Responsibility of the ECB in managing the European debt crisis: towards a European banking union?

Author:Papasavvas, Charalambos
Position:European Central Bank
  1. Introduction

    The financial crisis broke out in Europe in 2008 following a sovereign debt and banking crisis. It is now affecting the whole region having detrimental social and political effects on the citizens of Europe as well as economic effects on its common currency and banking system. EU policy makers have struggled to find adequate responses to the crisis. Within this context, the European Central Bank (ECB) has and continues to be a crucial player but also one with questionable legitimacy. The Bank today fronts the most far-reaching and crucial reforms in the Union after the introduction of the common currency. The Bank is the central actor in the creation of a European Banking Union. As with most of the newly introduced European reforms the Banking Union is a project born in connection with crisis management efforts. It will place all European banks under the auspices of the ECB and subject them to common regulation and supervision as well as to a common resolution mechanism. This article understands this initiative as part of a broader attempt to combine monetary integration with political integration. For the most part, the proposal for a Banking Union has given rise to positive reactions but there are problems. The ECB has adopted measures for which the legitimacy has been seriously challenged. It is confronted with a dilemma between legitimacy on the one hand and effectiveness in dealing with the crisis on the other. Will the Banking Union ease these problems or will it exacerbate them? This article constitutes a discussion of the above issues while providing a detailed historical and institutional background of the ECB and its response to the crisis so far. The paper proceeds as follows: Section 2 constitutes a short introduction to the Union's economic and monetary history and introduces the main institutional aspects of the ECB. Section 3 presents the major dilemma between effectiveness and legitimacy that the ECB is currently confronted with. The main argument is that the Union's constant refusal to understand the Bank as a political actor (as opposed to merely a body of technocrats) has ended up undermining the legitimacy of the Bank and monetary union. Section 4 proceeds with a discussion of the ECB's role and response during the crisis. This section serves as an introduction to the need for the creation of a Banking Union. Sections 5 and 6 deal with the difficulties inherent in the relevant proposal while they argue that the Banking Union may be a key initiative in striking the desirable balance between legitimacy and effectiveness in the actions of the ECB. However, it is argued that the Banking Union is itself not immune from legitimacy challenges (section 7). The final section (8) concludes that while the Banking Union is an important step towards the resolution of the crisis in the region at the same time the ECB must be very cautious to preserve its legitimacy and remain within its mandate as prescribed by the Treaties.

  2. European Monetary and Economic History

    2.1. The EU and ECB: Pre-crisis era

    The ECB was established on 1st June 1998 and was charged with the responsibility of establishing a single monetary union for the member countries of the EU. (1) Its launch was the result of a process of economic and monetary integration that began in the 1950s with the combined efforts of Jean Monnet and other European political actors. The process acquired vital impetus with Jacques Delors' committee report of April 1989 which recommended the establishment of a European economic and monetary union.

    The report of Delors' committee proposed three stages for economic convergence in Europe. Stage one which commenced in 1990, was characterised by open cross-country capital flow and convergence of central banks of member countries. Stage two began early in 1994 and was marked by the introduction of ECB's predecessor namely of the European Monetary Institute (EMI). EMI was established to strengthen the individual central banks and to foster integration and coordination of monetary policies. Stage three which began in 1999 was characterised by the fixing of individual currency conversion rates and ultimately by the introduction of the Euro which would be managed by the European System of Central Banks (ESCB). (2)

    The initial mandate of the ECB was to supervise and manage price stability in the Eurozone. The ECB's delineation of price stability must take account of the entire Euro area therefore price stability is analysed on the basis of the cumulative price level within this zone. Thus, changes in the monetary policy cannot be framed by addressing only a nation or multiple nations. The policy frame must apply uniformly on the entire Eurozone. Further, the monetary policy of the ECB must target the medium term (3)

    The ECB monetary policy understands the sustainability of price stability as the key element through which improved standards of living and economic conditions are to be achieved. Sustaining price stability guarantees that price levels remain equitable, thus increasing consumer welfare and boosting the overall economy. It also alleviates the risk premium on investments within the Eurozone while raising incentives for investors to bring more credit to the Euro industries. A stable and sustainable price level will disincentivize hedging activities and prevent any disturbances to the overall economic growth.

