Outsourcing Financial Stability: the ECB and Cyprus

I have just finished revising a paper on the ECB's learning from the Japanese crisis management in early 2000s. The important lesson of that episode is that the shift to market-based finance confronts central banks with a trade-off between financial stability and institutional stability defined through central bank independence. To fight liquidity spirals, runs on repo and pro-cylicality induced by shadow bankign activities (as large in Europe as in the US), the central bank must abandon independence understood in the most narrow, and politically sensitive, definition of severing links with government debt markets. The traditional lender of last resort approach cannot address the systemic risks generated by market-based finance.

This matters immensly for understanding the ECB's choices since the crisis.

It is important to remember first that the ECB has no explicit mandate for financial stability of the Euro-area. European Treaties, and the ECB's institutional design, are built on the premise that national governments can, and should, provide financial stability. That design reflects a flawed theoretical assumption in pre-crisis mainstream macroeconomics that central banks could pursue price stability alone, and that would ensure financial stability. The mea-culpas from other central banks across the world, including Ben Bernanke, can be stil heard if one listens carefully. This is why those central banks abandoned indepedence and directed their considerable fire power at preserving the stability of a financial system with new sources of systemic risk.

In contrast, the ECB has played a more dangerous game that simultaneously increased its political power and financial instability. By its own addmission, the Enhanced Credit Support, and then the LTROs, outsourced financial stability to the banking sector - with fingers crossed that delevraging banks would want/be able to perform such a function. That the strategy ultimately failed became clear when Draghi announced that it would do whatever it takes (the OMT) to stabilize market-based finance. But the OMT did not solve the trade-off between independence and financial stability in the same manner that other central banks did. The OMT instrument has been designed as an  escape clause from the 'no-debt monetization rule', and the ECB gained greater political powers as a non-indepedent arbiter to impose costs (conditionality) and to verify compliance.

So the Cyprus moment is just another episode in the long struggle of the ECB to use the crisis in order to cement its power while abdicating an essential central bank function. That such a paradox is possible testifies to how dangerous this institution has become to the European project. Outsourcing financial stability to the Russian government or to the political willigness of a small country to tax the big players (those with large deposits) is a risk no central bank should take. Fingers crossed over the weekend.