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Analysis
Forward guidance manoeuvre buys more time

Forward guidance manoeuvre buys more time

ECB dilemma over probable Greek restructuring

by David Marsh

Mon 8 Jul 2013

The intelligent manoeuvre last week by Mario Draghi, the European Central Bank president, to bring in modified ‘forward guidance’ as a way of reassuring bond markets about higher European interest rates was a sensible way of heading off imminent difficulties caused by expectations of tighter US credit.

The measure probably isn’t as significant and as binding as some observers think. If it had been, the Bundesbank, wary of anything that prevents the central bank from pouncing on any change in the inflation environment, would have voted against it.

But by breaking, even less than wholeheartedly, with the long-held ECB mantra against ‘precommitting’ on interest rates, the ECB may be storing up one more problem for the future. Opposition from the Bundesbank and the German public about a long-term suppression of the normal rules of monetary policy will be there in the shadows, waiting to strike.

Because of the almost mythological regard in which the financial markets hold the ECB, and because it is the only fully-functioning euro area institution, the central bank faces greater pressures than anyone else.

On one level, the ECB has to fight the overall deflationary impact of the corrective processes in play since 2010. The deficit countries are forced to take radical demand-cutting action to restore economic balance, but the creditors feel under no compulsion to take compensatory reflationary measures. 'Asymmetry' between creditors and debtors preoccupied John Maynard Keynes in the 1940s – and remains unresolved. These circumstances not only result in persistent complaints, aimed at Germany, about lack of economic coordination, but also contribute to a downward euro spiral that reminds some observers (such as Mervyn King, former governor of the Bank of England) of the depressive effects of the Gold Standard in the 1920s and 1930s.

On another level, the ECB’s constant entreaties for the politicians to take responsibility for putting Europe’s house in order are blocked by the most pernicious paradox facing the entire euro construction. The sole escape route for the euro must run via deeper political unification and economic integration.

Yet, because of mistrust between creditors and debtors caused by past miscalculations, building a genuinely federal Europe meets enormous resistance from all sides. So all kinds of sensible-sounding solutions, from mutualised eurobonds through to banking union, will either not happen at all or will be too late or will be decided only for countries that don’t need them.

The greatest examination of the ECB’s resolve will come as a result of a combination of all the above circumstances. Lack of growth and lack of effective crisis management have made the ECB and other official institutions by far the largest creditor of Greece. International Monetary Fund figures show that of Greek government debt of around 300 bn euros at end 2012 , more than 200 bn euros are held by official creditors, with less than 50 bn euros each held by residents and private sector non-residents. (By contrast, in 2009, Greece had roughly the same debt total but roughly 220 bn euros were owed to private sector non-residents and none to official creditors.)

The IMF and others who believe that Greece’s debt is unsustainable are calling for a debt restructuring, almost certainly after the German elections in September. The ECB is quite properly rejecting any such idea, but, if it is forced to write off credits to Greece, this not only leads to budgetary shortfalls among euro members but also could be a formal breach of the prohibition of monetary financing of governments.

In the meantime, we may see Greek citizens descending to the streets to protest against conditions that its own central bank (and the ECB) are enforcing on loans to their own government. Almost certainly, this is unprecedented in monetary history.

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