiscal policy to a sovereign government. Had the Spanish government resisted, no doubt threats would have followed. And once again, they would not have been credible - any more than the ECB's conditions for sovereign bond purchases are credible. The fact is that the ECB must do "whatever it takes" to prevent a Euro breakup, even if that means buying every sovereign bond and bailing out every bank. Its threats are empty.

This must be the last time the ECB is allowed to usurp fiscal sovereignty from a member state government. By design, the Eurozone does not have a single fiscal authority. It may be that at some time in the future, member states will agree to create a supranational fiscal authority. But until then, the governments of member states remain sovereign. The ECB needs to be firmly put in its place. One Bank it may be, but it should never rule them all.

UPDATE: It seems Spain was not the only sovereign subjected to ECB fiscal diktat in 2011. Via Filippo da Fiume comes this letter sent by Trichet and Draghi to Berlusconi, which - as with Spain - details three groups of fiscal policy recommendations:

  • measures to improve growth
  • fiscal consolidation
  • streamlining of public administration.