ECB's Dangerous Game?

Here is an odd thing. The EU summit failed to produce a credible plan for fiscal union. The ECB did not become the "lender of last resort" as economist's believe is necessary to end the crisis. Yet, the roof did not fall in and the panic has ebbed. With no political or monetary intervention to calm the markets, the Euro has muddled on through another week.

What has happened? Perhaps Mr Draghi has not been as invisible as I previously thought. The ECB did inject liquidity into Europe's struggling banks. That seemed to be a response to the freezing up of interbank lending which could have led to a new credit crunch. It seems to have done something else. The liquidity has found its way to the bond markets easing the pressure on Italy and other peripheral governments.

Coincidence? Or conspiracy? There is a fascinating analysis of ECB policy on Vox, published before the summit. It claims that, far from being a weak central bank unable to do what its peers can by guaranteeing government debt, the ECB is using its political independence to play a very political game.

The ECB is a full-blooded political actor engaging in a strategy aimed at forcing EU political leaders to embrace fiscal rectitude and a quantum leap forward in European integration.

The allegation is that Mario Draghi is using the crisis to force reform on reluctant governments. The ECB is doing just enough to keep their economies from collapse but not enough to get the market off their backs. In fact it wants the markets to keep the pressure on. Comparing the ECB approach to military strategy the article claims:

Its philosophy is that you never offer your opponent certainty (by pre-committing to buy all Italian debt at 5% yields, for example). Rather, you constantly seek the dislocation of your opponent’s mind until this dislocation (10-year interest rates above 6-7%) renders the delivery of a decisive blow practicable.

Indeed the article alleges that the ECB played a part in the ejection of Mr Berlusconi from office.

The implications of this analysis are profound. Are democratic governments being undermined? What legitimacy has the ECB for acting as a political player? Who decides on the policy agenda of the ECB and who can hold it to account?

Apart from legitimacy, is its policy correct? By backing a particular theory which puts supply side reform above addressing the deficiency in demand, is the ECB pursuing the wrong policy? That is one danger if the ECB is playing a political game: that it may be pursuing a disastrous policy.

Another danger of the ECB's alleged political role lies in the implementation of the policy. Could the ECB make the fine judgements necessary to keep the bond markets on edge without starting a bank run that would ruin us all?

Source: Jacob Funk Kirkegaard, The next strategic target: De Gaulle’s EU legacy, Vox, 30/11/2011