Everyone knows central banks are powerful. When I used to visit Alan Greenspan\u2019s office back when I worked for the Fed, he had a sign that said \u201cThe buck starts here.\u201d As powerful tools go, there\u2019s nothing that quite beats the power to print money.<\/p>\n
So it goes without saying that ECB President Mario Draghi\u00a0is powerful.\u00a0 He decides how much money is printed in Europe and what the cost of borrowing that money will be.\u00a0 But dig deeper and you\u2019ll find that the ECB exerts far more control over events in Europe than the Fed does in the US.<\/p>\n
For example, the ECB played a key role in the downfall of Italian Prime Minister Silvio Berlusconi. Since 2010, the ECB has had a program in which it can buy government bonds to help lower a country\u2019s cost of funding.\u00a0 When Italy\u2019s bond yields rose to dangerously high levels in August 2011, the ECB intervened to buy Italian bonds but also sent a\u00a0letter<\/a>\u00a0to Berlusconi demanding budget cuts and far-reaching reforms.\u00a0 When Berlusconi failed to act with sufficient haste, the ECB eased off on its bond purchases, yields rose again to dangerously high levels and Berlusconi was forced to\u00a0quit<\/a>.<\/p>\n More obscure than the bond-buying program but far more powerful is the little-known \u201crisk control framework<\/a>\u201d.\u00a0 Normally, the ECB is willing to provide loans to banks as long as they can pledge assets that are listed on its \u201celigible collateral list\u201d.\u00a0\u00a0 However, the risk control framework allows the ECB to deny credit to any bank or reject any assets as collateral should it see fit.\u00a0 Specifically:<\/p>\n the Eurosystem may suspend or exclude counterparties\u2019 access to monetary policy instruments on the grounds of prudence<\/p><\/blockquote>\n and<\/p>\n the Eurosystem may also reject assets, limit the use of assets or apply supplementary haircuts to assets submitted as collateral in Eurosystem credit operations by specific counterparties.<\/p><\/blockquote>\n The ECB has used the risk-control framework to control events at a number of key junctures in the euro crisis.<\/p>\n Ireland<\/strong>:\u00a0 In late 2010, the Irish banks were under severe stress.\u00a0 With international depositors pulling their money out, the banks became heavily dependent on the ECB for funding.\u00a0 The Irish government has sufficient cash on hand to finance the country for about nine more months and was not seeking funds from the EU or IMF.\u00a0 The ECB, however, was unhappy with the banking situation and decided Ireland should apply for program funds to sort out the banks.\u00a0 So, after clearing their throats by\u00a0revising<\/a>\u00a0the risk control framework with Ireland in mind, the framework was put to devastating use.\u00a0 Faced with ECB threats to withdraw funding and thus trigger a full-scale banking meltdown, Ireland quickly agreed to enter an EU-IMF program.<\/p>\n Spain<\/strong>: By late May of this year, it had become clear to all that Spain\u2019s banks needed substantial recapitalization, starting with Bankia, a recently-created conglomerate of a number of cajas.\u00a0 The Spanish government decided that its preferred method for recapitalizing Bankia\u00a0was to directly provide it with Spanish government bonds. \u00a0This approach is perfectly legal and would have been approved by Spain\u2019s banking regulators.\u00a0 However, the ECB didn\u2019t like this approach and effectively\u00a0vetoed it<\/a>.\u00a0 \u00a0What gave it such a power of veto? The risk control framework.\u00a0 ECB could simply threaten to refuse credit to Bankia\u00a0thus triggering the type of crisis the recapitalization plans were attempting to avoid.\u00a0 Since Spain could not raise the sums involved, this decision effectively forced Spain to apply to the EU for aid with recapitalising its banks.<\/p>\n Leveraging the EFSF\\ESM<\/strong>: Perhaps the most powerful suggestion for easing the sovereign debt crisis has been Daniel Gros and Thomas Meyer\u2019s\u00a0proposal<\/a>\u00a0to provide Europe\u2019s bailout funds with a banking licence, thus allowing them to borrow from the ECB.\u00a0 This ESM bank could potentially purchase trillions of euros worth of government bonds and its existence would provide Italy and Spain with the kind of \u201cbond buyer of last resort\u201d that the Fed has provided for the US government and the Bank of England has provided for the UK government.<\/p>\n