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Analysis
ECB ‘may be last one standing on a field of ruins’

ECB ‘may be last one standing on a field of ruins’

by David Marsh

Mon 5 Dec 2011

Who will blink first? In games of chicken on railway lines, at least one chicken ends up decapitated. The triple stand-off between the European Central Bank, European governments and the financial markets is building up to fever-pitch. We appear to be heading for a re-run of the fateful times nearly 20 years ago – at the height of the September 1992 exchange rate mechanism crisis – when President François Mitterrand browbeat Chancellor Helmut Kohl into urging the Bundesbank, after much tergiversation, to defend the French franc. If the Bundesbank had its way in remaining on the sidelines while the markets sold down the franc, Mitterrand told Kohl, the Bundesbank would be ‘the last one standing on a field of ruins.’

Expect, therefore, at some stage in the dramatic days ahead, another confrontation between these two latter-day standard-bearers of Franco-German cooperation, President Nicolas Sarkozy and Chancellor Angela Merkel. This will no doubt come in the run-up to the next EU summit on 9 December, where optimism is rising that a package of measures on economic surveillance, European treaty changes, steps to fiscal union and IMF aid for Italy will encourage the ECB to loosen its euro purse strings.

As Sarkozy, Merkel and newly-annointed Italian premier Mario Monti made clear at their meeting in Strasbourg on Thursday, there’s no way that European governments can give instructions for the ECB to defend peripheral countries’ bond markets. Such pressure would be counter-productive, as even Sarkozy must recognise now. The cleverest action the politicians can take is to refrain from pressure on the ECB – and wait for events to take their toll.

The ECB, meanwhile, like a thin red line of Victorian soldiers under attack from Zulu hordes, is standing firm – yet remains ready to counter-attack when and if the going gets better. No one who has visited the ECB in recent days, however, can be unaware of the central bank’s immense irritation at the incapacity of European politicians to assemble sufficient firepower to defend monetary union at an earlier stage. In an ever more bitter blame game, the ECB is determined to avoid responsibility for the potential breakdown of Europe’s emblematic integration project.

The ECB feels it has done enough – and that politicians have been negligent in not responding energetically and quickly enough to numerous stopgap measures implemented by the central bank in the last 18 months to shore up the euro’s peripheral members.

The ECB formally warned European finance ministers a year ago that it could not guarantee European financial stability unless governments at least doubled the size of the EFSF rescue fund.

The message to finance ministers late in 2010, outlined by Nout Wellink, the former president of the Dutch central bank in a book published in the Netherlands, was placed on the agenda of a meeting of euro finance ministers under Jean-Claude Juncker, the Luxembourg prime minister, attended by Jean-Claude Trichet, then ECB president. Trichet angrily reported to the ECB’s decision-making council that the letter made no impression.

All this shows why ECB action to buy Italian and Spanish bonds has been relatively small-scale, pretty ineffective in stemming the rise in yields to unsustainable levels around 7%. As Italy and Spain are driven ever deeper in to the vicious circle territory of debt deflation, the ECB has some remedial measures up its sleeve. And these are all the more likely to be taken if Monti, as everyone hopes, prevails on the Italian parliament to decide fresh deficit cuts. As the most likely alternative to massive selective purchases of trouble-hit members’ bonds, the ECB has discussed broadly-based US- and UK-style quantitative easing in recent months. In this case, the ECB would purchase government bonds across monetary union in proportion to member countries’ GDP – meaning that German and French buying would prevail over Italian. That might bring some respite to monetary union’s weeks of turmoil – but no one knows whether it would be sufficient to steer Europe towards a solution.

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