It's The Euro, Stupid

Frances Coppola, Contributor

I write about banking, finance and economics.

FORBES

A few days ago the German constitutional court referred the question of the legality of the ECB’s Outright Monetary Transactions (OMT) to the European Court of Justice (ECJ), claiming that the ECB was straying into fiscal policy that was beyond its mandate and that OMT breached EU treaty directives outlawing monetary financing of governments.

The question of the legality of OMT has been a running sore ever since it was first mooted in August 2012. The ECB has clearly stated that it regards OMT, or rather the threat of OMT, to be part of its monetary policy toolkit. It has nothing whatsoever to do with bailing out Eurozone sovereigns, although that may be an incidental effect. It’s all about the Euro.

The ECB’s mandate is first and foremost to protect the Euro. Those who insist that the ECB’s mandate is solely to ensure price stability are talking gobbledegook. The ECB only has jurisdiction over monetary policy in those EU countries that use the Euro: others, such as the UK, manage their own monetary policy. Without the Euro, the ECB has no purpose. Therefore the first and most important function of the ECB is to preserve the Euro. Price stability is a secondary objective: it can only be a primary objective when the Euro’s future is secure, which it certainly is not when sovereign bond yields in major periphery countries are heading for the moon and people are talking about Euro breakup.  The threat of OMT is currently keeping Italian and Spanish bond yields under control and the Euro stable. But if it were removed, the Euro could come under pressure again. It is worth remembering the fate of the Euro’s predecessor the Exchange Rate Mechanism.

But there are still too many people around who don’t get it. So here is Germany’s perennial hawk, Hans Werner Sinn, insisting that periphery interest rates should be allowed to soar because it is good for them:

Interest-rate premiums are the main mechanism by which excessive debt in the eurozone can be avoided. If states borrow too much, the probability that they will be able to repay falls, and creditors demand higher interest rates in exchange. This, in turn, reduces their inclination to borrow.

The economic crisis in southern Europe stemmed from an inflationary credit bubble that resulted from the absence of interest-rate premiums, and that robbed the afflicted countries of their competitiveness. Interest-rate differentials – including premiums reflecting the heightened risk of a eurozone exit and exchange-rate realignment to reestablish competitiveness – are crucial for the monetary union’s long-term existence, stability, and allocative efficiency.

This is dangerous nonsense. Interest rates spiraling out of control in periphery countries threatened to destroy the monetary union in 2012 and could very easily do so again.  The long-term survival of the Euro project depends on interest rate differentials being kept under control in the short-term – which is the purpose of OMT.

I am no fan of ECB policy, or indeed of the Euro. I think the Euro project is deeply flawed because of the evident lack of economic convergence between member states and the absence of (indeed opposition to) fiscal union. I have been severely critical of the tight money policies that triggered the Greek debt crisis and caused outright deflation in parts of the periphery. But undermining the ECB leadership and using legal action to restrict use of ECB resources is frankly stupid. It’s an open invitation to speculators to test the real ability of the ECB to defend the Euro – and I have no doubt they would accept that invitation.

So I hope the ECJ throws out the German action and confirms the right of the ECB to operate monetary policy in any way it sees fit in the interests of preserving the Euro. Any other judgement would be insane. Disorderly breakup of the Euro would send a shock wave around the world that would make the 2012 Eurozone crisis look like a walk in the park. Sinn and his allies are playing with fire.

http://www.forbes.com/sites/francescoppola/2014/02/11/its-the-euro-stupid/