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Mario Draghi's dilemma over European money

Mario Draghi's dilemma over European money

by David Marsh

Fri 11 Sep 2015

Lancaster House, a stately mansion built almost two centuries ago for Britain’s Hanoverian royal family, was once a glittering venue for society balls. Today the building is used for official seminars and receptions when the British establishment wants to make a good impression, particularly on influential foreigners. On the eve of the opening of the London Olympic Games, this was the venue for a government conference promoting British manufacturing and services.

Yet on a sunny morning in late July 2012, its chandeliered splendour was not the backdrop to a speech supporting British business. Instead, Mario Draghi, president of the European Central Bank, came to shore up the euro. In dramatic, even brilliant, style, he succeeded. The steps he outlined, however, and the many repercussions of the actions that they called for, opened up a string of questions about the role of the ECB in helping to complete what is still only the half-finished construction of economic and monetary union in Europe.

Draghi, a former senior official at the Italian Treasury and head of the nation’s central bank, the Banca d’Italia, took over from French monetary technocrat Jean-Claude Trichet in November 2011. He immediately stamped his mark on the central bank with his own combination of pragmatism, determination, and dry humour. The ECB boss is less ceremonial and more precise than Trichet, more attuned to the financial markets, and has strong links to the United States (he studied at the prestigious Massachusetts Institute of Technology and worked for a while as managing director at Goldman Sachs). Draghi combines a wry turn of phrase and a penchant for intrigue (which some say stems from his Jesuit upbringing) with an impressive set of responsibilities, some of which are mutually contradictory. Several of these characteristics were on show in his London address.

Draghi opened his short speech with a joke, comparing the euro to a bumblebee. “This is a mystery of nature because it shouldn’t fly but instead it does.” But he had a serious message: At the height of international capital market gloom concerning the fate of the single currency, speculators had been selling the euro and dumping bonds from countries like Italy and Spain. The central bank president thought anti-euro action had gone too far, and said so: “Within our mandate, the ECB is ready to do whatever it takes to preserve the euro. And believe me, it will be enough.” His words echoed around the world, propelling sharply higher bond prices for the countries that had previously been under attack and winning some essential breathing space for the single currency.

But what was effectively a masterful bluff to counter the pessimists laid bare important weaknesses in the euro’s defensive machinery. Many market participants assumed that Draghi’s announcement signaled agreement with the German central bank, the Bundesbank, to underpin the weaker euro countries through joint bond-buying action. In fact, as the following days and weeks showed, this was not the case.

In the immediate aftermath of his London statement, Draghi’s largely unprepared ECB colleagues worked hard to assemble a strategic blueprint to fill in the sparse contours of his announcement. They constructed a program that would allow the central bank to intervene and buy the bonds issued by struggling countries, provided they met stringent economic belt-tightening criteria agreed to with the European Commission and the International Monetary Fund.

But even if Draghi’s big idea had a positive psychological effect on the financial markets, it remained ambiguous. In fact, the initiative – later dubbed the Outright Monetary Transactions program – was never implemented, since the conditionality that was a precondition of its functioning proved (as was planned all along) extremely onerous.

The important point, though, was that the markets believed that the London announcement, and the OMT program that followed, demonstrated that Draghi had the technical skills and the political backing to rescue the euro from breaking apart. And it is this tough-minded credibility that has succeeded in maintaining the single currency intact so far – even when the euro appeared to be on the verge of collapse during the mutating crisis in Greece in June and July 2015.

As foreshadowed in his London speech, Draghi has given the ECB more shape and direction. For one thing, the bank has taken over the task (after European leaders agreed on a long-envisaged plan for a “banking union” in the monetary bloc) of making the bank responsible for supervising all of the leading banks in the euro area. This is a crucial way of ensuring that the single currency area becomes more integrated and avoids some of the financial upheavals of the last few years. He has also masterminded another significant operation that his London address facilitated: the ECB’s path towards direct open market operations, or so-called “quantitative easing”, under which it buys large quantities of government and other debt in the marketplace – and not just from the problem countries of the European periphery, as envisaged in the OMT, but from all the euro member countries, including the better-off and more solvent nations like Germany. The €60 billion a month purchase program started in March 2015, against the opposition of Germany and a few other countries, with the goal of trying to maintain low interest rates, spur greater euro area activity, and restore inflation to the ECB’s targeted level of close to 2 percent.

