On November 7, the ECB's governing body voted on cutting down benchmark main refinancing rate to as low as 0.25 percent amidst fear of deflation. However, the decision was not brought unanimously: a minority around Jens Weidmann, chairman of German Bundesbank, called the Council to keep the interest rates at the current level and wait for newer data and forecasts. Weidmann's reluctance towards excessively using central bank's tools to help economy was reiterated in a speech he delivered at Harvard University's Center for European Studies on November 25. He remarked that interest rates might prove to be a too inexact tool, stressing the need for financial policy's own set of instruments. Central bank, let alone unconventional monetary measures cannot solve EMU's systemic risk problem, currently not matching its institutional architecture.
During the last economic crisis many countries, but especially Eurozone -- where monetary policy is general yet fiscal policy is not -- witnessed an overlapping of fiscal, financial and monetary policies. In his view, Weidmann considers a strict separation of "policies, but not institutions" necessary. According to his perspective, having no firm borders between policies might diminish freedom of central banks instead of expanding it.
At the same time, he renounced the Central Bank's potential role as a lender of last resort to sovereigns, calling it "a slippery slope". If monetary policy was used to secure the sovereign's solvency -- clearly breaking of the principle of self-responsibility -- the risk of government's irresponsible behavior would be further exacerbated. Weidmann -- just as his predecessors at the head of the Bundesbank -- strongly opposed ECB buying government bonds. Outright monetary transactions mechanism (OMT), enabling unlimited purchase of government debt, is close enough to monetary financing to compromise ECB's independence. In addition to that, the ECB's balance sheet itself might become compromised.
Weidmann's "separatist" view clearly stems from the German concept of highly independent central banking, assuring price stability rather than trying to target other problems and ensure macroeconomic stability, something he sees is as the job of primarily fiscal and financial policy. ECB was not founded with a mandate to use monetary policy to attend to national economic issues; therefore, giving the ECB a dual mandate -- fighting unemployment -- or similar asymmetric shocks in a particular country would be risky for the very European Union since ECB cannot do that without hurting other countries of the Eurozone.
Another issue is whether the ECB should guarantee the stability of the financial system. Since it was the job of national central banks to supervise commercial banks, failure to centralize supervision early on showed that banking crises in integrated markets are difficult to deal with. Weidmann believes the ECB should not be in charge of supervising banks. As planned, responsibility for the new European bank supervision mechanism will be given to the ECB's Governing Council. Due to possible conflicts of interest, he urges this not to become a long-term solution. Financial policy has to have its own set of tools. In addition to that, the ECB might find itself in a situation in which its primary role according to Maastricht Treaty -- which is inflation targeting -- is not even among top three on its "to do" list.
In order to prevent a situation in which a bank or a sovereign tries to save itself from defaulting by drowning the other one too, Weidmann proposed a system in which default of either of the two will be possible without causing upheaval in the entire financial system. "Sovereign bonds need to be risk-weighed", Weidmann warns. Basel III and Single Supervisory Mechanism are steps towards the solution, possibly preventing fallout from unsound OMT policy, such as buying Greek junk debt. Central banks must not be as exposed to sovereigns as they are now, allowing preferential treatment of sovereign debt. One might think of the ECB as a stateless central bank, but also as a 15-state central bank.
However, Weidmann's criticism might be too harsh in the sense that during the crisis and recovery in the Eurozone, the ECB was the only institution capable of reacting quickly and substantially enough. In addition to that, if Eurozone countries cannot have a lender of last resort -- such as the ECB would potentially be -- investors can precipitate a liquidity crisis, forcing sovereigns into default.
"Negative consequences of bad policies of individual countries externalize to Eurozone, undermining incentives for sustainable policies", concludes Weidmann. What undermines them even more is the sovereigns transferring responsibility and tasks onto the central bank. Since the ECB is not as accountable (not nearly as the U.S. Federal Reserve), the incentives for Eurozone governments to try and reach their goals by avoiding structural reforms and the electorate's discontent are there. This position is clearly not sustainable.
Domagoj Babic, an analyst with EOS Project Europe, contributed to this article.
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