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Dilemma of the President of ECB
Would you like to be in the shoes of the President of the European Central Bank (ECB) Mr. Trichet? I believe the answer of those who follow the recent developments would be no. Do you know now many times he retracted from a statement he made and even had to do the exact opposite during the crisis? I do not know exactly, but it certainly is a lot.
The last one was announced by the economics news channels in a scrolling text. I do not remember the quotation completely but it read "the ECB is and will be independent". It was quite funny.
The plan the senior European Union (EU) leaders signed hurriedly in the weekend was welcomed with joy by the markets. Major stocks markets fueled big time. But in only 24 hours the joy was replaced with anxiety. What was the plan, really? What did the €440 billion part of the total €750 billion of the package imply?
This is the question everyone has been trying to answer since the announcement of the package. But one thing is clear: Despite Trichet's initial statements stating the opposite, the plan foresees the ECB will purchase the bonds issued by states in trouble. This responsibility assigned to the ECB was presented with fancy sentences like "provided that the liquidity dries and market fail to fulfill their functions". But this does not change the essence of the matter.
Years ago in 1981 an academic article with the title "Some Unpleasant Monetarist Arithmetic". The journal the article by Sargent and Wallace was published in was also interesting: the academic journal of the Federal Reserve Bank of Minneapolis. The article underlined that in a country where the level of public debt varies at high levels and thus the state borrowing interest rate is considerably high, the central bank would face a dilemma if it sought to implement tight monetary policy without taking into account the weaknesses of the fiscal policy. Even if the Bank tightened the monetary policy, the weakness of the fiscal policy would eventually require the loosening of the monetary policy. Otherwise, the state would be dragged into bankruptcy. In short, the central bank in question could not implement an independent monetary policy, or to put it differently maintain its independence.
In years, unpleasant monetarist arithmetic have changed shape and evolved into the concept "fiscal dominance". But the essence was preserved: it has always been a universal fact that a monetary policy in contradiction with the fiscal policy will not be sustainable. Loose fiscal policy could have been combined with tight monetary policy only temporarily.
As you might remember, it was due to this fact why the Central Bank of Turkey used to issue statements that emphasized fiscal discipline following the 2001 crisis. The crisis in the EU has brought this bare fact to light. What is more interesting is that the concepts "unpleasant monetarist arithmetic" and "fiscal dominance" are well known by macroeconomists and central bank officials. However, it now appears that in the Eurozone which relies on "one monetary policy and many fiscal policies" fiscal policy options must be limited upon sharp rules and the states failing to meet the rules must be punished. Ostensible rules that do not impose any sanctions will otherwise demolish the Euro. This should be the top item in the "to do" list of the EU.
This commentary was published in Radikal daily on 13.05.2010