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Analysis
Narrow Samaras victory brings more nail-biting

Narrow Samaras victory brings more nail-biting

ECB battens down hatches
An end to the Trichet doctrine

by David Marsh

Mon 18 Jun 2012

After the narrow election win for his New Democracy party, leader Antonis Samaras expounded on ‘a victory for all Europe.’ Spanish prime minister Mariano Rajoy said a week ago the bail-out for Spanish banks was a ‘victory for the euro’ – but the bloom soon faded.

Expect much financial market nail-biting as various manoeuvres of posturing and pleading, combined with a good deal of mutual blackmail, get under way in negotiations with coalition partners and creditors.

Meanwhile, amid signs of an uncompromising alliance with the German Bundesbank, the European Central Bank is battening down the hatches – and redrawing its contours of operation to adapt to a new, unforgiving future. This marks an end to some key doctrines espoused by ECB president Mario Draghi’s highly political predecessor Jean-Claude Trichet.

The ECB has now accepted that the functioning of economic and monetary union (EMU), through the earlier de facto convergence of capital market interest rates around a German-based norm, gave rise in its initial years to ‘moral hazard’ by encouraging creditors and debtors to take risks without fear of failure.

That may appear obvious to many people; but it hasn’t been officially admitted by the ECB up to now. And it starkly contradicts the line laid down by Trichet, who said repeatedly over several years that EMU’s promotion of capital market convergence was one of the monetary system’s greatest successes.

In coming weeks, the ECB stands ready, together with other leading central banks, to provide liquidity support and carry out other alleviation measures should money markets seize up on an intensification of Greek worries.

However the forthright message from the ECB’s Frankfurt headquarters is one that brings terse satisfaction to the Bundesbank. Responsibility for a solution to the euro imbroglio rests with governments and with governments alone.

This was underlined in a resolutely low-key Draghi speech at the annual ‘ECB Watchers Conference’ in Frankfurt on Friday. Draghi emphasised: ‘The ECB has the crucial role of providing liquidity to sound bank counterparties in return for adequate collateral.’

Note the word ‘sound’, a point stressed by Jens Weidmann, the Bundesbank president, who has made clear that Greek banks would be debarred from receiving ECB lending if they become insolvent. This could follow rather quickly if, for example, creditors disburse no more bail-out funds following a future Athens government’s refusal to accept the terms of existing rescue packages. Despite Samaras’ pro-euro statements last night in Athens, that could be the mechanism under which Greece eventually leaves EMU.

As far as a future EMU ‘vision’ is concerned, Draghi underlined on Friday that European governments building ‘strengthened foundations in the fields of financial, fiscal and structural policy-making’ would have to make genuine moves to give up sovereignty. That’s not happened so far. As he observed, ‘Some smaller euro area countries actually regained sovereignty with the euro by regaining influence over monetary policy at a higher level.’

That is music to Weidmann’s ears. Less diplomatically than Draghi, the Bundesbank chief last week lambasted other counties, above all France, for asking Germany to increase its funding for deficit countries without any transfer of sovereignty to European institutions.

‘The German government is now pushing for fiscal union, trying to find a solution,’ Weidmann told four newspapers last week from Greece, Italy, Portugal and Spain. ‘I would very much welcome it if President Hollande faced this debate and discussed both common liability and giving up sovereignty…. But just asking for Eurobonds doesn’t get us anywhere.’

Emphasising that building such a union could take years, Weidmann broke with post-war German tradition by saying it would require not just a change to existing European treaties and altering the German constitution, but also referendums in Germany.
The most remarkable address on Friday was by Peter Praet, the German-born Belgian who took over at the start of 2012 as the ECB’s board member responsible for economics.

Adopting as his theme EMU’s now all too evident heterogeneity, Praet said: ‘The institutional design of the euro area has clearly given rise to moral hazard and lacked the capacity to credibly engage in measures to prevent rising imbalances….. Financial markets were allowed to set financial conditions in such a way that private and public sector borrowers in those countries could essentially continue to borrow at the same interest rates as borrowers in countries with much sounder fiscal and macroeconomic fundamentals.’

Terming as ‘with the benefit of hindsight, a puzzling outcome’ the similar pricing of sovereign bonds of the various euro area countries, Praet took aim at a fundamental plank of the Trichet doctrine. ‘Despite the single monetary policy, differences in the default risk of individual countries, consumers and firms remained. But financial markets were less wary of such risks, thereby establishing improper incentives for public and private sector borrowers.’

All this is diametrically opposite to what Trichet said at the time. In 2004 he told a Hamburg audience: ‘The euro inherited immediately the yield curve of the most stable currencies, thus offering to 12 countries and 300m citizens the low levels of market interest rates that prevailed in a few countries only. This is a major success of the euro.’

On the 10th anniversary of the ECB in 2008 he opined: ‘The credibility was such that the medium and long-term market rates of the euro were at the same low level as those experienced by the most reliable national currencies before.’
Praet’s doctrine is significantly more plausible than Trichet’s. Whatever happens to Greece, the new version of history looks likely to stand the test of time.

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