Monetary re-insurance of fiscal states in Europe

Ever since the financial crisis of 2008, central banks in the rich Western hemisphere are engaged in extraordinary interventions to stabilise financial markets. They act as lenders and money market makers of last resort. But these interventions were also motivated by the need to stabilise public finances. This became obvious in the Euro Area (EA) when the Greek government was effectively shut out of bond markets in early 2010 and the panic rapidly spread to the Irish and Portuguese segments. The turmoil in bond markets has been widely interpreted as a symptom of the EA’s incompleteness as a fiscal union. But monetary re-insurance is not the same as fiscal dominance. Yet incentives for governments are sometimes more aligned with bond-holding banks and this can put central banks under a regime of financial dominance. By analyzing speeches of Executive Board members, the article shows how the ECB has come to develop monetary re-insurance of fiscal states and the financial system, while safeguarding against becoming dominated by other institutional actors. The need for monetary re-insurance of fiscal states is not confined to EA members. To illustrate this point, the article compares recent financial instability in the UK with Italy and shows how central banks navigate this dilemma of re-insurance and financial dominance.