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GLG: Italy and Greece deserve a central bank

December 7, 2011

Guest contributors Bart Turtelboom and Karim Abdel-Motaal run the Emerging Market strategy at Man GLG. The views expressed are their own.

History is written by the victors. That is what emerging markets discovered after their currency crises of the 1990s, and it is what will happen when the annals of the euro crisis are compiled. Treatment of this crisis has varied, but in all its forms the basic premise is already set: Germany and the world are the undeserving victims of Peripheral European excess.  The Periphery spent and borrowed too much causing the current crisis.  Add to this the cultural imagery of Greek pensioners retiring at the tender age of 55 on exotic Aegean islands at German savers’ expense and the colourful chapter on this historical saga is written.

If Emerging Markets is any guide, the problem with this narrative is not just that it is wrong, but downright dangerous in its policy implications.  The tyrannical hold of this perspective on European policy making is pushing the continent down the path of a historic pro-cyclical fiscal contraction almost as the be all and end all of crisis response.  There is already a mountain of evidence that this has not worked, whatever the merits of debt reduction and ideological divisions on its pace and timing.  The missing ingredient has always been and remains today, quite different.  Italy and Greece lack a central bank.  More importantly, they deserve one, desperately.

For an economy where paper money is the medium of exchange and fractional reserve banking exists where a bank transforms a unit of deposits into a multiple of that in loans, a central bank is essential.  This is as true of Switzerland as it is of Greece.  It performs a function of lender of last resort to prevent a rapid run on an otherwise solvent bank (a liquidity crisis) from turning into a solvency one for that bank or for the entire banking system.  When Italy and Greece signed onto the Euro, they had a legitimate right to expect that the Central Banks they were giving up would be replaced by a common Eurozone one, which would in effect perform the same function for their economies.  What they got instead was a Central Bank which is constrained by mandate, and German objection to its modification, from performing that function for anyone but Germany.

In the Eurozone, not only are the ECB’s clients the member state banks, but also the sovereigns.  We are in the advanced stages of a full blown and contagious run on both, with the ECB for all intents and purposes on the sidelines.  Whatever support it has provided so far in the guise of purchases of distressed member state debt and bank liquidity provision has been trivial in relation to the size of the run, and communicated in such a tentative way as to aggravate it, by signalling impotence.  The ECB’s absence, whatever its legal justifications, has effectively reduced Italy and Greece, not to mention the Eurozone, to the status of a barter economy.

Italians and Greeks can and should justifiably ask for redress.  They did not give up their Liras and Drachmas to be put through a fiscal vice as the cost of the most basic central banking services being provided them, any more than U.S. states did for the same service from the Federal Reserve.  The lender of last resort function is a relatively uncontroversial one, which has little to do with ideological debates about the desirability or effectiveness of active monetary policy or with Weimer Republic-induced phobias of hyperinflation and money printing.  The idea, that in the middle of a full-blown bank/sovereign run, a central bank’s intervention would be made conditional on preceding actions, fiscal or otherwise, that are subject to political vagaries, is extraordinary and dangerous.

A confidence crisis is precisely that; it cannot wait and must be dealt with decisively and conclusively if the vicious cycle is to be arrested.  This is not to say that the fiscal and debt problems which challenged confidence to begin with should not be addressed; they should.  However, in this European version of the Emerging Markets archetype, we are in now well beyond the phase where a medium term fiscal adjustment announced by technocratic governments in Greece or Italy will have any effect.  It maybe part of the solution, but it is certainly not sufficient, or the most urgent issue.  The ECB needs to act and act big.

Periphery Eurozone states have a legitimate existential grievance that has gone essentially unnoticed in the current crisis narrative.  They were not admitted into the Eurozone merely out of German altruism.  Germany may pretend otherwise but it derives a clear benefit from not having Italy and Spain devalue at its expense, as they used to with regularity in the past.  For these countries to be condemned to a decade-long common monetary policy, where rates were set to suit larger economies like Germany, and subsequently a global financial crisis, where their right to a lender of last resort function is denied, is laughable.  In fact, the fiscal union altar on which the ECB and bailout is conditional is itself a canard.  Both Germany and France were in violation of the Stability Pact 3 percent budget deficit rule and conveniently gave themselves exemptions.  Spain today has a public debt to GDP ratio some 20 percentage points below Germany’s.

This is not a story of German benevolence and peripheral European excess.  It is a story of extraordinarily poor institutional design, for which a read of Emerging Markets history might be instructive.  Italians and Greeks should demand that the ECB start acting like their central bank, and have its legal framework modified if need be to do so.  Their argument should be simple, if it does not, it will become nobody’s central bank, because there will no longer be a Eurozone.


I agree completely! This is a fantastic article. If only policy-makers in Europe would listen. Unfortunately, we can be pretty sure they won’t. Now that Europe is ruled entirely by right-wing governments, fiscal responsibility is not really in the cards.

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