Managing the rage in the eurozone

Violent clashes and threats of secession from regions like Catalonia suggest a fracturing eurozone. But the EU's strong institutions can weather the storm.


After a quiet few weeks, political pressures are rising again in Europe. Petrol bombs exploding in Athens and news reports of mounting support for the rightist Golden Dawn party bring into questions the durability of the summer stabilisation in the eurozone.

Yet there is little to indicate that these developments change anything of significance in the eurozone crisis response. Greek protesters invariably fight with police, but so what? The Greek government is likely to agree on a further austerity package, despite the violence and the first strike by (mostly) public sector workers since the new coalition government took office. As for Spain, the government in Madrid presented their fifth fiscal austerity and consolidation package last week, despite a few thousand protesters in Madrid.

In fact the only example of public outrage having an impact in the eurozone recently has come in Portugal, where protests have spread spontaneously against the government’s new proposal to shift social security contributions from firms to workers. The furore forced the government to withdraw this step, which had been aimed at increasing competitiveness by an 'internal devaluation'. While Portuguese developments thus illustrate that widespread public outrage does – when present – lead to shifts in specific austerity and reform policies in the eurozone periphery, concerns about the general political stability of the eurozone periphery and general direction of reform policies are overblown. Indeed the main risk is that the protests merely make governments less bold on necessary reforms.

Two matters outside the eurozone periphery have raised doubts that can be put to rest. First is the public scepticism voiced by the German Bundesbank and its president, Jens Weidmann, over the ECB's new program of bond purchases – known as outright monetary transaction, or OMF – to allay concerns about contagion. As I have noted before, this is largely German political theatre. In reality the Bundesbank’s criticism suits both Mario Draghi, president of the ECB, and Chancellor Angela Merkel of Germany very well. In their dealings with Prime Minister Mariano Rajoy of Spain, the role of ‘bad cop’ falls to the Bundesbank. Indeed, the political benefits for all the German political establishment (not just Angela Merkel) of the Bundesbank’s public defence of ‘traditional German conservative monetary policies’ go further than merely helping putting more pressure on the Spanish government to act. In practice, the Bundesbank’s opposition to the OMT program is irrelevant, because the vote to adopt it at the ECB Governing Council was 22-1, over the Bundesbank’s dissent. In US Congressional political terms, the Bundesbank dissent is a ‘free vote’ of no consequence, politically similar to the House Republicans’ 33rd vote to repeal Obamacare.

But the Bundesbank’s lectures about the dangers of printing money to assist distressed banks and countries helps channel potential German conservative scepticism about European integration in a non-threatening direction. With the Bundesbank publicly lecturing the ECB (and the IMF incidentally), there is less political space for other actors in Germany to make that case. Or put another way, the Bundesbank venting about ECB money printing pre-emptively takes the wind of potential German real populists by stealing some of their thunder as guardians of traditional German monetary policy virtues. This is important in a country where monetary and fiscal policy matters are never far removed from moral teachings. For the German establishment it is better that a known quantity like Jens Weidmann is articulating such traditional concerns in the public, rather than have them come from a populist platform of the maverick politician Thilo Sarrazin and others. Allowing the Bundesbank to dissent is reminiscent of Lyndon Johnson’s famous quip about keeping J Edgar Hoover at the FBI: that it was better to have him inside the tent relieving himself toward the outside, than outside the tent facing in.

A second question relates to what the ECB might do if the OMT program and a separate action revamping its collateral requirements fail to restore market confidence in the eurozone. Will the creation of a credible backstop in the eurozone prove sufficient? What happens if the divergent borrowing costs for businesses and individuals in the eurozone persist because of backtracking in Spain and delays in the creation of the European banking union? Will such problems aggravate what Draghi has called "unfounded fears about the future of the eurozone” on the minds of global investors?

Since early 2010, the ECB has shown that it has unparalleled coercive crisis management powers to nudge eurozone governments in the direction it wants. But even if the ECB decides to not unleash the full force of the crisis on eurozone elected leaders again to get them to do their political homework, it retains a large arsenal of other measures to recreate the monetary transmission mechanism (i.e. ensure that non-financial firms and households in every eurozone country faces the same cost of borrowing). Lowering financing costs for households and the non-financial sector in the eurozone periphery can be accomplished by the ECB by loosening its collateral requirements to banks further by for instance accepting highly illiquid collateral or buying more private financial assets, such as the roughly €70 billion in covered (e.g. supported by earmarked collateral) bond purchases already acquired.

