A View on the October 6th ECB Decision - Mazars - Ireland

The decision of Thursday 6 October by the ECB governing council probably did not come easy. Judging from the subsequent press conference there were divisions, though a vote was averted. If stimulatory in intent, it will not have the desired effect: Europe is in recession and the ECB decision to hold interest rates won’t change that.

In all probability stimulatory in intent it is not: quite simply it can be viewed as holding to the line of treaty-based and statutory independence of the Bank from political institutions. It is an announcement not at all at variance with the mind of the bank and understood as such by all.

A number of points might be made about the backdrop to last week's decision. First, the fact that the EU is at risk of deep recession with some states in fact gripped by balance sheet depressions. Second, the EU banking system in the aggregate is insolvent with many individual banks being if not quietly "resolved" then drastically shrunk. Third, many governments are equally if not insolvent then in serious funding difficulty (can only borrow at very high cost) with their bonds no longer accepted by the markets as a no-risk asset class. Fourth, this decline in the standing of the European sovereign asset class is primarily because of one thing: in 2007/08 very many EU governments nationalised the losses of their banks. These losses had, in the main, arisen from a credit bubble which was ignored or unrecognised by governments, banks, regulatory authorities and investors, focused in particular in the property sector. Banks and governments that did not engage in this episode were contaminated by contagion. The undermining of the financial system and the passing of the parcel of toxic debt to the public authorities has not been well received by markets and, as such, might be described as an unmanaged excercise. The stress-tests and recapitalisation measures applied to European banking have not been received as credibly restoring order. Furthermore, the cost of bail-out when crystalised was passed onto the general public through ‘austerity’ - with attendant consequences for demand in the Eurozone (EZ) economies. Finally, the ECB has largely stuck to the interpretation of its statutes as a monetary authority with no role in last resort but also that it was beyond governments to pursue quantitative monetary policies or (Keynesian) fiscal policies. The ECB has effectively insisted that members of the EZ are not sovereign in this sense.

There are variations around this core story. The US and the UK authorities and governments - largely responsible for creating the global financial system is at the heart of it all - are sovereign and have acted as such although stopping short of using Keynesian (fiscal) stimuli (thus partially dissipating the effect of monetary expansion and creating a liquidity trap for themselves). Greece is also a variation - given the history of its crisis, including, as many now point out, the roots of problems preceding its entry to the EZ. A key point is that the ECB sees its primary role as being to keep inflation in the range 1.7 to 1.8 percent, that inflation currently is "elevated" at more than 2 percent and is likely to remain there over coming months. This signals to the ECB that the monetary policy message is not getting through to the EZ economy and governments. For Trichet, governments are not "getting it"; are not doing enough whether in fiscal consolidation, introducing substantial and comprehensive structural reforms for example in liberalising "closed professions", or putting an end to automatic inflation-adjustment of wages and labour market rigidities. Furthermore, there is not enough plant-level bargaining and wage-setting and a general need to push competition all-round. If that sounds like Troika-era Ireland it is. Such programmes would anchor inflation in the target range and thus enable monetary policy through low stable interest rates to play its role in a growing EZ economy. Low unemployment (and high growth) requires such measures (unendingly) if they are to be consistent with a low and non-accelerating inflation rate target being pursued by the monetary authority - the NAIRU view of how the world and economies should work.

Also money markets have become disrupted, seriously so: but no more than inflation, this is no fault of the ECB. Commercial bank balance sheets and government balances are in the mess they are in because of a breakdown in governance, specifically for Trichet, insufficient compliance with the Stability and Growth Pact (SGP). For Trichet, monetary policy does have a role in restoring order: it is primarily to provide on a non-standard basis (which is to say temporary) liquidity to banks (in addition to always available standard repo) thus assisting a return to normality. Other aspects - recapitalisation and so on - are the responsibilities of other authorities such as supervisors, governments, the European Council and the like including (somewhat circularly) the markets. The ECB has no role here - other than to exhort. Thus the EFSF must leverage quickly but not through the ECB - in short, let governments themselves leverage the fund.

The logic may be somewhat smoky: getting from non-compliance with SGP to bank and sovereign insolvency is a bot of an "ask" as they say. But it is consistent with the NAIRU view. It is also very far indeed from the contrary view of fund manager M Edouard Carmignac of Carmignac Gestion (motto, "Growth Discoverers"). On the eve of the ECB governing council meeting M Carmignac, rather remarkably, bought a full-page of the FT to place an open letter to the retiring Trichet. "Farewell, you certainly won't be missed!" Trichet, he continued, had in recent times "... endangered the Euro with ill-considered rate hikes and clearly inadequate support for the debt of weakened European countries". M Carmignac prescribed cutting the ECB interest rate to zer o making a declaration that the ECB would buy unlimited amounts of distressed sovereign debt from equally distressed banks without 'sterilising[1]’ the money injected into bank balance sheets. Ending ECB sterilisation operations would integrate monetary and fiscal policy in the cause of economic stabilisation and growth - turn the ECB into an arm of European economic government. That makes sense to M Carmignac (and many others) but not for M Trichet and the ECB Governing Council for whom it is not simply anathema it is heresy.

There is possibly a light on the hill. It is that the European Council has commenced its discussions on EFSF2 and on Thursday the 20th the ECB is scheduled to meet. What comes from that, we can only wait and learn.

[1] Sterilisation is a process whereby central banks ensure any new money they create does not spark new lending by the banks while it does create new capital on their balance sheets.