Merkel Cautions Central Bankers
German Chancellor Angela Merkel caused a stir when warning the European Central Bank not to engage in asset purchases. She has received a lot of attention as it is an unwritten rule not to infringe upon the independence of central bankers. While we would typically agree that the independence of central bankers is of paramount importance, we believe it is not only appropriate, but also her duty to speak out. Let us elaborate.
As a backdrop, it is the primary role of central banks to ensure price stability. To achieve price stability, central banks traditionally control money supply or the cost of credit available to the banking system. This is referred to as monetary policy. Part of the role of central banks is to "take away the punch bowl" when the party is getting out of hand. Central banks are given independence so that they can take the tough measures necessary, possibly to induce a recession, to focus on their mandate to promote price stability. In the U.S., the Federal Reserve (Fed) has a dual mandate, namely to also pursue a policy promoting maximum sustainable growth; in Europe, the ECB has a "single needle" as ECB President Trichet likes to call it, to pursue price stability.
When Merkel speaks out, there are two dimensions to consider, one fiscal and one monetary. On the former, central banks throughout the world have veered into fiscal policy by engaging in specific asset purchase programs. That's outside of the mandate of central banks and Merkel is doing the only right thing by warning that such policy must be reversed. The ECB recently announced it may start buying "covered bonds", mortgage backed securities popular in Germany. The purchase of covered bonds ought to be a fiscal, not a monetary decision, as a specific sector of the economy is supported. The reason for central banks to engage in these types of programs is that such "credit easing" as Fed Chairman Bernanke likes to call it, is a targeted stimulus, possibly less costly than trying to provide liquidity to the banking system as a whole. However, we have questioned the value of such programs as they tend to substitute, not encourage, private sector activity as prices are driven to levels where rational players may want to abstain.
More importantly, asset purchase programs are also highly problematic as they are extremely difficult, if not impossible, to unwind. Securities purchased tend to have maturities measured in years, not days. In practice, we do not see how it is possible to ever resell such securities in the market. There are numerous ways that have been proposed to "sterilize" such purchases, but - in our view - all proposals have fundamental flaws. That means, central banks engaged in asset purchases, the Fed in particular, may dig themselves into a corner, unable to mop up liquidity when economic growth resumes. Substantial inflation may be the result.
Just as importantly, when central banks veer into fiscal policy, they invite political backlash. Watch this unfold in the U.S. - Wednesday's testimony by Fed Chairman Bernanke in the House Budget Committee was already far more acrimonious than in the past. It comes with the nature of meddling with fiscal territory - the Fed ought to find a way out from such policies, fast. The ECB should not veer into such territory.
The other is a monetary issue - is too much money being printed? This is open to argument; however, as far as Germany's economy is concerned, it can stomach a recession far better than Anglo-Saxon economies, as Germany's economy has less leverage. It is therefore absolutely in Germany's interest to err on the side of caution. Again, the primary role of a central bank is not to support growth, but to ensure price stability. It is more than appropriate for a politician to speak out when central bankers are at risk of veering from their mandate.
The ECB's policy makers will not be rocked by the comment of the Chancellor, although I very much hope the ECB listens. And it is not so much about the fight between the offices, but in the ECB's interest to stay on track to pursue sound monetary policy. Some say Merkel's comments may drive a transatlantic wedge into policies just when greater coordination is needed. That gives Merkel too much credit - that process started about 6 years ago and is breaking into the open now. The ECB has long showed more restraint; Trichet and his predecessor Wim Duisenberg have long made it clear that they prefer suboptimal growth and possibly a recession over the expansionary policies pursued by the Fed. Giving Merkel credit for the divergence does not give credit to the ECB.