How a Lender of Last Resort Could Reassure Global Markets
NICOLAS JABKO is associate professor of political science at Johns Hopkins University and at Sciences Po-Paris.
November 4, 2011
The anxiety surrounding the G-20 meeting in Cannes this week only deepened when Greek Prime Minister George Papandreou called for a popular referendum on the debt agreement reached between his country and its foreign lenders, placing the deal in jeopardy. Although Papandreou soon called off the vote, fears of a Greek default highlighted a critical transition at the top of Europe’s banking system. The accession of Mario Draghi, the former governor of the Bank of Italy, to the presidency of the European Central Bank will help decide how the Europeans will address the fundamental problems at the root of the current debt predicament.
Draghi is replacing Jean-Claude Trichet, who is stepping down after eight years on the job. Trichet made the ECB a respected and powerful institution. Only the U.S. Federal Reserve currently surpasses the ECB in steering global market expectations, and Trichet himself became a central figure in EU policymaking and an indispensable partner to European governments. Yet he is retiring in the midst of an emergency. Draghi immediately asserted himself as he took the helm, lowering interest rates by a quarter of a point, to 1.25 percent. But he may need to expand the ECB’s role even further to prevent a catastrophe in the eurozone.
Under Trichet, the ECB undeniably helped to alleviate Europe’s economic troubles. In 2007, when European banks stopped lending to each other out of concern that the toxic subprime loans from the United States on their balance sheets would force some of them into bankruptcy, the ECB quickly injected massive liquidities into the market. This prevented a breakdown of financial transactions, and other central banks soon followed the ECB’s lead. To stop Greece’s debt troubles from spreading, the ECB established a program to buy government bonds issued by struggling European economies, which has absorbed over $240 billion in debt since May 2010. In doing so, the ECB has operated at the legal edge of the Treaty on European Union, which contains a no-bailout clause that explicitly prohibits the bank from rescuing governments in fiscal trouble. Given the severity of the situation, however, Trichet argued that the ECB has a responsibility to safeguard the financial stability of the eurozone.
Still, Trichet refused to overstep the boundaries of the treaty entirely. Under his watch, the ECB intervened to rescue eurozone nations only in response to imminent dangers of financial meltdown or sovereign default, such as in Greece. Trichet walked a fine line between assisting countries and giving them incentives to enact meaningful reform. For example, he recently rejected French President Nicolas Sarkozy’s proposal that governments grant a banking license to the European Financial Stability Facility, the fund that major eurozone nations established to provide financial assistance to their struggling partners. According to Sarkozy, this step would have committed the ECB to provide unlimited liquidities to the EFSF, thereby convincing markets that its lending capacity could handle major emergencies. Trichet, however, viewed the idea as a violation of the no-bailout rule.
But despite the ECB’s best efforts, the debt vortex deepened and market confidence declined. Critics condemned Trichet’s caution as Ireland, Italy, Portugal, and Spain seemed liable to go the way of Greece. France may now lose its AAA sovereign debt rating, which would limit its capacity to help its neighbors and leave Germany as the only country with a strong credit position in the eurozone. And Germany’s credit is not infinite. Even if Berlin is prepared to bail out its weaker neighbors, it may not be able to keep providing loan guarantees to countries with crippling debt. The contagion nightmare could then become a reality, heralding sovereign and bank defaults, a major recession, and perhaps even the collapse of the euro.
To stave off a system-wide disaster, Sarkozy and German Chancellor Angela Merkel are scrambling to find alternative sources of financing. They have requested assistance from the International Monetary Fund, courted a variety of potential backers, from China to the private sector, and will appeal to the G-20 this week in Cannes. Yet if the debt position of Greece and other EU states continues to deteriorate, the reluctance of investors outside of Europe to help will only grow.
The ECB, then, may be the only entity with enough financial firepower — the ability to bail out debt-ridden countries — to reestablish market confidence. Critics of Trichet argue that he should have used that firepower a long time ago. In their view, the ECB’s failure to act unequivocally as a lender of last resort is at least partly responsible for pushing the eurozone into a vicious debt spiral. And the pressure is now on Draghi to carry out the unconventional and risky actions that his predecessor refrained from taking. He began by enacting a modest interest rate cut, but he may need to rescue struggling states and banks with vast amounts of new money. If Draghi decides to pursue that course, he will face a serious hurdle: gaining the confidence of his European counterparts, both among central bankers and among government leaders.
Despite Trichet’s mistakes, his colleagues in the European system of central banks still respected him. As a central banker from France, he also benefitted from the perception that he stood as an impartial arbiter between central bankers from struggling, peripheral EU member states and those from the more secure states in northern Europe. Yet Draghi may find it difficult to gain the respect of his peers. To do so, he will need to overcome his association with Italy, whose debt is now almost as much of a concern as that of Greece. His reputation as a fiscal hawk will certainly help, but if he tries to open the gates of bailout finances without broad support, his authority at the head of the ECB will come into question.
Draghi may also find it hard to sway EU governments, especially those of France and Germany. Although Sarkozy and Merkel sometimes chose to ignore Trichet’s advice, they always consulted him and tacitly counted on him to settle their differences. For example, in their long quarrel over writing down Greek debt, the two leaders heeded Trichet’s insistence that any such cuts must be voluntary for the big European banks that hold Greek bonds.
If Europe’s debt problems continue to fester, acute conflicts are all the more likely to arise. And in this environment, Europe will need Draghi to secure his influence quickly and wield it to solve the many difficulties ahead. Draghi must convince his counterparts both within and outside of the ECB to undertake the drastic new actions that the crisis requires.