CAMBRIDGE – Recent statements by European Central Bank President Mario Draghi and Bank Governor Ewald Nowotny have reopened the debate about the desirable limits to ECB policy. The issue is not just the ECB’s legal authority under the Maastricht Treaty, but, more importantly, the appropriateness of alternative measures.
Nowotny, the president of the National Bank of Austria, suggested that the European Stability Mechanism (ESM) might (if the German Constitutional Court allows it to come into existence) be given a banking license, which would allow it to borrow from the ECB and greatly expand its ability to purchase eurozone sovereign bonds. Draghi later declared that the ECB can and will do whatever is necessary to prevent high sovereign-risk premia from “hampering the functioning of monetary policy.”
Draghi’s statement reprised the rationale used by his predecessor, Jean-Claude Trichet, to justify ECB purchases of eurozone members’ sovereign debt. Not surprisingly, financial markets interpreted his declaration to mean that the ECB would buy Spanish and Italian government bonds again under its Securities Markets Program, as it did earlier this year. Although the previous purchase of more than €200 billion ($246 billion) had no lasting effect on these countries’ risk premia, the presumption is that the effort this time could be much larger. But is that what the ECB should be doing?
While any central bank must be able to conduct open-market operations to manage liquidity in financial markets, selective purchases of individual country bonds that bear high interest rates because of current and past fiscal profligacy is both unnecessary and dangerous. A better rule for the ECB would be to conduct open-market operations by buying and selling a “neutral basket” of sovereign bonds, with each country’s share in the basket determined by its share in the ECB’s capital.