The political and economic implications of purchases by the ECB of covered bonds or other even riskier private asset classes is different from what they would be in the US. Because eurozone countries retain their fiscal sovereignty and because the EU treaty bans monetary financing of sovereign bonds, the Securities Market Program and potentially the OMT are more politically difficult for Frankfurt than buying more private assets. Recall that not even German monetary hawks paid much political attention to the ECB’s two covered bond purchase programs in 2010. It is the sovereign bond purchases that carry the political risks in the eurozone, whereas more covered bond purchases and the like would probably be more acceptable.

By contrast, the US Federal Reserve has bought large amounts of treasuries and treasury-guaranteed mortgage bonds. But it, despite being legally able to buy these at short maturities, has shied away from US municipal bond purchases and – apart from crisis and bailout related programs like the Maiden Lane Special Purpose Vehicles in 2008*  – generally not bought US private assets. This reflects the legal constraints on the Fed, which according to the Federal Reserve Act’s Section 14 is not allowed to conduct open market purchases of anything other than assets issued or guaranteed by the US federal government with the exception of municipal bonds with a maturity of up to six months. This design of the Federal Reserve Act in return reflects the alarm bells that go off in the US when the government is seen to be 'picking winners' in the marketplace. The hardest thing to do from Washington is to buy private assets.

In the eurozone, however, the politics work just the opposite. The threshold for further ECB actions to secure the reinstatement of the monetary transmission mechanism through such non-standard measures as the purchase of private assets is much lower than in the US. The ECB might be explicitly barred from purchasing bonds directly from member states’ governments, but otherwise have a remarkably free hand in the markets as outlined by Article 18 in the ESCB/ECB Statute. It merely states that: "In order to achieve the objectives of the ESCB and to carry out its tasks, the ECB and the national central banks may operate in the financial markets by buying and selling outright (spot and forward) or under repurchase agreement and by lending or borrowing claims and marketable instruments, whether in euro or other currencies, as well as precious metals.” With the restoration of the monetary transmission mechanism now clearly defined as within the ECB’s objectives, there are in other words no real legal constraints on what additional non-standard measures it might take in the future to ensure this goal. Certainly additional covered bond and/or corporate bond purchases seem fairly straight forward options for Frankfurt, if required by market circumstances.

Finally, coming back to Spain, there are some danger signs surrounding the recent events in Catalonia and the cynical attempt by the Catalan government to exploit long-standing nationalist sentiments to divert attention away from the region’s deep economic problems. The decision by Artus Mas, the Catalonian leader, to call a new election on November 25 – two years ahead of schedule – to move toward a referendum on Catalan independence, must be seen as driven by the longer-term constitutional process in Spain. In 2010, the Spanish Constitutional Court rejected parts of a new Statute of Autonomy for Catalonia, which would have devolved more powers to the Catalan region, effectively granting it nationhood within Spain. Beyond the legal issues are objections in Catalonia, as a relatively wealthy part of Spain, to continue subsidising other parts of Spain though regional fiscal transfers within Spain.

Yet, despite all this and despite the largest separatist march in decades in Barcelona recently, the risk of secession by Catalonia is virtually zero. It is far from obvious that most Catalans would back such a step. Mas’s political gambit is likely to be seen for what it is – an attempt to divert attention away from a tough economic situation and to secure more powers for the region within Spain. It is also it is not obvious that the Spanish constitution can accommodate a move towards independence. Moreover, other eurozone countries would not welcome a highly destabilising move towards Catalan independence. They can be expected to play hardball and demand that an independent Catalonia would have to re-qualify for eurozone membership without being grandfathered into the privileges enjoyed by Spain as a member of the EU and the eurozone. Like Scotland, Catalonia can dream. But there is no persuasive economic case for secession.

*These emergency measures were legally carried out under the emergency powers granted to the Federal Reserve by the Federal Reserve Act Section 10A, allowing it to lend to various entities (such as Maiden Lane SPVs) provided that a super-majority of Federal Reserve Board Governors agree.

Originally published on Reproduced with permission.

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