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Central banks are not omnicompetent after all. For the past eight months, the European Central Bank and US Federal Reserve have nudged western economies towards recovery – the former by countering worries about the eurozone’s stability, the latter through open-ended “quantitative easing”.
Why, then, could the ECB not stop the crisis in Cyprus, one of the eurozone’s tiniest members, from spinning out of control and posing significant risks to the financial market recovery story?
The ECB was closely involved in drawing up the rescue package for the Mediterranean island that created alarm about bank customers being hit in the future across much of southern Europe, and called into question eurozone leaders’ commitment to correcting construction flaws in Europe’s 14-year-old monetary union.
Two aspects of the ECB’s role are striking. First was its threat to bring down the Cypriot banking system if a deal was not reached – which jarred with the assurance last July by Mario Draghi, president, that the ECB would do “whatever it takes” to preserve the eurozone’s integrity (a pledge that accounts for much of the subsequent global equity rally).
Nicos Anastasiades, Cypriot president, revealed that the ECB had threatened to revoke approval for billions of “emergency liquidity assistance” provided by the national central bank, which would have led to “a complete collapse with a possible exit from the euro”.
If his account is correct, the ECB took a harder stance than with Ireland or even Greece, subject of earlier bailouts, where it preferred deliberate “constructive ambiguity” – leaving unclear exactly what it would do if a package was not agreed.
Second was the ECB’s failure to stop Cyprus trying to finance its part of the rescue plan by imposing a levy even on bank deposits smaller than €100,000, the level supposedly guaranteed under a cross-EU pact. Throughout the eurozone crisis, the ECB has understood likely market reactions; it would have realised the incendiary consequences of such a step.
Of course the ECB was in an acutely difficult position; funding the bailout involved terrible choices, a way out had to be found. But the ECB could have insisted on higher levies on deposits above €100,000. Not only is it an enthusiastic backer of a European banking union, which would eventually include common deposit protection; as an unelected institution, it has to worry about its reputation and popular legitimacy.
Instead, Cyprus has become the latest political misstep in the eurozone crisis. Back in early 2010, Jean-Claude Trichet, then ECB president, had to overcome German hesitancy in dealing with Greece, which allowed its debt woes to become an existential eurozone crisis.
Later that year, eurozone leaders unintentionally let the crisis escalate after announcing at a summit in Deauville, France, that in future bailouts private sector investors would bear a greater burden. Last year, the ECB failed to prevent eurozone leaders forcing losses on Greek government debt holders, which led to the region’s crisis flaring yet again.
Generally, setbacks have occurred when German policymakers’ rules-based thinking and insistence on risk takers paying a price for mistakes has clashed with short-term crisis management imperatives, with the conservative Bundesbank often leading the resistance.
Under Mr Draghi, who took over as ECB president in November 2011, such difficulties appeared to have eased. The “outright monetary transactions” programme put in place last year, by which the ECB could buy the debt of distressed eurozone governments, has been effective in calming market worries about a eurozone break up – even without a single bond being bought – because of backing from Berlin.
One explanation for why the ECB failed to prevent the Cyprus crisis escalating could be that Mr Draghi took his eye off the ball. Talks last Friday night were left to Jörg Asmussen, the former German finance ministry official who sits on the ECB’s executive board.
Another, perhaps more plausible explanation, is that the politics and arithmetic of Cyprus’s banking and financial problems were simply so intractable that the ECB judged any outcome would be unsatisfactory – but that the improvement in financial markets since last July would prevent contagion effects becoming catastrophic.
So far, that has been the case. This week’s sell-off in European equities has been limited, and European sovereign bond markets have largely shrugged off the threat to eurozone financial stability: after all, eurozone leaders did honour their pledge that Greece’s debt rescheduling would not be repeated.
But Cyprus is a reminder of the shakiness of the eurozone’s turnround and the limits of central banks’ powers.
The writer is the FT’s capital markets editor
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