This Week in the Euro Area

by Jacob Funk Kirkegaard

Peterson Institute for International Economics
May 20, 2011

While much of the financial world has focused recently on the upheaval at the International Monetary Fund, a series of other events in Europe this week brought additional uncertainty to the circumstances surrounding the continuation of the Greek bailout program after 2012. A cacophony of opposing public statements is inevitable when multiple democratically elected policymakers and a genuinely independent central bank are engaged in a zero-sum game. But recent events have marked a low point in the European Union’s ability to manage even minimum message discipline. It is increasingly evident that the euro-group ought to find a new leader and public spokesman who masters the art of keeping quiet when there is obvious deep-seated disagreement among the key policymakers about how to proceed.

It is evident that the European Central Bank (ECB) is vehemently against any type of Greek restructuring at present. Because its Governing Board wields control over its collateral policy—i.e. it can reject collateral from individual issuers (like Greece)—it quite possibly has the ability to block policymakers’ attempts at implementing any type of Greek restructuring, at least temporarily.

The ECB apparently remains too worried about the immediate effects of any restructuring of Greek debt on the still precarious European banking system, and also about the risk of contagion to Spain and Italy from undermining the "risk free status" of euro area sovereign debt. As long as this remains the principal concern of the ECB, given its pivotal role in maintaining financial stability in the euro area, policymakers’ options look severely restricted. This is a true display of supra-national independent central banking!

But if you assume that its opposition to restructuring arises from of contagion effects, the ECB’s opposition will not likely last indefinitely. Indeed, if it did, the ECB would be saying in essence that private sector creditors would always be bailed out fully in the euro area. That of course would present financial markets with untenable incentives and guarantee that the next crisis arrives soon.

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