Why the ECB Won't (and Shouldn't) Just Print

Mon, Nov 21, 2011 - 8:01am

Over the past week, we've heard all sorts of propositions that the European Central Bank (ECB) "must" begin printing money to bail out Italy and other countries, because "there is no other option." There are three basic difficulties with this idea. The first is that ECB buying might help to address immediate liquidity issues of distressed European countries, but it would not address long-term solvency issues, and would in fact make them worse. The second is that the ECB, under existing European treaties, has no such authority, and the prohibitions against it are very explicit. Changing that would be far more difficult than many market participants seem to believe, because it would require an explicit and unanimous change in the EU Treaties that AAA rated countries such as Germany and Finland vehemently oppose. The third difficulty is that even if the ECB was to buy the debt of distressed European countries with printed money, the inflationary effects would likely be far more swift than anything we've seen in the United States. This would not "save" the euro, but would simply destroy it by other means.

Investors are not likely to be treated with a "surprise" announcement that the ECB is going to expand its purchases of distressed European debt. Any significant ECB intervention would likely follow a formal revision of EU treaties that trades greater ECB flexibility in return for more centralized fiscal control.

Let's cover these points individually.

Liquidity versus Solvency

First, it is important to keep in mind that while ECB buying of distressed European debt can address short-term liquidity problems (the need to roll over maturing debt as it comes due), it does not address the long-term solvency problems in these countries (the fact that they are mathematically unable to make good on it because the debt violates the no-Ponzi condition ).

A central bank works like this. It buys some amount of government debt, and pays for it by printing currency (or bank reserves). That initial purchase essentially represents free revenue to the government, since it gets to buy goods and services in return for costless pieces of paper, and the income from the bonds held by the central bank is transferred back to the government over time. The central bank can exchange maturing bonds new ones, or change the composition of its portfolio in other ways, but if it doesn't increase the size of its overall portfolio, no new "base money" is created.

The outstanding stock of euros was created by the ECB when it purchased a portfolio of debt issued by EU member countries. The income received on the bonds held by the European Central Bank, as well as the losses should those bonds default, is effectively "distributed" across EU members. All of the EU Treaties have a central feature - the "Principle of Proportionality" - that seeks to allocate benefits and costs proportionally among the European member states. The basic formula for each country's "share" is the average of the GDP share of each country (as a percent of total EU GDP) and the population share of each country (as a percent of total EU population). That is also the formula that is used to determine how much capital each EU country contributes to the ECB - obviously, Germany contributes the largest share.

The key problem is this. It would seem easy for the ECB to address immediate liquidity concerns by buying distressed European sovereign debt. But if the ECB buys those bonds, and they don't pay off over the long-term, the ECB will have given a fiscal subsidy to those distressed countries, and Germany will end up bearing most of the cost.

Moreover, as the president of the Federal Reserve Bank of St. Louis said in 2006, "Everyone knows that a policy of bailouts will increase their number." ECB bailouts would destroy the ECB's credibility, and without any credible way to put a hard constraint on the fiscal policies of EU member countries, would create a "moral hazard" toward even higher deficits in Europe. Having created new euros to purchase distressed sovereign debt, it would be unlikely that those new euros would ever be removed from the system.

In terms of the mix of bonds held by the ECB, a reasonable target is to hold bonds in proportion to the average of the GDP share and the population share of each EU country. Over the past two years, the composition of ECB bond holdings has increasingly deviated from proportionality, as the ECB has purchased the debt of distressed countries and has "sterilized" this intervention by selling the same value of debt of stronger countries such as Germany (sterilization ensures that no new currency is created). The deterioration in the quality of the ECB's balance sheet isn't illegal, but it does stretch the principle of proportionality unless the ECB normalizes these w eightings over time. While the shift in the composition of the ECB's asset portfolio is somewhat uncomfortable, the portfolio can still be normalized over the long-term.

Legal Issues

On the legal front, the European System of Central Banks (ECSB), and specifically the ECB, explicitly identifies price stability as its most important objective. It can pursue other objectives in furthering other objectives of the EU, but any additional goals are secondary, and must be "without prejudice to the objective of price stability." From the Treaty on European Union:

Article 105: "The primary objective of the ESCB shall be to maintain price stability. Without prejudice to the objective of price stability, the ESCB shall support the general economic policies in the Community with a view to contributing to the achievement of the objectives of the Community as laid down in Article 2 [European economic and social progress, identity, freedom, security and justice]. The ESCB shall act in accordance with the principle of an open market economy with free competition, favouring an efficient allocation of resources, and in compliance with the principles set out in Article 4 [EU political and development guidelines provided by the European Council]."

The Treaty is very specific in restricting the ECB from assisting individual governments. Article 123 of the Treaty on the Functioning of the European Union prohibits the ECB from providing any type of credit facility to central governments (and specifically "any financing of the public sector's obligations vis-a-vis third parties"). That Article also effectively means that the ECB is prohibited from providing funds to "leverage" the European Financial Stability Facility (EFSF).

As a side note, it's interesting that the EFSF has many of the characteristics that the U.S. securitized mortgage market had in 2007 - attempting to provide credit to borrowers that actually weren't creditworthy, by repackaging the debt in a way that it could still get a AAA rating. The EFSF hasn't been able to issue much debt, but the debt it has been able to issue is trading at widening spreads versus German benchmark rates. The actual yields are still only in the 4% range, but the trend isn't encouraging.

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