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The role of the ECB in the eurozone crisis

The European Central Bank (ECB) is an institution of the EU. It has a number of purposes, among which are to:

  • Ensure price stability by keeping inflation in check, particularly in countries that have adopted the euro as their official currency
  • Ensure financial stability in the EU by ensuring that financial institutions and markets are properly supervised

The ECB works closely with the central banks in all 27 EU member countries. Collectively, the ECB and these member central banks form the European System of Central Banks (ESCB).

The ECB also oversees the tight co-operation between central banks in the 17 EU countries that have adopted the euro as their official currency, the so-called eurozone countries.

The bank achieves its objectives by, among other means, controlling the supply of money in the eurozone and determining key interest rates. The ECB also has the task of controlling the eurozone’s foreign currency reserves and of buying and selling individual currencies as required to keep exchange rates within reasonable limits. Central banks in the eurozone must obtain authorisation from the ECB to issue euro banknotes.

The European Financial Stability Facility (EFSF), on the other hand, is an autonomous vehicle created on 9 May 2010 by the 27 countries comprising the EU, with the specific aim of combating the European debt crisis. The EFSF is funded by the issue of bonds, which are in turn backed by the individual member countries in proportion to their share in the capital of the ECB.

The ECB and the eurozone crisis

As mentioned earlier, setting key interest rates is an important tool in the ECB arsenal. In an economic downturn such as that currently being experienced by Europe, it makes sense to lower interest rates in order to try and stimulate the economies of the individual member countries. This is exactly what the ECB did; at one stage it dropped its refinancing rate from 4.25% to 1% over a period of only six months.

In 2009 the bank also did something that many consider to be against the spirit, if not the letter, of the 1992 Maastrict treaty; it embarked on the so-called ‘purchase programme for covered bonds’, whereby it directly bought a limited number of government bonds from eurozone member countries that urgently needed financial assistance.

The ECB and the EFSF

So far there has been strong resistance from eurozone member countries, Germany in particular, against the ECB becoming directly involved with the EFSF, despite numerous calls that the EFSF should be converted into a bank, allowing the ECB to issue it with a line of credit.

The latest picture

At the EU summit held on 8/9 December 2011, it was decided to make an additional €200 billion available to the IMF to enable this institution to help out member countries that needed a bailout. It was also decided to leverage the EFSF, effectively increasing its capital to €1 trillion.

Another important decision was to move towards a system whereby there will be a certain measure of control over the fiscal affairs of member countries, which is partly why Britain was not prepared to sign the agreement.

Market reaction

See the daily chart of the EUR/GBP exchange rate below. If we look at what happened since the EU summit ended on 9 December, it is quite clear that few really believe the eurozone has found a permanent solution to its problems. In fact anyone entering into a long trade on the euro right now will have a difficult time rationalising it later.

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Published: 16 December 2011

You should under no circumstances consider the information and comments provided as an offer or solicitation to invest. This is not investment advice. The information provided is believed to be accurate at the date the information is produced.

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