Economics

The day the ECB lost its last credibility

January 14th 2011 is the day on which the Greek government ultimately would have failed. Only extreme interventions by the ECB, breaking former promises, are holding the Greek government afloat. On January 14th, Fitch downgraded Greece from BBB- to BB, a rating considered junk status. Fitch was the last of the big three rating agencies after S&P and Moody’s that had rated Greece above junk.

The ratings are essential for governments because of the collateral rules of the European Central Bank (ECB). When governments spend more than they receive as tax revenue, they issue government bonds. These government bonds are bought by the banking system because banks can use government bonds as collateral for new loans from the ECB. This mechanism is explained in detail in my book The Tragedy of the Euro. The ECB does not accept just any kind of security or government bond as collateral for its valuable loans. The ECB wants some quality, and requires a minimum rating by one of the three rating agencies for these securities.

During the financial crisis the ECB had lowered the required minimum rating for its open market operations from A- to BBB- in order to help out banks because the rating of securities, especially mortgage backed securities, were falling. The reduction was supposed to be an exception and was to expire at the end of 2010.

The uncertainty of Greece’s rating triggered the sovereign debt crisis in 2010. Due to budgetary problems, Greece was in danger of losing the minimum A- rating. What would happen in 2011 when the minimum rating would be raised back to A- and Greece’s rating would not meet this requirement?

The market started to have doubts about Greece’s being able to repay its debts. And it was feared that the ECB would stop financing the Greek deficit indirectly. If the ECB would stop accepting Greek bonds as collateral for loans, no one would buy Greek bonds. The government would have to default on its obligations.

In January 2010 Jean-Claude Trichet, ECB president, still maintained a hard money rhetoric:  “We will not change our collateral framework for the sake of any particular country. Our collateral framework applies to all countries concerned.”

Market participants interpreted this statement as a pledge that the ECB would not extend the exceptional reduction of the required minimum rating to BBB- just to save the Greek government. Along the same line, chief economist of the ECB, Jürgen Stark, stated in January that markets were wrong in believing that other member states would bail Greece out.

As Greek problems intensified in March 2010, Trichet, in contrast to his January statement, announced that emergency collateral rules would be extended through 2011. Greek bonds regained the potential to serve as collateral.

Yet, the Greek situation was worse than central bankers had expected. Markets started to believe that Greece would even fail to meet the BBB- rating in 2011, an expectation that finally became reality on January 14th with the downgrade by Fitch. They continued to sell Greek bonds.

In May 2010 at the height of the debt crisis, the independence of the ECB began evaporating when it announced it would drop all rating requirements for Greek government bonds. The ECB would accept Greek bonds as collateral no matter what. Only by this measure does the ECB continue to accept junk rated Greek bonds as collateral.

By contradicting its previous approach and becoming an executor of politics, the ECB lost its credibility. The ECB presented itself more and more as the inflationary machine—in service of high politics—that had been intended by French and other Latin politicians.

From the beginning, the Euro has been a political project. In order to save the project, the ECB disregarded its mandate of price stability and changed its collateral rules to accommodate the bailout of Greece. Far from being a copy of the Bundesbank that during its history repeatedly dismissed inflationary wishes of politicians, the ECB proved to be an instrument of politicians toward a centralization of power in Europe.

In 2011 we are at a decisive moment regarding the future of the European Union. Either the EU takes a leap forward toward a strong centralized European state, or we will move towards more freedom as competition is fostered. The ECB has shown on which side it stands.

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