Would Mario Draghi Do Whatever It Takes To Save The Euro?

Includes: FXE
by: Martin Lowy

On November 3, 2011, Mario Draghi, the new president of the ECB, gave his first news conference. Most of the text of Mr. Draghi’s presentation and the most of the questions that followed had to do with the ECB’s outlook for the European economy and its just-announced decision to lower interest rates. What many of us want to know, however, is whether Mr. Draghi is prepared to do “whatever it takes” to stave off the breakup of the eurozone. On that subject, the newspaper reports have not been uniform.

The Financial Times said that “Mr Draghi also ruled out the ECB acting explicitly as ‘lender of last resort’ to governments. ‘I don’t really see that as the remit of the ECB. The remit of the ECB is price stability over the medium term.’”

The Telegraph reported “No, and a thousand times no, he said to those calling on the ECB to stem the crisis with massive purchases of periphery-nation debt. The ECB's function, he reiterated, was to focus exclusively on price stability, not to act as lender of last resort to governments. Already, he seems like a clone of his predecessor, Jean-Claude Trichet, who famously had only ‘one needle in his compass’ – inflation.” source

The Wall Street Journal’s “Heard on the Street” column opined, “But when it came to unconventional policy, Mr. Draghi simply reiterated ECB orthodoxy, praising the German Bundesbank tradition. He repeated that it was up to national governments to put their houses in order rather than relying on external support. He ruled out acting as a lender of last resort. And he reiterated that the ECB's government-bond purchase program was temporary, limited and aimed only at restoring the functioning of the monetary-transmission mechanism, although he dodged a question about whether the program would be shut down.” source

The Bloomberg reporter’s take was more nuanced:

“The new head of the European Central Bank demonstrated yesterday that’s he’s ready to step in to support the euro-area economy. We hope that also means he’s willing to do what it takes to save the euro.

After only three days as president of the ECB, Italy’s Mario Draghi oversaw the euro area’s first interest-rate cut in more than two years, lowering the central bank’s target rate by 0.25 percentage point to 1.25%. The decision surprised investors and economists, most of whom had expected Draghi to hold rates steady in his debut meeting at the ECB’s helm.

In the subtle game of monetary policy, it was a bold move, and one that could distinguish Draghi from his predecessor, Jean-Claude Trichet. The ECB’s primary mandate is to control inflation, which is currently running at 3%, well above the central bank’s 2% target. But Draghi, with the unanimous support of the bank’s 23-member Governing Council, put more weight on the deteriorating outlook for the euro-area economy, which he says is headed for a recession.

The big question now is where Draghi will stand on a larger issue: Whether the ECB will pledge the trillions of euros needed to guarantee the financing needs of solvent euro-area governments. The central bank, with the power to print euros, is the only European institution that can credibly make such a promise, which would be the linchpin of any plan to resolve finally the region’s sovereign-debt crisis.

No Backstop

Under Trichet, the ECB had been unwilling to be the euro’s backstop. Together with Germany, the bank has essentially been betting that the threat of financial disaster will maintain pressure on countries such as Italy to agree to reforms, including a European authority that could take over the finances of troubled governments. It’s a laudable goal, but one that could take years to reach, whereas a market meltdown could do irreparable damage to the global economy in a matter of weeks.

On the surface, Draghi’s position is identical to Trichet’s. In a news conference yesterday, he said the central bank can’t do politicians’ jobs and act as the lender of last resort to governments. He characterized the bank’s purchases of government bonds, which amount to some 174 billion euros ($240 billion) so far, as “temporary” and necessary to restore “the functioning of monetary policy transmission channels.”

Draghi, though, has vast leeway in interpreting that last clause, which is central banker-speak for intervening in various markets to make sure interest-rate policies have the desired effect. In an emergency, it could be used to justify a blanket guarantee on newly issued government debt. After all, if credit markets freeze on concerns that European governments can no longer borrow, monetary-policy transmission channels - even at a target rate of zero - won’t function very well.

If and when Draghi finds himself staring into the abyss, we hope he’ll remember the mantra of Federal Reserve Chairman Ben S. Bernanke during the 2008 crisis: Do whatever it takes.” source

After reading these and other newspaper stories (sorry, English language only), I realized I had better watch the press conference itself. (Available here). That turned out to be quite instructive. As was natural, much of the press conference focused on the ECB’s rate cut and its view of the European economy. But the bigger question was addressed in a variety of ways. Here are some of Mr. Draghi’s responses to questions that I think are potentially important in divining his point of view.

