Time for International Monetary Coordination

(forthcoming on Voxeu.org)
Many observers of the European Sovereign debt saga had long realized that the ECB was the only European institution up to the task of avoiding a breakup of the Euro, as all newly forged institutions, the ESFS/ESM, were at the same time ill designed and inadequately funded. However, by indulging in sharp criticism of Germany piece-meal approach, too many seem to forget that the ECB was created “in the image and likeness” of the Bundesbank, with price-stability as its core mandate. That was the price to be paid in for convincing Germany to give up the DM, and to share the same currency with inflation and deficit prone Italy. Now that the survival of the Euro seems to hinge on the monetization of Southerners’ public debt, one way or the other (primary or secondary purchases, anti-spread firewall), it is not surprising that Bundesbank, backed by the FDP and CSU parties, is simply saying “no”. Weidman’s alleged demission just proves the case.

Draghi thus has a problem: not so much with Bundesbank, which does not command a majority in ECB’s Governing council, but with Angela Merkel, who cannot afford to risk a crack in her coalition government by granting her internal opponents such a precious ally (the Bundesbank) and such a popular accusation, to take side with the Italian “money forger”, in the words of CSU general secretary, against the German people. Now it seems that Mrs. Merkel also understand that if she doesn’t, she risks being remembered as the leader who buried the Euro, at quite a large cost for the German tax payers. How to break out of this dilemma?

So far Draghi has been trying to fence off these political tensions by paying lip service to the conditionality attached to a program of government debt purchase (the Memo of Understanding whose details are already specified in the EFSF statute). This is unlikely to do the trick. A more reasonable strategy would be to present the problem for what has now grown into: a risk to the global economy, no longer a European problem. The reason is clearly the negative impact on global growth (see the recent IMF World Economic Outlook Update) and on unemployment in Europe and the US, not to mention the potentially global disruptive effect of a disorderly default in Spain and Italy. The Bundesbank may find it more difficult to renege on her international responsibilities.

A global problem requires a global solution. Recent episodes of international policy coordination go back to the late seventies when at the Bonn Summit in 1978 the G7 leaders agreed on an ambitious (and successful) plan for fiscal and monetary coordination in order to reduce US trade deficit vis à vis Germany and Japan: fiscal reflation in Germany, tax cuts in Japan and a moderate monetary tightening in the US did the trick. One of the most recent example of successful policy coordination among central banks was that of October 2008, when the Federal Reserve, jointly with five other major central banks–the Bank of Canada, the Bank of England, the ECB, Sveriges Riksbank, and the Swiss National Bank (SNB), and the Bank of Japan expressing support, announced a reduction in its policy interest rates (see Bernanke). The intervention had a double motivation: to contrast the economic slowdown of their respective economies, in the absence of inflationary pressures, and to address the shortage of dollar financing outside the US, as European institution who had been lending to US non-financial institutions and buying ABS were badly hit by the subprime crisis.

Today, the scope for international fiscal cooperation more limited: it is time for another round of monetary policy coordination, with the ECB (or the ESFS) committing to keep sovereign debt yields within “reasonable” bands, possibly with joint interventions of other Central Banks, and the Fed engaging in a new round of unconventional operations in order to reduce long term yields. This strategy would hopefully yield relevant economic gains, and, this time, large political dividends.