The Euro in Crisis: Decision Time at the European Central Bank

The Euro in Crisis: Decision Time at the European Central Bank

"Great powers have great currencies." -Robert Mundella

On May 8, 2010 in Brussels, the finance ministers of the 16 Eurozone nations gathered to craft a response to the spreading financial crisis in Europe. Two weeks earlier, the credit rating agency Standard & Poors had downgraded Greek sovereign debt to junk status (BB+), pushing its two-year bond yield to 10% and the ten-year bond yield to 19%. Unable to finance operations, and without a pledge of support from within the European Union (EU), Greece had approached the International Monetary Fund for a bailout On May 2, the EU agreed on a 110 billion euro support package, but markets were not allayed. Six days later, the EU Council of Ministers convened in order to approve a stabilization mechanism that would provide a more robust response to the Greek debt crisis.

Also attending was European Central Bank (ECB) Vice President Lucas Papademos. The ECB formally dealt with monetary policy, not issues of fiscal solvency. But, unlike other EU institutions, the ECB could act quickly, since it already had the authority to purchase sovereign debt. In this case, it was contemplating a purchase of 60 billion euros in sovereign debt that would be heavily weighted toward Greece. Doing so would also support a core purpose of the bank. To the extent that the Greek debt crisis drove a contagion that undermined confidence in Spanish, Irish, or Portuguese sovereign bonds, it could threaten the very existence of the euro. The ECB's formal objective was to maintain price stability within the Eurozone, and that presumably extended to defending the euro itself.

Yet the risks of such a move were also significant. At the European level, a bailout for Greece would send a signal to other indebted member states that the ECB would step in if private lenders became nervous. Confidence in ECB support could lead to reckless spending. The moral hazard problem also applied to EU policymakers. Any move by the ECB to diffuse the Greek debt crisis could take pressure off of national finance ministers to negotiate a robust political response that would help to manage fiscal over-runs in member states over the longer term.

Finally, intervening posed risks for the BCB itself, The core function of any modern central bank was price stability, Achieving this required that they push against the economic minds: loosening policy when growth slowed and tightening as enthusiasm built, Former U.S. Federal Reserve Bank chairman William McChesney 1artin explained that his role was to "take away the punch bowl just when the party starts getting interesting." Because this was frequently unpopular, any central bank therefore required insulation from political pressures. This sort of insulation bad been built into the governing structure of the