Founding ECB Vision Eclipsed by Europe’s Debt Crisis

May 11 (Bloomberg) -- The central bank envisioned by the euro’s founding fathers is being eclipsed as the sovereign debt crisis forces it to help clean up the fiscal mess of governments.

Fighting speculation that soaring budget deficits would break up the 16-nation currency, euro region finance ministers yesterday came up with an unprecedented aid package worth almost $1 trillion -- and relied on the independent European Central Bank to help foot the bill.

Ministers pushed through the decisions at the 14-hour overnight crisis session at the European Union’s Brussels headquarters to put the euro on a sounder footing with more unified economic policies. The risk is that they will instead stoke investors’ concerns that uncontrolled deficits will undermine the euro -- a danger highlighted by the currency surrendering gains made after the announcement.

“Think differently about the place from now on,” said Kevin Gaynor, chief markets economist at Royal Bank of Scotland Group Plc in London. “What we’re seeing is everything being glued together by bailouts rather than integration. The currency is starting to turn into an average of its members rather than the deutsche mark, which people thought it would be.”

Gains Lost

The euro traded at $1.2777 as of 9:49 a.m. in Tokyo, down from a high of $1.3094 reached yesterday in the aftermath of the bailout announcement. The currency has lost almost 16 percent since late November and is down against 15 of the 16 most-traded currencies this year.

“No one’s saying that this is easy,” said John Lipsky, the No. 2 official at the International Monetary Fund, in an interview with Bloomberg Television today. “It’s an important step. Now let’s see what happens in other countries that need to undertake adjustment programs.” As part of the European Union’s agreement, Spain and Portugal pledged deeper budget cuts to be outlined this month.

Lipsky added that “this was a very big step by the ECB” to agree to buy bonds.

ECB President Jean-Claude Trichet was in Basel, Switzerland, 570 kilometers (354 miles) away, when finance ministers threw out Germany’s insistence on budgetary rigor and standalone monetary policy that governed the euro since it was conceived in 1991.

Fighting Contagion

The euro’s political leadership agreed to rescue countries that failed to control their deficits and a divided ECB backstopped it by purchasing government bonds after the Greek fiscal crisis sparked a sell-off in Spanish and Portuguese debt.

“We’ve reached a crossroads,” said Paul de Grauwe, a professor at the Catholic University of Leuven in Belgium and two-time candidate for an ECB post, in a telephone interview. “They have realized there is more to monetary union than a central bank. Whether you like it or not, that is increasingly a fiscal union.”

Trichet’s decision to sign up to a euro-region bailout mechanism may see him start his final year in office fighting suspicions that the German model of the independent central bank no longer applies. Just hours after the program was announced, Bundesbank President Axel Weber said buying bonds has “significant risks.”

Risk Taking

Weber’s predecessors warned that it would be irresponsible for central banks to finance deficits, arguing that this would kindle inflation and rely on government assistance if the purchases turned sour.

A ban on central bank overdraft facilities for governments or direct loans is “of especial importance,” Germany’s central bank wrote in February 1992, two months after European governments hashed out the euro’s founding treaty.

The ECB’s actions may also open it to the same attacks that the Federal Reserve has fought for the past year. Its critics argue that propping up companies triggers greater risk-taking among investors confident they will be saved if their bets turn sour.

Trichet, an architect of the euro who oversaw the French central bank’s deliverance from political control in the 1990s, denies that the ECB sacrificed its autonomy by volunteering to purchase government bonds on the market.

‘Fiercely Independent’

Yesterday’s ECB move also skirts the direct-financing prohibition by buying the bonds of countries like Portugal or Spain on the secondary market. The bank described the move as “interventions” that aimed to ensure “depth and liquidity.” The purchases will be sterilized, meaning they won’t increase the overall money supply.

While the ECB remains “fiercely independent,” Trichet said in a Bloomberg Television interview that the bank’s 22- member decision-making council only mustered “an overwhelming majority” -- instead of unanimity -- to venture into the uncharted territory of financing public debt.

Weber, the Bundesbank’s current chief, broke with Trichet yesterday to say he’s “critical” of the bond plan. The risks stemming from purchases must be kept “as minimal as possible,” he said in an interview with Boersen-Zeitung newspaper.

The comments suggest that Trichet struggled to build a consensus for bond purchases before the monthly council meeting of May 6, where he says they weren’t even discussed.

ECB Reluctance

The ECB’s perceived reluctance to take that route last week rattled markets around the world, even briefly driving the Dow Jones Industrial Average down by almost 1,000 points on May 6, erasing more than $1 trillion in wealth before the market bounced back.

By the evening of May 7, the euro zone was in crisis mode, its political leaders closeted with Trichet in Brussels to improvise a strategy for heading off a sovereign debt explosion -- and to do so by a 48-hour deadline before the markets reopened yesterday.

“For all of the ECB’s attempts to remain independent and bask in the image of the Bundesbank, there was no ability to push back on the EU power base in a crisis period,” David Zervos, a managing director at Jeffries & Co. in New York, said in an e-mailed note to investors. “This, in the end, makes the euro area far less stable in any crisis times than a traditional national union.”

To contact the reporters on this story: James G. Neuger in Brussels at jneuger@bloomberg.net; Simon Kennedy in Paris at skennedy4@bloomnerg.net