Why the ECB Is Not Going to Ride to Europe's Rescue

Markets appear to have high hopes for this week’s summit meeting in Europe to begin putting an end to the financial crisis.

European Central Bank
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European Central Bank

Yet there’s ample reason to believe the market’s hopes will be dashed again.

Specifically, it seems unlikely that whatever is agreed to this week by leaders will be sufficient to prompt the European Central Bankto wield the proverbial bazooka that markets await so desperately.

There are many complicated, legal and technical reasons why this is likely true, but there’s also a simple one: Germany is not going to allow the ECB to make an unlimited commitment to buy bonds of European governments.

This idea was repeated to me in meetings with German officials in Berlin and Frankfurt last week — the ECB is not the answer, however much markets say it’s the necessary and only solution.

The German strategy at this point is two-fold: First, put as much pressure on governments now to fix their deficit problems, so that markets see the troubled countries are clearly on improving fiscal paths. Letting the ECB backstop troubled sovereigns would take the pressure off governments, countering the German’s own strategy.

Second, work for long-term changes to the European Union treaties, for example, allowing deficit violators to be sued in the European Court of Justice in the hopes of avoiding such problems in the future.

These changes eventually — one day in the distant future — allow the ECB to backstop either individual sovereign issues or a Eurobond. But it's not going to happen this week or next month, maybe not even next year.

Several times I heard comments such as this one from an official: “The bazooka requires ignoring of the German constitution and the (EU) treaty.” Neither the Merkel government nor the Bundesbank, as far as I can tell, has any intention of ignoring either. The obvious implication: unlimited ECB purchases will require changes to both before they can happen.

Which is not to say that rules can’t be bent. Already the ECB has purchased $200 billion of bonds. There was speculation among German market participants I spoke with that the number could be quietly increased to $300 billion or $400 billion. But remember, even that first $200 billion was so controversial that it prompted the departure of two German officials from the ECB.

There's also talk of lending from individual central banks to a fund controlled by the International Monetary Fundthat could be used to lend to troubled countries. The idea itself is troubled in a variety of different ways, but what I heard is that the Bundesbank would not support such a fund if funded only by European central banks and meant only for European countries. It could, however, support a regular IMF program designed for all IMF members.

The German solution is actually simple. First, they say the Italian debt problem isn’t really that bad. They point out that when Italy entered monetary union a decade ago, it spent 10 percent of its budget on interest costs. Today, that ratio is closer to 5 percent.

Second, they point out that Italian wealth per capita is actually higher than that of Germany. So Italy has the means to solve its sovereign debt problem, and Germany believes that the new Monti government has far more ability to convince markets of its credibility in lowering the deficit than the Berlusconi government ever did.

Third, they want to push toward “limited but precise” treaty changes that would allow countries who violate existing fiscal rules to court to enforce changes.

To be sure, I spoke with several people who believe the strict interpretation of the German constitution or ECB rules will not carry the day. Tomas Mayer, chief economist at Deutsche Bank, suggested that the ECB would eventually be forced to come into markets in a big way over the objections of the Bundesbank. Another official believed that consensus on the ECB could be found for a larger role by pegging it to the idea that the bank has responsibility for price stability and can act to make sure there is a single monetary policy in the euro zone. The argument is that sharply different interest rates across the continent mean sharply different monetary policies.

I’m skeptical of both lines of thinking. First, I believe the leadership in Germany is wary of any acts that will commit the ECB to financing individual nations’ deficits and committing their own citizenry to the future liabilities of those nations.

Second, I think the ECB could do some additional sovereign debtpurchases, but it is almost unthinkable that it would commit to unlimited purchases without the Germans. If it did, it would not be hard to imagine that the Germans would be the first to leave the euro zone.

All of which raises questions about what the U.S. government wants Europe to do. Treasury Secretary Tim Geithner is headed to Germany and the rest of Europe next week essentially to urge the Europeans to erect a firewall against a sovereign debt meltdown. But in a briefing with reporters last week, a senior Treasury official would provide no specifics for what the source of the firewall’s funds would be. Is the U.S. government urging the Europeans to violate their own treaties or constitutions? If not, how exactly does Geithner propose the firewall be created if not with additional guarantees from fiscal authorities?

Geithner would do well to take account of the popularity of the Bundesbank in Germany, quite in contrast to that of the U.S. Federal Reserveat home. More than once it was said to me, “All Germans may or may not believe in God. But they all believe in the Bundesbank.”