Why the ECB Can't Fix Europe 1

by David Crossland

The European Central Bank joined the United States Federal Reserve and other major central banks in cutting key interest rates by half a point on Wednesday in a concerted move to stabilize financial markets and avert recession, but the ECB's power to stem the financial crisis in Europe is limited, economists say.

The cut brought key interest rates down to 3.75 percent in the euro zone and to 1.5 percent in the United States, the banks said in a surprise announcement that followed a dramatic slump in world financial markets this week. The Bank of England also cut its key rate by half a point.

It was the ECB's first rate cut in more than five years and the move echoed the coordinated rate cuts on Sept. 17, 2001 in the aftermath of the 9/11 attacks.

The cooperation among central banks contrasted with a divided response to the crisis from European governments this week which has undermined investor confidence and highlighted chronic weaknesses in Europe's financial architecture.

The Frankfurt-based ECB, guardian of the euro and responsible for setting interest rates for the 15-nation euro area, has been keeping the continent's financial system afloat with cash injections into the money market which has been at risk of drying up because banks are increasingly unwilling to lend each other money.

"The confidence is out of the system and you can quite clearly see that in money market interest rates and in turnover in the money market. The banks no longer trust each other," said Thorsten Polleit, chief German economist at Barclays Capital in Frankfurt.

Economists say the ECB has effectively replaced the money market, where banks trade money in overnight and other short-term loans to remain liquid.

It has been supplying tens of billions of euros via so-called "quick tenders" for money. And banks have been parking any surplus funds with the ECB rather than lending it to each other.

The reluctance of banks to lend each other money is reflected in an increase in interest rates for interbank loans—the key three-month Euribor, the euro inter-bank-offered rate, reached 5.377 percent on Tuesday, the highest level since late 1994.
Taxpayers' Money Is Key

Technically, the ECB can go on propping up the money market in this way indefinitely, and there's nothing to stop it continuing to cut interest rates aggressively. But the general loss of investor confidence that is causing the dramatic slump in share prices and putting banks in trouble can only be solved by pledging taxpayers' money to rescue major banks, economists say.

"The ECB is effectively the money market now," said Dario Perkins, senior European economist at ABN Amro in London. "Banks can get as much money as they need from the ECB so that in itself isn't the problem. In theory it can do that as long as necessary."

"The question is whether that's enough to stop these broader problems in financial markets. Clearly the evidence is that it isn't if you look at what's happening to bank share prices and broader equity markets."

Europe's chaotic response to the escalation of the crisis over the last week has highlighted an inherent weakness in the continent's financial system that central bankers have warned about ever since the launch of the ECB in 1999.

The independent ECB can dictate monetary policy by determining the price and supply of money for 320 million citizens, but it has no say over the disposal of taxpayers' money, which is in the hands of individual nation states and is the key to solving the crisis.

Central bankers never tire of exhorting EU governments to rein in their budget deficits and coordinate their fiscal policies to avoid imbalances in the system.

But despite decades of integration, the EU remains a bloc of sovereign states with separate tax and spending regimes that make it very hard to reach pan-European agreements.
Europe Less Well-Equipped than US to Fight Crisis

As a result, Europe is inevitably less well-equipped than the United States to tackle the financial crisis, economists say. The US last week agreed a $700 billion package to bail out America's banks.