As the new year began, good reason arrived to expect relief in Europe’s financial crisis. The European Central Bank (ECB) signaled that it had jettisoned its former hands-off policy and begun, at last, to support European financial markets. The remarkable nature of the change drew only a few headlines and even less commentary, but it deserves more. ECB help is crucial. Only Europe’s central bank has the financial wherewithal to ease the panic over sovereign debt. Its new willingness to provide needed liquidity, if it continues, as it seems it will, can do more to stabilize markets than any number of Merkel-Sarkozy embraces or agreements.
Liquidity, of course, cannot answer all the continent’s needs. Europe’s problems run deep. Governments need to rethink not just their fiscal policies but their political-economic frameworks. The European Union (EU) may ultimately need to rethink the structure of its common currency, the euro. But by relieving markets of the waves of panic they have suffered periodically during the past two years, ECB liquidity can buy the stability Eurozone nations need to carry out their longer-term, more fundamental reforms.
Until the recent shift, European monetary policy actually compounded the continent’s financial problems. Claiming that its narrow charter forbade it to intervene on behalf of governments, the ECB left the Eurozone’s finance ministries on their own. It refused to contribute to the fund Germany, France and others designed to relieve default concerns. While national borrowers scrambled for funds, faced unsupportable financing costs and threatened default, the ECB in early 2011 actually raised benchmark interest rates twice for a total of 50 basis points. It further curtailed liquidity by restricting the growth of reserves in Europe’s banking system. And it slowed the pace of monetary expansion, for instance, reducing the annual growth rate of Europe’s narrow, M1 definition of money to a mere 2% to 3% for most of 2011, too slow to meet normal economic needs much less offset the liquidity lost in the crisis.
For half of 2011, the bank could believe that the zone’s governments could deal with the problems of the relatively small, financially insignificant economies of Greece, Ireland and Portugal. But in August, when investors began to flee the bonds of much more sizable players Spain and Italy, the central bankers could see that the crisis had outstripped the resources of the Eurozone’s finance ministries. Still hiding behind a facade of reserve, the ECB at last began to quiet markets, buying Spanish and Italian bonds in secondary markets. The bank followed that initial move in November and December by reversing its previous rate hikes. It took its biggest step as 2011 ended, offering European banks 489 billion euros ($640 billion) in low-interest loans. This European brand of quantitative easing both injected liquidity directly into markets and helped banks recapitalize after the losses of 2010 and 2011.
The ECB will need to do more. Europe’s problems demand a special liquidity flow in excess of 1 trillion euros. But the recent policy shift would seem to signal that the central bank is ready at last to do what is necessary, to do for Europe what the Federal Reserve did for U.S. markets and U.S. financial institutions after the 2008-09 financial crisis. ECB officials will, of course, continue to avoid interventionist rhetoric. They will refuse to say the words “quantitative easing,” even as they embrace its fundamentals. As they do, the new policies will offer investors more stable markets in 2012 than they have enjoyed since this crisis began in 2010 and breathing room for them to assess whether Europe’s government will use the relief to deal with their more fundamental problems.
Milton Ezrati is senior economist and market strategist for Lord Abbett & Co. and an affiliate of the Center for the Study of Human Capital and Economic Growth at the State University of New York at Buffalo.