The future of Europe hung in the balance at the battle of Waterloo in 1815. The British, led by the Duke of Wellington, held Napoleon’s Grand Armeé to a standstill, waiting for General Blücher and his Prussians to add their weight to the battle. Without his Prussian allies, the best the Duke could expect was an inconclusive outcome that would prolong the fighting. With them, Wellington could end Napoleon’s dreams of empire. As it turned out, Blücher arrived toward the end of the day and tipped the scales against the French. Europe could look forward to peace and stability.
The future of Europe again hangs in the balance, not because of the forces of empire but because of the threat of financial chaos, and all are looking for a latter-day Blücher. The European Central Bank (ECB) could and should play this role. It is the only party with the necessary financial resources to reliquefy markets and calm them. But the bank’s leadership shows remarkably little commitment, certainly less than the Prussians and the British did that Sunday in June 1815.
The ECB’s abilities were on display late last year. During much of Europe’s debt crisis, the bank had taken a hands-off attitude. And in early 2011, when Europe’s periphery desperately needed credit and could not get decent terms, the ECB actually raised rates twice for a total of 50 basis points. But last August, as matters reached extremes and investor concerns spread from Greece, Ireland and Portugal to the much larger economies of Italy and Spain, Europe’s central bank realized that matters threatened the zone’s cohesion and the euro’s existence. It took action, buying Italian and Spanish bonds in secondary markets. Markets calmed immediately. Long-term Italian and Spanish bond yields fell by 100 basis points in short order.
The ECB then extended its support, reversing the rate hikes it put in place during the first half and offering 1 trillion euros in subsidized three-year loans to recapitalize Europe’s banks. Confidence in the ECB’s support allowed markets to withstand last winter’s Greek refinancing, a matter that had caused near panic earlier and no doubt would have again, if not for the presence of an active ECB. Spanish yields, for example, fell throughout last year’s fourth quarter and this year’s first quarter, for a total of 300 basis points.
But after this sudden burst of effort, Europe’s central bankers stepped away again. ECB President Mario Draghi announced earlier this spring that the bank had “done enough.” Market concerns intensified almost immediately. Without that reliable source of liquidity, investors and traders worried about Spanish bank capital and the political backlash against austerity that was so apparent in Europe’s recent elections. Spanish bond yields retraced their earlier fall, rising to exceed 7%, and Italian bond yields reapproached the highs of last summer. Although markets are reacting to more than the ECB’s renewed aloofness, an active bank with the willingness to provide needed liquidity would have helped quiet markets. That fact was evident last month, when Draghi’s comment that the ECB stood ready to support the relief offered by the eurozone’s governments brought on a temporary rally. Moments after he made his remark on June 15, Spanish and Italian bond yields fell more than 15 basis points.
Given Europe’s needs and the ECB’s critical importance, it is a wonder the bank has not been more active. Sometimes ECB officials reference legalisms to explain the bank’s reserve, but from a policy standpoint, there is nothing that should hold it back. Even its mandated focus on inflation offers no impediment to an easier stance. Consumer prices in May registered only a 2.4% rise over the previous 12 months, down from the 2.6% increase recorded in April, which itself was hardly a threat to the ECB’s 2% target. Since money growth in the zone is miniscule and liquidity continues to shrink, policy makers have no reason to worry that liquidity injections would lead to future inflation. The zone's narrow M1 definition of money has risen less than 2% during the past 12 months and expanded hardly at all over the last six months. On this basis, there is a greater threat of disinflation or even deflation than that of inflation. Yet the ECB remains aloof.
If the ECB were to act with half of Blücher’s vigor in 1815, it would ease the current crisis considerably. But even given the bank’s strange behavior, it’s still likely that it will act in a pinch. After all, the ECB provided liquidity the last time matters reached extremes, in 2011. Europe must know by now that the bank offers the only secure answer to its crisis concerns. What is more, the situation poses an existential threat to the institution. If the zone falls into financial chaos, the euro could cease to exist, and without a euro, there is no need for a European Central Bank. With such a powerful motivator and for all these other reasons, the bank is more likely to act ultimately than stick to its renewed hands-off approach. Until it does, the uncertainty in Europe and emanating from Europe will continue to plague markets.