How to restore trust in the ECB

When Mario Draghi takes office on November 1, he will face tough choices. Should he be more “German” than the Germans or more “Italian” than the Italians? Should he increase or lower rates? More fundamentally, should he continue or discontinue the European Central Bank’s bond purchasing programme? Failure to steer the right course amid formidable obstacles could very well lead to the end of the euro; to a melt-down of the financial system and a severe recession; or to an end of German support for the ECB and the euro. The new ECB president will have to square the circle.

Regaining trust in debtor and creditor countries will be of central importance. Public trust in the ECB and the euro has drained away in the last three years: Eurobarometer data show it has fallen by more than 40 percentage points in Germany, Greece, Ireland, Portugal, Spain and the Netherlands. In France, it was and remains low. In countries under financial assistance programmes, trust has fallen because of the role the ECB played in their formulation. In Spain, the combination of fiscal austerity and rate increases has added to a sense of desperation about growth prospects. In creditor countries, trust has fallen because the ECB is seen as departing from its core mandate. In Germany in particular, the ECB’s bond purchasing programmes and the tough stance on restructuring have been deeply unpopular. A number of steps should be taken.

First, a significant rate cut is needed to help stabilise activity in the euro area as a whole and ease the impact of the necessary fiscal austerity in the eurozone periphery. Economic activity is cooling and inflation measures are falling, with inflation swap spreads at 1.9 per cent on a two-year horizon. Core inflation has been even lower in the euro area as a whole. In addition, growth in monetary aggregates has been very weak. The incoming president should lower rates rapidly once more negative figures become visible. In doing so, he needs to communicate clearly and openly, in particular to the German public, that the rate cut is a response to falling euro area inflation expectations. Such a step will also help to regain trust in the so-called periphery countries as it will help to boost growth and adjust balance sheets.

Second, the new president must find the right middle ground as regards the bond purchasing programme. While it is true that only the ECB can ultimately stabilise the bond market when there is a run on large countries, the conclusion cannot be that the ECB buys bonds without rules. Financial markets have focused on some countries for a reason and market pressure is indeed helping to foster much delayed reforms. The best way forward would be to clearly anchor market expectations by announcing a rate at which the ECB would intervene. Moreover, a clear policy rule is needed that divides the work between the European Financial Stability Facility, which has primary responsibility for stabilising the bond market after Thursday’s decision, and the ECB.

Third, the ECB will have to continue monitoring the implementation of reforms. The bold reforms promised are necessary, and the Commission has been given prime responsibility for monitoring them. But as long as the ECB is part of the game, it will also have to monitor and push for action. Only a clear message from national and European policymakers can stop the current dangerous capital outflows. However, the ECB has only limited time to do this, as it will lose trust and support if it is too involved in national policies. Ultimately, conditionality cannot be imposed by the common central bank. The incoming president must therefore advance Jean Claude Trichet’s calls for a eurozone finance ministry with democratic legitimacy, that is in a position to follow up on structural and fiscal reforms.

Trust in the ECB will return with a successful resolution of the problems. The last European summit has laid the foundations for a resolution of the main Greek problem, and the ECB is contributing to a solution. The incoming ECB president must further restore trust by stabilising the bond market, where the EFSF’s firepower reaches its limits, while avoiding moral hazard. A combination of clear rules for intervention as regards interest rates, and tough conditionality, will be needed as long as the eurozone lacks the necessary institutions, in particular a eurozone finance ministry, to ensure its survival.

Guntram Wolff is the authors of the policy contribution Changing of the guard - Challenges ahead for the new ECB president

A version of this column was also published in the Financial Times