    Before the crisis, the ECB undertook its task in a satisfactory manner as inflationary targets were constantly met. Accordingly, the Bank's reputation was strong and so was confidence in the European banking system.

    2.2. The EU and ECB: Post-crisis reactions

    The significant expansion of the ECB's mandate came as a result of the intensification of the problems surrounding the single currency in 2010. (4) Today, not only has the ECB provided banks with liquidity and launched government bond purchasing programmes; it has also become a member of the Troika. (5) The latter development means that the ECB participates actively in the formation and monitoring of macroeconomic adjustment programmes (economic conditionality programmes). (6)

    The financial recession affected large parts of the region and notably the Union's (and Eurozone's) southern Member States. (7) This region was already confronted with serious financial problems and with significant national sovereign debts. In some cases those were triggered by bank bailouts such as in Spain and Ireland. (8). The cases of Greece and Cyprus put the final nail in the coffin of a strong Eurozone and robust currency. Those countries inevitably turned to the Union and its institutions for financial assistance.

    2.2.1. Cyprus: An example of the inadequacies of EU's response

    Cyprus was struck by the crisis as a result of its banking system being disproportionate to the size of the country's economy. (9) This made it difficult for the country to rescue its largest banks. This example of disproportionality between banking sectors on the one hand and national economies on the other is typical of various Eurozone countries (e.g. Luxembourg, Malta, Ireland). (10) Secondly, the example is indicative of the inadequacies of the Union's and Eurozone's response. In reaction to the Cypriot crisis both the EC and the ECB introduced restrictions on capital and payment flows. Such a development is open to question if not borderline illegitimate as it does not comply with article 63(1) of the TFEU which establishes the principle of free movement of capital. (11)

    Further, the effects of setting aside the terms of deposit guarantees has been characterised as inappropriate and undesirable not merely on legal grounds but also based on practical considerations. A number of authors have argued that such a development was bound to counteract the restoration of confidence in banks when it was much needed. (12) Most importantly, the case of Cyprus is emblematic of the thinking of major political actors and serves as a reason to reconsider how the EU will strengthen its banking system.

    2.3. Institutional Aspects of the ECB

    The legal foundations for a centralised and unitary monetary policy are framed in the various treaties of the EU and its institutions. The ECB was established to regulate, implement and monitor the monetary policy throughout the EU. In 1999, eleven national banks acceded to the ECB. Later, another six EU Member States joined the ECB as participants. The current seventeen members take active part in framing the monetary policy for the EU. The two decision-making bodies that help to frame the monetary policy of the ECB are the Governing Council and the Executive Board. The monetary policy is framed by the Governing Council and implemented by the Executive Board.

    New members entering the ECB relinquish their domestic exchange rate policies in order to implement the ECB policies as laid down by the Governing Council. They are free to maintain their fiscal policy mechanisms but face legal obligations laid down in a series of EU Directives and Regulations. These usually refer to the preservation of stability within the Union through strict adherence to the rules. For example, the Stability and Growth Pact based on articles 121 and 126 of the TFEU is a series of legal measures enacted to coordinate national fiscal policies. The reforms were enacted through a number of secondary legislation instruments known as the Six Pack. (13) The Six Pack, inter alia, creates the mechanism of a centralised form of monetary policy while allowing for a decentralised fiscal policy with certain limitations.

    To summarise, the ECB's monetary policy is primarily aimed at preserving the Euro's purchasing power by securing price stability within the Euro zone. This mandate is found in both the primary and secondary legislation of the Union. However, the Bank significantly broadened its mandate as a result of the financial crisis yet the decision-making processes of the...

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