Editor’s note: This column first appeared as a chapter in the VoxEU eBook “Hawks and Doves: Deeds and Words – Economics and Politics of Monetary Policymaking”, available to download here.
Since the beginning of the euro area crisis, euro area governments have experienced greater fiscal stress than governments of advanced economies outside the euro area with comparable or weaker fiscal fundamentals (De Grauwe 2011, Orphanides 2017b and references therein). What has been the source of this fragility? How does it relate to the role of the ECB in exerting fiscal discipline in the euro area? How can it be corrected?
The cause of the instability in euro area government bond markets can be traced to a discretionary decision taken by the ECB Governing Council before the crisis, in the aftermath of the failure of the Stability and Growth Pact (SGP) – the mechanism of the Maastricht framework meant to ensure fiscal discipline by euro area governments. The decision effectively delegated the determination of collateral eligibility of euro area government debt to private credit-rating agencies and subsequently led to the compromising of the safe asset status of government debt. This chapter sheds light on the circumstances of this unfortunate decision and discusses how its consequences can be ameliorated with appropriate use of the ECB’s discretionary authority, in accordance with its mandate.1
The demise of the Stability and Growth Pact
A prerequisite for the success of the economic and monetary union is a framework that can ensure sound fiscal policies by the governments of member states. The SGP was adopted in 1997, before the introduction of the common currency, as the pillar meant to provide incentives to the member states to maintain fiscal soundness. It required governments to contain fiscal deficits to be at most 3% of GDP and to work towards keeping government debt below 60% of GDP over time. The SGP failed in 2003, when the French and German governments first violated its provisions and subsequently successfully demonstrated that they could block its enforcement, rendering it meaningless. By March 2005, the demise of the SGP was sealed when EU governments formally adopted reforms that weakened the pact (Eijffinger 2005, Buiter 2006).
Without a credible mechanism to ensure sound fiscal policies by the member states, the long-term success of the monetary union was under threat. Following the failure of the SGP, financial markets became more important as a means of discouraging member state governments from running excessive deficits. If fear of default on government debt could be cultivated in financial markets whenever governments with high debt ran excessive deficits, holders of government debt would demand an additional credit premium. Although this would unnecessarily raise the cost of debt finance for governments, it could also discourage fiscal profligacy. In this manner, market discipline could potentially replace the role of the SGP as a mechanism for securing fiscal soundness in the monetary union.
Market discipline and the ECB collateral framework
The operational framework of ECB monetary policy blunted the potential role of market discipline. Similar to the treatment of government debt issued by their governments in any other central bank, when the euro was adopted the ECB accepted the government debt of all euro area member states as eligible collateral for credit operations. Financial institutions holding the debt of any euro area government could obtain liquidity from the ECB to finance their holdings by posting the debt as collateral. This ruled out the possibility of liquidity pressures on any euro area government and, since the SGP assured long-term debt sustainability, there was virtually no market discrimination among the government debt of euro area member states. The government debt of all euro area member states was considered a safe asset. This was appropriate also in light of the favourable treatment of government debt that had been hardcoded into the regulation of banks and pension funds.
In the context of the demise of the SGP in March 2005, the ECB faced criticism for not using the discretionary power relating to its collateral framework in a manner that would leverage market discipline. At the press conference following the 7 April 2005 meeting of the ECB Governing Council, President Trichet was asked to comment on the view that the ECB framework hindered the market instead of helping the market “reward sound public finances and punish unsound finances”. In his response, Trichet reiterated that it was imperative to restore the SGP’s credibility and stressed that “every institution has to be up to its responsibility, and this is truer than ever”. With respect the ECB’s collateral framework, he noted that: “… it is not the intention of the Governing Council of the ECB to change our framework now”. (ECB 2005.) Speeches by ECB Executive Board Member Otmar Issing on 20 May 2005 and ECB Vice President Lucas Papademos on 3 June 2005 followed up on this issue. Papademos (2005) observed: “… it has been suggested that the ECB’s collateral policy could encourage market reactions to fiscal policies, for example, by imposing haircuts for bonds issued by governments that fail to comply with the SGP”. While acknowledging that such proposals might appear appealing, both Issing and Papademos expressed their disagreement, and Issing (2005) explicitly called these suggestions “misguided”.
Using the collateral framework of the ECB as a disciplining device could be seen as being inappropriate on several grounds. As Papademos summarised: “The purpose of the ECB’s collateral policy is to ensure sufficient availability of collateral to allow a smooth implementation of monetary policy and to protect the Eurosystem in its financial operations. Using the framework for alternative purposes would be contrary to the ECB’s mandate.”
