#Business RSS feed European Central Bank RSS feed Eurozone crisis RSS feed European monetary union RSS feed Economics RSS feed Financial sector RSS feed Euro RSS feed World news RSS feed European Union RSS feed Europe RSS feed Project Syndicate economists RSS feed Turn autoplay off Turn autoplay on Please activate cookies in order to turn autoplay off * Jump to content [s] * Jump to comments [c] * Jump to site navigation [0] * Jump to search [4] * Terms and conditions [8] Edition: UK * US Sign in Mobile * Your profile * Your details * Your comments * Your clippings * Your lists Sign out Mobile About us * About us * Contact us * Press office * Guardian Print Centre * Guardian readers' editor * Observer readers' editor * Terms of service * Privacy policy * Advertising guide * Digital archive * Digital edition * Guardian Weekly * Buy Guardian and Observer photos Today's paper * The Guardian * Comment and debate * Editorials, letters and corrections * Obituaries * Other lives * Sport * Review * Travel * Family * Money * Work * Weekend * The Guide * Subscribe Subscribe * Subscribe to the Guardian * iPhone app * iPad edition * Kindle * Extra * Guardian Weekly * Digital edition * All our services The Guardian home ____________________ [Business_____] Search * News * Sport * Comment * Culture * Business * Money * Life & style * Travel * Environment * Tech * TV * Video * Dating * Offers * Jobs * Business * European Central Bank Series: Project Syndicate economists Previous | Next | Index The limits of the European Central Bank Stock markets and the euro have risen on the presumption that the European Central Bank will buy Spanish and Italian government bonds again. But is that what the ECB should be doing? * Share * Tweet this * * * Email * Martin Feldstein * guardian.co.uk, Monday 30 July 2012 15.03 BST Jump to comments (…) Construction site for the new headquarters of the European Central Bank in Frankfurt Construction site for the new headquarters of the European Central Bank in Frankfurt. Photograph: Kai Pfaffenbach/REUTERS 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 Programme, as it did earlier this year. Although the previous purchase of more than â¬200bn (£156bn) 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. This "neutral basket" approach would permit the ECB to purchase substantial volumes of Italian and Spanish bonds, but only if it was also buying even larger amounts of French and German bonds. The ECB's bond purchases would become as similar to the open-market operations of the United States Federal Reserve and the Bank of England as is possible in the absence of a single eurozone sovereign government. By contrast, focusing potential ECB purchases on the sovereign debt of those countries with high interest rates would have serious adverse effects. It would reduce pressure on the governments of Italy, Spain, and other high-interest countries to make the politically difficult decisions that are needed to cut long-term fiscal deficits. Spain needs to exercise greater control over its regional governments' budgets, while Italy needs to shrink the size of its public sector. An ECB policy that artificially reduces their sovereign borrowing costs would make these steps even more politically difficult. Indeed, when the ECB controls interest rates on long-term bonds, it is hard for political leaders, parliaments, and voters to know whether they have achieved significant fiscal improvement. The peripheral eurozone countries became over-indebted in the last decade because the bond market failed to provide a signal that debts were too high. That has now ended, because bond investors no longer treat all eurozone sovereign debt as equal. But an ECB program to limit interest-rate differentials would eliminate this important signal. Moreover, because the ECB cannot simply buy sovereign bonds without regard for individual governments' fiscal policies, it risks finding itself in the politically dangerous position of deciding whether a country's fiscal actions are tough enough to be rewarded with lower interest rates. The ECB would thus cross the threshold from monetary policy to fiscal policy. Would it put a common ceiling on "well-performing" governments' interest rates, as Italy's Prime Minister Mario Monti suggested not long ago? Or would it set and revise sovereign interest rates according to its current evaluation of each country's fiscal efforts? Finally, Germany might not continue to accept the default risks implied by large ECB purchases of high-risk sovereign bonds. Germany already faces large financial risks, owing to the ECB's balance sheet and the Target2 balances at the Bundesbank that are generated by international flows of deposits to German commercial banks. While