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Abstract:
This paper argues that the new permanent European rescue fund, the European Stability Mechanism (ESM), should be provided with a liquidity backstop by having it registered as a bank – and be treated as such by the European Central Bank. If the crisis were to become acute again, the ESM would stand ready to intervene in secondary markets, potentially with almost unlimited amounts of funding. Access to central bank financing will be crucial in a future crisis, because in such a crisis risk aversion is likely to be extreme, and even the ESM might not be able to raise at very short notice the huge sums that might be required to prevent a breakdown of the financial system. Hundreds of billions of euro might be needed just to top up the programmes for Greece, Ireland and Portugal – and Spain and Italy may require more than a thousand billion euro. Sums of this order of magnitude cannot be raised quickly by a new institution. Simply increasing the headline size of the ESM might thus be of little use. The ‘ESM-bank’ (effectively a European Monetary Fund) would be subject to the same rules that apply to all other banks and the ECB would accept only high-quality collateral from it. The ECB could abandon its programme of purchasing peripheral government bonds and it would retain the final say on whether to provide liquidity to the ESM. Thus, the ECB would remain in control of central bank money supply and its role would be restricted to the classic functions of ensuring price stability and acting as a lender of last resort for banks. The management of external and internal imbalances within the euro area would be left to the ESM under the supervision of the finance ministers.
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