ECB shift from lender of last resort casts doubt on independence
ANALYSIS:What lies behind the abrupt change in the bank’s monetary policy over the last fortnight?, writes ANTOIN MURPHY
THERE HAS been a most profound change in the European Central Bank’s (ECB) approach to monetary policy over the last two weeks, produced in great part by the financial crisis in Ireland.
This change has involved the ECB running for cover from its role of lender of last resort to the euro zone banking system, and in turn seeking some assistance from the European Commission with respect to co-insuring its lending to the banking system.
The problem has been a growing one over the last year as the ECB realised that its policy of shoring up the Irish banking system’s liquidity position was necessitating an increasing amount of lending on its part, both directly to the Irish banks and indirectly through the Irish Central Bank.
Most recent estimates put this lending at about €130 billion, either directly or indirectly through the Central Bank of Ireland to the Irish banks.
A growing flight of capital out of Ireland, initially led by corporates seeking external banking systems with triple AAA ratings, and then followed by Irish people who had lost confidence in the banks, has produced a run on the Irish banks, the effects of which were temporarily minimised by the ECB acting as a lender of last resort.
Presumably Jean-Claude Trichet, the president of the ECB (pictured below), had become increasingly uncomfortable about the fact that a country with 1 per cent of the EU’s gross domestic product (GDP) had ended up with more than 20 per cent of the ECB’s emergency bank lending.
The situation became more acute when Angela Merkel announced that private investors (ie bondholders) would have to assume more of the risk of euro zone bailouts, a statement later modified that this would only apply to the system post-2013.
The financial markets were greatly unsettled by her initial remarks, pushing up Irish 10-year bond yields over 9 per cent and precipitating further capital flight out of the Irish banking system. The latter phenomenon must have set off further alarm bells in the ECB’s headquarters in Frankfurt.
As a result the Irish crisis, which has been initially a fiscal/funding crisis as highlighted by the bond markets, shifted to a full-scale crisis about the liquidity and solvency of the Irish banking system. There is strong reason to believe that this shift was precipitated by an increasingly concerned ECB seeking a new mechanism to relieve it of some of the burden of acting as a lender of last resort to the Irish banking system. Experts on the art of European spinning should be able to trace some of the sources of leaks that started to circulate about the Irish economy as emanating from the ECB.
Suddenly Dublin was invaded by the international media tipped off that something big was about to happen to Ireland, a move that outflanked our already ponderously moving Government. I would further surmise that Patrick Honohan’s morning time interview on RTÉ on Thursday, November 18th, had been encouraged by Ppresident Trichet and members of the board of the ECB in an effort to stress to the Irish gGovernment that the nature of the game had changed dramatically.
It was no longer a case of emphasising extra ways of plugging the budget deficit and becoming more specific about the four-year plan to bring the budget deficit down to 3 per cent by 2014; the game had changed to finding ways of obtaining, to quote Central Bank governor Patrick Honohan, “tens of billions” to assist the Irish banking system along with devising a strategy to share some of the risk between the ECB and the European Union.
Ireland had become an important reference point for a major change in European monetary policy. The background to this may be traced to Maastricht in 1993 when the template for the European Monetary Union was established. The architects of the new monetary system placed primordial importance on the control of inflation which was perceived as the number-one enemy for the euro zone macroeconomy.
It stipulated that an independent ECB should have one major objective, namely the control of inflation. This fixation with inflation produced an eventual ECB with few concerns about other issues.
Two of these other issues are central to the current crisis: 1. the one-size-fits-all macroeconomic policy of the ECB; and 2. the inadequate attention given to another fundamental macroeconomic objective – that of the maintenance of financial stability.
As a result of the one-size-fits-all macroeconomic strategy, countries such as Ireland, already experiencing high rates of economic growth, were allowed to borrow without limit at low rates of interest that were the byproduct of the German weight in the determination of European interest rates.
In Ireland, a property market that had been in serious difficulties in 2001, was resuscitated by a mixture of tax concessions to the construction lobby in 2002, along with an infinitely elastic supply of loans from European financial institutions at very low interest rates.
The huge increase in international lending to the Irish banks and building societies should have sent off alarm signals not only to the Irish financial regulator but also to the ECB and its Irish branch, the Central Bank.
One wonders if the newly created ECB had any interest in monitoring the accelerated growth of lending by Irish financial institutions – a key indicator for identifying potential banking problems - at this time.
By September 2008, it was forced to take a more acute interest in Irish financial developments when, after the collapse of Lehman Brothers and the freezing of the international interbank markets, Irish financial institutions, by now accustomed to borrowing short on the interbank markets and lending long into the property market, found themselves short of funding.
This shortage of funding was further exacerbated by an incipient capital flight, prompted by the fear that the Irish banks might follow Lehman Brothers into bankruptcy. These events led to the fateful meeting of September 29th, 2008, in Dublin, resulting in the decision to provide a 100 per cent guarantee to depositors and bondholders of the Irish banks.
There is strong reason to believe that the ECB approved this decision and it may transpire over time, when more is known about what happened on September 29th, the ECB had a major role to play in backing the decision.
The insurance guarantee for depositors and bondholders was, however, a decision that has proved to be extremely costly. Why, it may be asked, did the Government ask for the advice of Merrill Lynch in the days ahead of September 29th? Presumably the ECB, as the governing central bank of the euro zone should have had the expertise to present a range of options to the Government at this critical juncture.
Since the September 2008 crisis, the ECB has acted as a lender of last resort to the Irish banking system. Its lending cushioned the Irish banks from capital flight in recent months. However, on Thursday, November 12th, the ECB made a decision to discontinue lending to the Irish banking system and sought a new arrangement from the European Commission and the IMF to provide an alternative bailout strategy which raises real questions about the independence of the European Central Bank.
Antoin E Murphy is associate professor of economics at Trinity College Dublin