Global Economics

Why the ECB Can't Fix Europe


The European Central Bank's powers are limited, and its efforts could be undermined by the chaotic response of EU governments to the turmoil over the last week

The European Central Bank joined the United States Federal Reserve and other major central banks in cutting key interest rates by half a point on Wednesday in a concerted move to stabilize financial markets and avert recession, but the ECB's power to stem the financial crisis in Europe is limited, economists say.

The cut brought key interest rates down to 3.75 percent in the euro zone and to 1.5 percent in the United States, the banks said in a surprise announcement that followed a dramatic slump in world financial markets this week. The Bank of England also cut its key rate by half a point.

It was the ECB's first rate cut in more than five years and the move echoed the coordinated rate cuts on Sept. 17, 2001 in the aftermath of the 9/11 attacks.

The cooperation among central banks contrasted with a divided response to the crisis from European governments this week which has undermined investor confidence and highlighted chronic weaknesses in Europe's financial architecture.

The Frankfurt-based ECB, guardian of the euro and responsible for setting interest rates for the 15-nation euro area, has been keeping the continent's financial system afloat with cash injections into the money market which has been at risk of drying up because banks are increasingly unwilling to lend each other money.

"The confidence is out of the system and you can quite clearly see that in money market interest rates and in turnover in the money market. The banks no longer trust each other," said Thorsten Polleit, chief German economist at Barclays Capital in Frankfurt.

Economists say the ECB has effectively replaced the money market, where banks trade money in overnight and other short-term loans to remain liquid.

It has been supplying tens of billions of euros via so-called "quick tenders" for money. And banks have been parking any surplus funds with the ECB rather than lending it to each other.

The reluctance of banks to lend each other money is reflected in an increase in interest rates for interbank loans—the key three-month Euribor, the euro inter-bank-offered rate, reached 5.377 percent on Tuesday, the highest level since late 1994.

Taxpayers' Money Is Key

Technically, the ECB can go on propping up the money market in this way indefinitely, and there's nothing to stop it continuing to cut interest rates aggressively. But the general loss of investor confidence that is causing the dramatic slump in share prices and putting banks in trouble can only be solved by pledging taxpayers' money to rescue major banks, economists say.

"The ECB is effectively the money market now," said Dario Perkins, senior European economist at ABN Amro in London. "Banks can get as much money as they need from the ECB so that in itself isn't the problem. In theory it can do that as long as necessary."

"The question is whether that's enough to stop these broader problems in financial markets. Clearly the evidence is that it isn't if you look at what's happening to bank share prices and broader equity markets."

Europe's chaotic response to the escalation of the crisis over the last week has highlighted an inherent weakness in the continent's financial system that central bankers have warned about ever since the launch of the ECB in 1999.

The independent ECB can dictate monetary policy by determining the price and supply of money for 320 million citizens, but it has no say over the disposal of taxpayers' money, which is in the hands of individual nation states and is the key to solving the crisis.

Central bankers never tire of exhorting EU governments to rein in their budget deficits and coordinate their fiscal policies to avoid imbalances in the system.

But despite decades of integration, the EU remains a bloc of sovereign states with separate tax and spending regimes that make it very hard to reach pan-European agreements.

Europe Less Well-Equipped than US to Fight Crisis

As a result, Europe is inevitably less well-equipped than the United States to tackle the financial crisis, economists say. The US last week agreed a $700 billion package to bail out America's banks.

"The history of these kinds of crises in Europe is that governments typically do disagree, they rarely come to coordinated agreements and you get this fairly inefficient solution," said Perkins at ABN Amro.

"There are very different philosophies in Europe about how you deal with these problems. You're never going to get the kind of coordinated policy response that you have in the US."

Scott Livermore, director of international macro forecasting at Oxford Economics, a leading economic consultancy in Britain, said: "Where Europe has been lacking is that they have no contingency plan at the moment and we're adopting this piecemeal."

"The problem is that if Europe is hit as hard as the US was there is no contingency plan in place, and in such a crisis you need to have a rapid response. You can say what you like about the US rescue package, it may or not be the best approach but it is there and something is happening."

Part 2: U-Turns and Vague Pledges

The actions by Europe's governments over the last week have failed to inspire confidence, as slumping equity markets show.

First the leaders of Europe's top four economies Germany, France, Britain and Italy failed to agree on a common plan at a mini-summit in Paris at the weekend.

Then German Chancellor Angela Merkel made a surprise policy U-turn by announcing an unlimited state guarantee for all private German bank deposits on Sunday, a move that sparked confusion and put governments across Europe under pressure to follow suit to prevent their nation's banks from suffering a competitive disadvantage.

On Tuesday, EU finance ministers issued a vague pledge that EU governments would not allow "system relevant" financial institutions to fail, a statement that seemed aimed at masking the absence of a pan-European approach.

"It's very important when one makes announcements such as issuing a bank deposit guarantee to be precise. Vague ad hoc announcements can sow confusion," said Polleit at Barclays Capital.

"I think it's important that politicians do more to consult people who operate in financial markets and who know how expectations gets translated into market prices. I think the crisis management now requires not just bureaucrats but experts."

Everyone for Himself

Despite all European pledges to take joint action, the underlying message this week has been that every EU nation will sort out its own mess itself. Fresh evidence of that approach emerged on Wednesday when Britain announced plans to inject up to £50 billion ($87.2 billion) into its biggest retail banks.

The country's top banks suffered a share slump this week in which some lost nearly half their market value amid investor fears they could collapse. "Extraordinary times call for bold and far-reaching solutions," British Prime Minister Gordon Brown said.

Holger Schmieding, chief economist for Europe at Bank of America, said Europe was likely to come up with effective answers to the crisis, but that it would take time.

"I'd say it's a bit more difficult for Europe to get out of the crisis than it is for the US because there are different national responses to the crisis. It takes longer in Europe but things are going in the right direction. The measures taken won't end up differing much from country to country."

"There is a certain convergence process, almost everyone is thinking about deposit guarantees and almost everyone is pledging to bail out domestic banks with government support."

Schmieding said Europe didn't need a pan-European fund to tackle the crisis, and that such a move would be difficult to implement anyway. "Taxes are a very national affair, the top prerogative of national parliaments. That makes it very difficult in practical terms and politically to set up a European fund."


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