Draghi’s Master Plan
Here we go again. The first reaction of the markets to the European Central Bank’s decision to sit on the problem a while longer has not been positive. Yields for sovereign bonds of Spain and Italy have soared, with equities suffering as well. Once again, investors showed how little they understand how the interplay between European politicians and the ECB really works. Expecting bold action now was a bit naïve. What matters is that, despite some caveats, the Eurotower in Frankfurt is preparing to act with decisiveness, most likely in September.
Overall, Mario Draghi is trying to address the crisis in a comprehensive manner. On the one hand, he reiterated the need for long-term structural reforms in the zone countries; on the other, he made clear that reforms could be jeopardized if the delicate balance between political and market pressure on one side and short-term relief on the other gets out of whack. According to Draghi, sovereign bond markets are currently in a state of “severe malfunction,” and the problem needs to be addressed. Draghi argues that moving on the bond market to reactivate the monetary transmission channels is “classic monetary policy” and well within the mandate of the Bank. In fact, what is the point of keeping interest rates in the euro zone at record lows if loans for companies and consumers in peripheral countries get more and more expensive, he asks.
Much has been written about the renewed tension between Draghi and the head of the Bundesbank, Jens Weidmann. But going beyond the headlines, what seems to emerge is that the spat has produced a compromise.
It is true that Draghi confirmed the central bank is getting ready to buy sovereign bonds on the secondary market to alleviate pressure on Spain and Italy. However, it is also true that it will only do so with strict conditions attached and in conjunction with the European bailout funds, which are controlled by euro zone governments and need the green light from Berlin.
And while it is true that Draghi refused to put a cap on how many bonds the ECB would buy or whether it would sterilize those purchases − in effect signaling that he is prepared to act with unlimited firepower and switch on the printing press − he also said that efforts would be focused on the “shorter part of the yield curve.” In other words, the role of the ECB will not be to rescue countries like Spain or Italy, but rather to help them buy a little more time to implement their structural reforms. Governments in the periphery should simply not assume they are about to get a blank check from the ECB. On the contrary: if politicians fall short of their commitments to stay on course, market pressure could punish those countries in a year or two when the short term debt that the ECB is preparing to buy needs to be refinanced.
In order to make this point even clearer, Draghi reiterated that the ESM (European Stability Mechanism), in its present form, could not be granted a banking license. Translated into plain English: If some countries think they can print money to buy their sovereign bonds through the ESM, well, they should think again.
Vague plans announced by some European politicians alluding to changing the ESM to fit the ECB’s requirements for a banking license are outright disingenuous. Given how reluctant the German Constitutional Court is to allow more German sovereignty to be transferred to EU institutions, any expectations that the character of the permanent bailout fund might be altered would be a mistake. In fact, fueling such expectations could quickly backfire. The Constitutional Court still has to allow the ESM to become operational in its present form, with its ruling on the matter expected on September 12. Only then will the ESM become fully operational. Any premature talk about amending the rules governing the ESM would only trigger stiff opposition in Germany, and likewise fuel renewed doubts in the markets about Berlin’s fundamental commitment to the common currency.
Last but not least, the ECB has recognized that to be successful, it cannot crowd out private investors from bond markets. In its opening statement to the press on Thursday, August 2, Draghi made clear that “the concerns of private investors about seniority will be addressed.”
Will German politicians now recognize that Draghi is not seeking to jeopardize the ECB’s independence or the Bundesbank’s principles? I don’t know. However, it is certainly the case that, all too often, announcements by the ECB have come undone after critical comments from the Bundesbank or members of the ruling government coalition in Berlin. This has to change. Otherwise, markets will continue to bet against the common currency and the price tag for the rescue of the euro zone will only become bigger.
Markets and German politicians should analyze carefully Draghi’s plan of action. They should recognize that, once again, he is trying to address both the need for long-term solutions (both within member countries and at the EU institutional level), as well as the need for pragmatic short-term action.
Last but not least, it would not come as much of a surprise if the ECB, the European bailout funds and the Federal Reserve were about to start a coordinated effort to address the current weaknesses in the U.S. and European economies. Particularly, those advocating big financial bazookas to fight the slump should watch out. September could indeed be a very interesting month.