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This Will Not Be Enough, Mr. Draghi

Author: Sebastian Mallaby, Paul A. Volcker Senior Fellow for International Economics and Director of the Maurice R. Greenberg Center for Geoeconomic Studies
August 8, 2012
Financial Times

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Financial markets, it has often been observed, are thin and volatile in August. Much the same can unfortunately be said for crisis management in Europe. The latest initiative from the European Central Bank has cheered markets. But it appears too qualified to be a lasting game changer.

The ECB has announced that it will resume purchases of sovereign bonds. In principle, this policy could salve the crises of peripheral Europe by reducing borrowing costs. But US experience teaches that there is all the difference between the shock-and-awe bond purchases pursued in the first round of quantitative easing and the tepid intervention of today. Mario Draghi, ECB president, has appropriated the shock vocabulary, vowing to do "whatever it takes". But his true position is, "whatever it takes – maybe".

To qualify for ECB support, countries must apply for a formal bailout, accept the attendant conditions and have their application approved by the rest of the eurozone, including fiercely austere Germany. Then, if they stay on track with the conditions, ECB bond purchases will supplement bond buying by the eurozone's bailout funds. Mr Draghi is unspecific on the crucial question of how powerfully he would intervene. But one weakness is clear. Given that the crisis economies have a shaky record of delivering on reform targets, the ECB may be unable to sustain support under the conditions it has stipulated.

The ECB plans only to buy bonds with short maturities. This will ease the risk of losses. But by signalling that it is leery of the long end of the yield curve, the ECB will encourage investors to feel the same. Governments will find long-term debt as hard as ever to issue. The shortening of debt maturity is a classic early warning of a full-blown crisis.

Mr Draghi promises to address concern about the ECB's seniority in debt restructurings. At present, the more bonds the ECB buys, the larger the potential haircut for remaining private bond holders, so ECB support can perversely accelerate investor flight from sovereign bond markets. However, having acknowledged this problem, Mr Draghi fails to specify a fix. If the idea is that the ECB may accept losses in a restructuring, how does that square with its insistence on protecting itself by buying only short-term paper?

In sum, the ECB has not quite shaken off its longstanding schizophrenia: it is bold when providing crisis loans to banks, less so when supporting sovereigns. This double standard makes no sense. Europe's banks own sovereign bonds and its sovereigns are on the hook to save the banks, so the two cannot logically be separated. Yet when it comes to government bond markets, the ECB's approach is not to provide open-ended liquidity in the classic manner of a lender of last resort. It is to insist on policy conditionality of the sort found in International Monetary Fund programmes.

Mr Draghi is hemmed in by his colleagues at the Bundesbank, who believe that unconditional sovereign purchases create moral hazard. But this concern makes sense only if additional pressure on politicians will elicit additional reform. Unfortunately, pummeling Spain's Mariano Rajoy or Italy's Mario Monti could open the door to their opponents, who are unlikely to be preferable. Indeed, Italy is haunted by talk of a Berlusconi comeback.

The hawks at the Bundesbank also assert that unconditional sovereign bond purchases will compromise the ECB's independence. But this is back to front. Once it imposes conditions, the central bank will be in the highly political position of deciding if they have been met. Even if it seeks to pass this role off to the IMF, the ECB is too big a player to hide behind a smaller outside agency.

The better path for the ECB would have been for it to embrace QE. This would have allowed it to buy bonds, without explicit political conditions, in whatever quantity and duration it saw fit. Its actions could have been justified on the same grounds that Mr Draghi used last week: that the monetary transmission mechanism is broken; and that it is within the ECB's mandate to address "reversibility risk" – the fear that the eurozone will splinter.

Indeed, QE would surely have been easier to justify than the quasi-political role that the ECB has now assumed. After all, QE has become an almost standard part of central bankers' tool kit.

. . .

Last week's ECB statement mentions the possibility of "further non-standard monetary policy measures". Perhaps it is not too late to hope the ECB will come round to QE. But barring a dramatic rethink, the ECB's effectiveness will depend on crisis countries' ability to meet its conditions. This looks like a gamble.

The ECB's new policy clearly has Spain in mind. But Mr Rajoy's government has yet to say it will apply for the prerequisite bailout. The Socialist opposition promises to make hay out of the humiliation that rescue conditionality would entail. Not unreasonably, Mr Rajoy says he will wait to hear how the ECB's support would work before he decides whether he wants it.

And then there is Italy. Mr Monti has fought for the ECB to resume bond purchases. But now that he has won, he is not sure whether he wants his trophy. He is sliding in the opinion polls and there are limits to the reforms that voters will tolerate. Already, he has shelved a plan for labour market reform. Bowing to austerity conditions designed in Berlin may be politically impossible.

At the start of this year, Europe was moving in the right direction. Reformers had the upper hand, and the ECB's dramatic refinancing of the banks temporarily subdued the markets. But now the optimism has seeped away. Mr Draghi needs to do more if he wants to restore it.

The writer is a senior fellow at the Council on Foreign Relations and an FT contributing editor

This article appears in full on CFR.org by permission of its original publisher. It was originally available here (Subscription required).

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