Doubts about the European Union’s latest agreement to resolve the bloc’s debt crisis continue to roil financial markets. The so-called fiscal compact, agreed upon last week in a bid to tighten budget rules among the 17 countries using the euro, will take at least six months to put into place, and even then it will serve mainly to minimize the risk of future crises. In the meantime, EU countries are sending mixed signals about their willingness to deliver €200 billion in fresh loans to the International Monetary Fund, money that would boost the fund’s crisis-fighting firepower in the near term.
And so market participants are keeping a close eye on the European Central Bank, the only institution with the capacity to stem a crisis and supply the flow of liquidity to hard-pressed governments and banks. Yves Mersch, governor of the Banque Centrale du Luxembourg, knows the terrain as well as anyone. As director of the Luxembourg Treasury, he served as the country’s chief negotiator of the Maastricht Treaty on European Union, which laid the groundwork for the launch of the euro. And as central bank governor, he has held a seat on the ECB’s governing council since its founding in 1999, longer than any of his colleagues. He spoke with Institutional Investor International Editor Tom Buerkle at the central bank’s offices in Luxembourg.
After the original Greek package in May 2010, European policymakers thought they had the debt problem fixed, but over the next 18 months we’ve seen one crisis after the other. How did Europe get to this point?
If you look at what the ECB said and wrote at that time, I think the gap between what we said was necessary and what is now being proposed, took, unfortunately, one and a half years to close; and still the question is whether this will be fully sufficient. So the answer is very clearly, a great difficulty to live up to reality and to get rid of a state of denial where 10 to 15 years of mispricing of risk has brought us.
Now, I wouldn’t say that in each and every case what we see today in the markets would be fully justified. The reforms that have been undertaken in a certain number of countries go far beyond what has been undertaken in some other countries, like the U.S. or U.K. Sooner or later, this will be reflected in the fundamentals. So if you look at the medium- to long-term, you see that Europe is doing reform and Europe is also laying the basis for a stability-oriented environment.
The ECB has called for a quantum leap toward fiscal union. How do you define that?
First, one where you would still have a decentralized functioning of the national budgets, but where the spillover effects of negative fiscal behavior on neighbors would be able to be reined in. And therefore you would need a more rules-based system; more automaticity and not scratching each other’s back. You also would probably need an institution that would be in charge of defending the interest of the euro. You would need people to follow each national situation. In case of a breach, you would need to develop know-how, which presently does not exist, like the IMF has in presenting conditionality.
Markets want to see the ECB step in to cover that gap between today’s arrangements and the institutional setup you’re talking about. Is the ECB prepared to do that?
Our limits are we have to act in a way that is compatible with a market economy. Our aim is to act in a way that is compatible with price stability over the medium-term, and our aim is to have our markets being financed by our banking systems. These three guidelines will be at the beginning and at the end of our thinking. [That seems to leave scope for doing rather unconventional policy.] There is scope. The ECB has in the past shown that it is able to react rapidly and also to react in an innovative way, if need was there. But we again are guided by our statutes, our treaty, our objectives. Those are the principles that guide us.
There are critics who say that the Central Bank’s single-minded focus on price stability could kill the euro. Is that a fair criticism?
If we present ourselves as you depicted it, then it would be fair, but it’s not like that. First, we have a definition of price stability that is a symmetric one, and that is not only to have price stability below 2 percent, but close to 2 percent. We are committed in both directions.
Second, we are not worried by the present level of inflation, which measures the past. We are considering price stability over the medium run. Over the medium run, we know that the development of HICP [Harmonized Index of Consumer Prices] will be much more in line with our definition of price stability than it is right now.
All analytical evidence that is at our disposal, not only from our internal staff analysis but also from private-sector analysis, is not pointing to a medium-term deflationary environment that would be hugely destructive for social welfare.
Is there a risk that the euro, a device that was meant to bring Europe together, could actually drive it apart?
Obviously, the union only lasts as long as people believe in this idea. Ultimately, as with every political project, it’s a question of willingness to live together. This is the first of the definitions of a nation, the willingness to live together.
I do not have any doubt that the euro area will survive. We have in Europe more than just the belief in an idea and in trade. I think the people in the center of Europe are aware that history commits us to more. We have a long history in Europe of trying different models of governance. We had the model of 350 small states. It did not work. We had the model of large countries trying to forge unions and holy and unholy alliances. It did not work. We had the attempt of one country forcing itself upon all the others. It did not work.
What we did after World War II is a new approach, a mixture of all what we had experienced before. You are quite right to say, “Will it work?” After all, one could have asked the same questions about the U.S for a long period. At least you must acknowledge that the newest model that we have endorsed is a model that, in terms of peace, has been working quite well. But in the end, it’s up to the people to decide whether they want to participate and we see that still today, so many countries in Central Europe are just waiting to join and to enter. Even among those who riot or who protest, many do not want to leave. That’s a contradiction.