Yet Draghi’s activist stance, precisely because of its all-encompassing nature, carries a certain amount of paradox. Many euro proponents say the currency will not survive – let alone prosper – unless the ECB becomes a fully-fledged central bank like the US Federal Reserve, the Bank of Japan, and the Bank of England – which all carried out quantitative easing programs to fight recession some years before the central bank in Frankfurt. Draghi’s institution, running a single monetary policy at the centre of 19 still politically autonomous states, is a deliberately amorphous entity, a central bank unlike the others, whose lack of clear contours reflects one of the principal reasons for the lingering euro malaise. In contrast to the other main central banks, the ECB cannot easily intervene to stabilize conditions in any specific country or economic area. The ECB’s counterparts in the US, Japan, and the UK can carry out, with far fewer political complications, direct support in domestic bond markets to lower interest rates and ease credit conditions, but this is not possible in an across-the-board manner for the central bank in Frankfurt due to the lack of a political union in Europe undergirding its monetary union.

The problem with Draghi’s energetic stance is that, by taking widespread credit for “saving the euro”, Draghi may be distracting the people who count – the politicians – from taking essential measures in the “real economy” necessary to make the euro area more competitive, convergent, and efficient. By giving politicians leeway in the struggle against the harsh pressures of economic realities, Draghi may be preventing governments from taking tough action that, over the longer term, could be necessary to shield the euro bloc from fresh crisis.

The ultimate stability of a currency lies not in the technical ability of its central bank to print money, but on the resilience of the economy beneath it and the political and fiscal authorities behind it. As Draghi well knows, the euro remains a currency in search of a state, the centrepiece of an imbalanced and frequently incompatible series of relationships between different countries’ central banking and governmental responsibilities. The ECB’s uneven nature weakens monetary union by raising uncertainty over its ability to resist economic attrition, greatly complicating the task of crisis management.

The OMT, for example, was strongly opposed by the Bundesbank and much of the German press, which gleefully published a 29-page Bundesbank document setting out its evidence to the German constitutional court – well before court action actually began – that any OMT bond purchases would be illegal. Draghi was well aware that some of his activity could be counterproductive, which explains why the ECB was careful to keep a low profile during the summer 2015 Greek imbroglio. Forever poised between the two extreme perceptions of not doing enough “to save the euro” and doing too much, Draghi and his bank face a near-insoluble dilemma. As long as the euro bloc remains a lopsided construct without adequate political union, the ECB will have little choice but to be permanently stationed on the front line to ward off adversity.

Draghi himself has frequently spoken out on the need for governments to do more to restructure their countries’ economies and provide a more solid underpinning for the single currency. But he is well aware of the depth of the underlying rifts: principally, the divisions in Europe between net creditor and net debtor nations, emphasized by persistent wrangling between Greece and its creditors, which will continue to occupy Europe for years. In 2013 he described the fault lines as follows:

“No one ever imagined that the monetary union could become a union divided between permanent creditors and permanent debtors, where the former would perpetually lend money and credibility to the latter.”

The imbroglio over Greece is a political and economic roller coaster. Not only are the debtors and creditors separated from each other; the creditors are divided among themselves. Greece and its main lenders have to solve a set of interlinked conundrums in the next six months, and European creditors (led by Germany) will have to agree to important debt relief measures on existing loans, on top of Greece’s €86 billion bailout package (its third), agreed in August. New elections in Greece in September, engineered by current prime minister Alexis Tsipras in a bid to consolidate his power, will result in fresh uncertainty and delay reforms. The additional bailout loan has added to Greek government debt, which will rise from an already unsustainable near-180 percent of GDP to a still more burdensome 200 percent or more, making debt relief essential. Yet Germany and the other creditors will not decide on debt relief unless the Greeks make progress in both approving and implementing reforms. And the IMF, which the Europeans badly wish to keep on board, will not grant any new loans unless the Greeks show much more progress with reforms and the Europeans agree to some measure of debt relief.

Obviously a lot could still go wrong between Greece and its creditors – and this is only one of a series of fissures ahead. In a speech in Helsinki in November 2014, Draghi made clear what was at stake:

“When countries join a monetary union, they share monetary policy and no longer have individual exchange rates. This offers significant benefits, but it also creates costs … When shocks do occur – as they inevitably will – adjustment has to take place through other [non-monetary] channels. And crucially, those channels have to be at least as effective as if countries were not part of monetary union. Members have to be better off inside than they would be outside. The reason for this is as follows: if there are parts of the euro area that are worse off inside the Union, doubts may grow about whether they might ultimately have to leave. And if one country can potentially leave the monetary union, then this creates a replicable precedent for all countries.”

Draghi knows the importance of keeping countries like Greece within the euro. But he also knows that the activist stance he him-self has promulgated could undermine the single currency just as he tried to prop it up. Solving Draghi’s dilemma will be important – and not just for the peace of mind of the ECB president, but for the long-term survivability of Europe’s most ambitious monetary experiment.

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