Article 18 of the Statute governing the ECB authorises the institution to conduct credit operations “with lending being based on adequate collateral”. The determination of what constitutes “adequate” collateral is left to the discretion of the ECB Governing Council. When the euro was created, the eligibility of government debt was beyond questioning; it was inconceivable that the ECB would use its discretion to declare that the government debt of a member state was not “adequate” collateral, absent extreme circumstances that rendered that state’s debt unsustainable. The ECB also decided to accept private assets as eligible collateral, provided that these assets met “high credit standards”. Since the list of eligible collateral included tens of thousands of private assets, the ECB took into account available ratings by private credit-rating agencies in its assessment of these assets. By declaring some private assets, but not others, to be eligible collateral, the ECB powerfully demonstrated its discretion in determining the meaning of “adequate” collateral in its credit operations.
Credit ratings, the cliff effect, and the euro area crisis
As 2005 progressed, the consequences of weakening the SGP on fiscal finances became increasingly evident. About half the member states ran afoul of the rules. The criticism directed at the ECB for not using its collateral framework as a disciplining device continued. In early November 2005, the ECB communicated a drastic change to its collateral framework. Collateral eligibility for all assets, including government debt, would be subject to a minimum credit-rating threshold. The policy change was immediately recognised as the ECB’s response to the weakening of the SGP, an attempt to cultivate market discipline by punishing governments that were perceived as more likely to follow loose fiscal policies (e.g. Atkins and Schieritz 2005, Barrett 2005, Curtin 2005). With this decision, the ECB effectively communicated that it had decided to use the discretionary authority relating to its collateral framework as a disciplining device against member states governments.
The decision to tie collateral eligibility to credit-rating thresholds created the potential for a destabilising cliff effect, thereby precipitating a crisis. During a panic, fears of downgrades and potential default would become self-fulfilling if investors projected that the ECB would refuse to accept government debt as collateral even for member states with sound fiscal fundamentals. The loss of eligibility could lead to an unnecessary credit event. In light of the potential multiplicity of expectational equilibria in sovereign markets, the credit-rating threshold would guide markets to adverse outcomes for “weaker” member states. In the monetary union, investors would scramble to replace lower-rated debt – seen as more likely to fall off the edge of the eligibility cliff – with higher-rated debt, which would remain eligible. The demand for euro-denominated government debt would shift away from states perceived to be “weaker” to states perceived to be “stronger”, inducing an indirect transfer in the form of a risk premium for “weaker” states and a safe haven subsidy for “stronger” ones. In a panic, declaring government debt as ineligible collateral merely on the basis of private credit ratings rather than on the basis of fundamentals, would virtually inevitably lead to crisis.
The force of the potential instability created by the ECB in 2005 became evident during the Global Crisis but was only fully realised following the October 2010 agreement reached in Deauville by the French and German governments. The Deauville agreement implied that if a euro area member state faced liquidity difficulties, capital losses would be forced on investors holding the debt of that state, even if the debt was sustainable. Given the ECB policy to deny collateral eligibility even for governments with sustainable fundamentals when credit-rating agencies downgraded a sovereign below the minimum threshold, the Deauville agreement successfully injected unnecessary default risk in most euro area sovereign markets, thus compromising the safe asset status of government debt. While the French and German governments later pulled back from the automatic imposition of default, the demonstration of how the ECB collateral framework could be used to precipitate default has sustained an elevated credit default risk in financial markets for “weaker” euro area member states relative to other advanced economies with similar or worse fiscal fundamentals.
Can the damage be reversed?
The ECB’s decision to use its collateral framework as a disciplining device following the demise of the SGP in 2005 was unfortunate. In retrospect, the misgivings that had been expressed in May and June of 2005 by Issing and Papademos proved justified. Their analysis already suggested a fundamental legitimacy problem with the subsequent ECB actions. As Issing had pointed out: “[I]t is clear that the design of the Stability and Growth Pact and its implementation are governmental responsibilities, to be controlled by parliaments. . . . [I]t is not and cannot be the ECB’s role to enforce fiscal discipline and to correct shortcomings in the implementation of the Stability and Growth Pact. Attempting to do so would politicise the ECB’s operations and ultimately threaten its independence, on which the credibility and effectiveness of monetary policy crucially rely.” Using the ECB’s collateral framework as a disciplining device is contrary to the ECB’s mandate.
In accordance with the Treaty, enforcement ought to be left to the European Commission and the member states of the European Union and the euro area. The ECB should suspend its earlier discretionary decisions that have effectively converted its collateral framework to a disciplining device. The ECB should discontinue delegating the determination of collateral eligibility of government debt to private rating agencies. The ECB has the responsibility to independently determine whether government debt of euro area member states is “adequate” collateral on the basis of fundamentals- based debt sustainability analysis. The ECB can make a positive contribution towards stabilizing the fragility of the euro area by focusing on its mandate.