  • Mr. Draghi repeated several times that “price stability over the medium term” is the ECB’s job. That is not new. But if we extrapolate from the repeated importance the ECB attaches to this concept, we might see that there could be a time that price stability was seriously in doubt, as it would be if breakup of the eurozone seemed a material possibility. At such a time, one might expect that Mr. Draghi would advocate measures that otherwise he might deem outside the ECB’s “remit."
  • The ECB will continue to provide liquidity to banks “to ensure that European banks are not constrained on the liquidity side.” That suggests that the ECB is prepared, on a continuing basis, to act as lender of last resort to European banks, though not countries, perhaps regardless of the banks’ capital levels, so long as “good” collateral is pledged.
  • Regarding the program to purchase debt of European countries, notably, at this stage, Italian debt, that program is ongoing and the ECB will not bind itself in any way to limits. Nevertheless, the program is limited in three ways:

o It is temporary.

o It is limited in amount.

o It is “limited to restoring the functioning of the monetary policy transmission channels.”

I do not understand the ramifications of the last limitation. I might know what “monetary policy transmission channels” means. But I do not see the connection between that concept and buying Italian debt that is suffering from rising market interest rates. In this regard, we might note that in response to a later question, Mr. Draghi said the ECB was not paying particular attention to rising interest rates on Italian bonds. To me, that statement does not ring true. To me, it adds to the likelihood that the monetary policy language is a subterfuge.

  • That the monetary policy language might be a subterfuge also might be confirmed to a degree by a later answer that I will paraphrase as follows:

For a number of years, spreads between the bonds of different European nations were narrow - the word Mr. Draghi used was “thin." This did not reflect realities in the different countries, which had different rates of growth and other different economic characteristics. The crisis of 2007-2009 made many investors risk averse, and their consequently deeper analysis made them more perceptive. That is how larger spreads started. The countries with large spreads now have to reform themselves to redress the problem.

I contrast this realistic description of the market with the “monetary policy transmission” hocus pocus. The economic analysis is straightforward. But when the policy is being described, Mr. Draghi lapses into central-bank-speak, possibly because a straightforward explanation might lead some people - possibly including some people on the ECB’s 23-person board - to allege that the ECB is exceeding its “remit." That they might so allege is not strange, since the ECB is prohibited from lending directly to eurozone nations. (See Section 101of title VII of the Treaty.) source

  • In response to a question as to whether the ECB would “do whatever is necessary” to prevent the breakup of the eurozone, Mr. Draghi parried by saying that such a concept “is not in the Treaty.” And later he said “The Treaties are all we have.” “We cannot really conceive of events that are not within the Treaty.” And later he also said “The remit of the institution is in the Treaty.”
  • The Financial Times reporter asked whether the ECB was prepared to be a lender of last resort to countries. Mr. Draghi parried again: “What makes you think that the eurozone needs a lender of last resort?” Mr. Draghi followed up by offering “I do not think that is in the remit of the ECB.”
  • Asked whether the ECB could operate with negative capital, Mr. Draghi avoided the issue.

Based on his performance, we can see that Mario Draghi is a highly intelligent, very competent and well-versed man whose parries, we should assume, have as much meaning as his more direct and succinct answers. We must therefore, read between the lines.

As I see it, Mr. Draghi has left the door open to any form of intervention the ECB chooses. That is because the default of significant countries in the eurozone or, even worse, the failure of the euro experiment, almost certainly would not be conducive to “price stability over the medium term” or “economic stability,” another phrase Mr. Draghi used. Mr. Draghi knows that such situations could arise. Therefore, it is my guess that he means to say that there could come a time when the ECB must do whatever it can to prevent a major default.

Even the statement concerning lender of last resort status is way short of a ringing denial: “I don’t really see that as the remit of the ECB,” the language reported by the Financial Times, is not the most convincing way to say “no." In circumstances that currently do not exist, he may come to see many new things as being part of the CB’s remit, and as I read it, he left that possibility open.

The ECB cannot solve the euro’s basic problems. But the ECB’s vigorous action to “do whatever it takes” could buy enough time for the political process to make fundamental changes in a less heated atmosphere. That is an optimistic view. But unwinding the euro seems sufficiently fraught that I am optimistic that the Europeans will find a way to avoid it. Vigorous ECB action is likely to be a necessary first step, and based on his press conference, I expect Mr. Draghi to be a proponent of “whatever it takes” when the time comes, although he will have to couch the action in terms that avoid the restriction the treaty places on loans directly to the countries of the zone.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

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