German political leaders now declare their allegiance to the eurozone, opinion polls in Germany show that public support for the euro is very weak. As the risks accumulate, it is not inconceivable that Germany might conclude that, despite the potential impact on its exchange rate, it would be better off returning to the Deutsche Mark. For all of these reasons, the ECB's direct purchase of high-yield sovereign bonds to limit their interest rates would be a mistake. It would also be a mistake to do this indirectly by another â¬1tn long-term refinancing operation aimed at encouraging commercial banks to buy those bonds. And it would be a mistake to allow the ESM to have a banking license so that it can borrow from the ECB, greatly increasing its purchase of peripheral countries' bonds. Individual governments should take the tough political steps needed to reduce the risk of a eurozone breakup, which would have very substantial financial costs for all â and not only its members. Unfortunately, ECB officials' recent statements may have reduced the pressure on governments to do those things, and, by reversing the decline of the euro's value, may have blocked the market response that is needed to shrink current-account imbalances and boost GDP in the eurozone. Sooner or later, the ECB will have to clarify the limits of its policy. Copyright: Project Syndicate, 2012 * Print this Print this * Share * Contact us Send to a friend Close this popup Sender's name ____________________ Recipient's email address ____________________ Send Your IP address will be logged Share Close this popup Short link for this page: http://gu.com/p/39c9n * StumbleUpon * reddit * Tumblr * Digg * LinkedIn * Google Bookmarks * del.icio.us * livejournal * Facebook * Twitter Contact us Close this popup * Contact the Business editor financial@guardian.co.uk * Report errors or inaccuracies: reader@guardian.co.uk * Letters for publication should be sent to: letters@guardian.co.uk * If you need help using the site: userhelp@guardian.co.uk * Call the main Guardian and Observer switchboard: +44 (0)20 3353 2000 * + Advertising guide + License/buy our content Article history About this article Close this popup The limits of the European Central Bank This article was published on guardian.co.uk at 15.03 BST on Monday 30 July 2012. It was last modified at 10.35 BST on Friday 31 August 2012. Business * European Central Bank · * Eurozone crisis · * European monetary union · * Economics · * Financial sector · * Euro World news * European Union · * Europe Series * Project Syndicate economists More from Project Syndicate economists on Business * European Central Bank · * Eurozone crisis · * European monetary union · * Economics · * Financial sector · * Euro World news * European Union · * Europe More blogposts * More on this story * Mario Draghi ECB's eurozone crisis remedy runs into German resistance European Central Bank president Mario Draghi pushes bond-buying plan to cut borrowing costs for Spain and Italy * ECB 'willing to buy bonds of weaker EU nations' says Draghi * ECB bond-buying: what the economists say * Eurozone crisis live: Markets await ECB decision * Bundesbank warns over eurozone crisis as ECB prepares to meet * The ECB has bought itself time, if not a stable euro * Jens Weidmann â the man with the key to Mario Draghi's handcuffs * Poll Can the European Central Bank live up to expectations? * Euro crisis: holding out for Super Mario * European leaders must end 'panic mentality', says Finnish prime minister * Interest rates in the UK since 1694 * Eurozone crisis live: UK PMI figures shock * UK manufacturing figures deal hammer blow to recovery hopes * Tim Geithner backs EU leaders but says more action needed * Eurozone break-up would trigger UK economic slump, warns City firm * Eurozone crisis live: Markets await ECB action on Thursday * France and Italy add to pressure on Germany to prop up the euro * There is a euro crisis solution â use the European Stability Mechanism * How European Central Bank can safeguard the euro * UK economic outlook slumps on eurozone crisis * Eurozone crisis: strong rally falters as euro loses ground * Eurozone crisis live: Leaders pledge to protect euro * Greece auditors vow to do 'whatever it takes' to assemble cuts package * Eurozone crisis knocks Greek tourist trade * Britain and Sweden: a tale of contrasting EU economies * Merkel and Hollande pledge to safeguard euro * Spanish recession to last until 2014, IMF warns * Spanish unemployment reaches record high * Markets rally on Draghi's pledge to preserve euro * Euro is irreversible, declares Mario Draghi * Share * Tweet this * * * Email Comments Click here to join the discussion. 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