The European Central Bank
Ready for the ruck?
Taking over the European Central Bank puts Mario Draghi in a position as perilous as Europe’s
Oct 22nd 2011 | from the print edition · ·
AT THE end of October, after eight years in the top job, Jean-Claude Trichet will pass the presidency of the European Central Bank (ECB) to Mario Draghi. Italy’s leading central banker thus takes his place in the front row of the fight to push back the euro crisis, bearing every bit as heavy a responsibility as chancellors and presidents. Whatever plans Europe’s political leaders draw up at their summit on October 23rd, the ECB’s new head will be a vital part of their success—or failure. Mr Draghi has much in common with the Frenchman he is following. Both have had long careers in public life, including stints at their finance ministries and heading their national central banks. As chairman of the Financial Stability Board, Mr Draghi has been leading international efforts to remedy the ills of global banking. Besides his strong credentials for the job, Mr Draghi shares with Mr Trichet a pragmatic streak, a desirable characteristic when confronting a challenge as grave as the euro crisis. Related topics · Bond markets · Government bonds · Fixed-income securities · Financial markets · European markets Not all of Mr Draghi’s background works in his favour. His brief excursion into the private sector, working at Goldman Sachs between 2002 and 2005, might in some circles be seen as betokening welcome breadth in a central banker, but it has made others suspicious that he might be overly lenient towards banks. And then there is the matter of his nationality. Nationality is not supposed to count at the supranational ECB; but it always does. Until the start of this year it looked likely that Axel Weber, then the head of the German Bundesbank, would take over the ECB: a popular prospect with the German public and other onlookers who doubt the anti-inflationary zeal of the non-teutonic. But Mr Weber could not stomach some of the measures the ECB was taking in response to the euro crisis and bowed out of the race. German public opinion was sceptical of Mr Draghi—"Mamma mia!”, the newspaper Bild imaginatively began an article on the horror of his candidacy. But the Italian has seduced his critics by endorsing Germany’s tough line on inflation (Bild now says he’s an honorary German). Given the horrendous mess being bequeathed to him, he must be wondering whether the wooing was worth it. The debt crisis has pushed the ECB a long way from its original role as a Bundesbank-like guarantor of price stability above all else. It has been forced to try its hand at tasks to which it is ill adapted and on which its 23-strong governing council, made up of the heads of the 17 national central banks and a six-member executive board, finds it very hard to reach consensus. The ECB, which Mr Trichet had fought to keep as independent as it was originally meant to be, finds itself endlessly entangled in and compromised by the inability of Europe’s political leaders to commit to a workable plan for dealing with the crisis. The idea of a stateless central bank running a currency beyond the bounds of a state has never looked stranger, or harder to sustain. Mr Trichet deserves credit for his handling of the financial crisis of 2007-08 and the ensuing recession. The ECB was prompt to respond to the funding dearth that started in August 2007 with big dollops of liquidity, moving beyond the standard tools aimed at price stability. Many (though not Mr Trichet) think the ECB erred in raising interest rates in July 2008, shortly before the crisis was amplified by the collapse of Lehman Brothers. But it was then swift to bring rates down, from 4.25% at that time to 1% half a year later (see chart 1). The ECB also bought covered bonds (bank debt backed by loans) to ease banks’ funding difficulties, although the purchases were far smaller than the quantitative-easing programmes in America and Britain. Mr Trichet was successful earlier on, too. For most of his term the euro has been a strong currency, at times reaching $1.60. Mr Trichet takes pride in the ECB’s effective monetary control over the rapidly growing euro area, which has expanded from 11 members to 17 since its creation in 1999. Stung by a reference to German criticism of the bank at a press conference in September, the normally even-tempered Mr Trichet protested vehemently that the ECB had conducted monetary policy "impeccably, impeccably!” The ECB had kept inflation at 2% a year, in line with its target (below but close to 2%)—and its record in Germany had been better than that of the Bundesbank over similar stretches of time. The good interred with his bones Inflation has generally been low in rich countries over the past 15 years. But grant Mr Trichet the benefit of the doubt on impeccability. Acknowledge, too, that while the euro zone’s GDP growth has been disappointing compared with America’s over the past decade, on a per-person basis it has more or less kept pace. And concede that, contrary to common misconception, the euro zone has outperformed America on employment over that period, even if its productivity growth has been slower. By other measures, though, Mr Trichet’s tenure is marked by a failure to perceive the processes that culminated in the current crisis. The euro zone, with its widely differing constituent economies, did not start off as an optimal currency area. But it was hoped that the single currency itself would bring about an "endogenous” convergence as it allowed goods and labour to move around the euro area ever more freely. That convergence would make the members better able to cope with a single monetary policy and the loss of exchange-rate flexibility. But instead of converging, in crucial ways northern and southern Europe (with Ireland as an honorary member of the south) diverged. In that divergence lie the seeds of today’s crisis. Stripped of currency and inflation risk, interest rates in the southern countries plunged to unprecedented lows. That spurred a great deal of cross-border borrowing that fed prodigious construction booms in Spain and Ireland. In slower-growing Italy and Portugal, lower borrowing costs propped up demand. Safely inside the euro area, and benefiting from the gift of lower funding costs on their debt, governments could drop the austerity they had pursued to meet the fiscal entry demands (notably the 3% of GDP budget-deficit limit) laid out in the stability and growth pact to which euro-zone countries signed up in 1997. The boom stored up all manner of trouble. Although the current account of the euro area as a whole stayed broadly in balance, foreign capital pouring into non-traded sectors of the southern economies sent their current-account deficits ballooning. Spain’s reached 10% of GDP in 2007; in 2008 Portugal’s deficit hit 12.6% of GDP and Greece’s soared to an astonishing 16.3% of GDP. By contrast, core northern economies like Germany and the Netherlands started to pile up big surpluses, reaching highs of 7.6% and 9% of GDP respectively. Measured by unit labour costs, peripheral countries lost an alarming amount of competitiveness relative to Germany (see chart 2). When the financial hurricane of 2007-08 hit the peripheral economies, it flattened public finances that had been flattered by the boom. Spain’s budget balance flipped from a surplus of 1.9% of GDP in 2007 to a deficit of 11.1% in 2009; that year Greek public borrowing reached 15.4% of national output. Ireland’s previously low state debt expanded vastly following the ill-conceived blanket guarantee to the creditors of its domestic banks that the government offered in September 2008. That saddled taxpayers with a bill now reckoned at about 40% of GDP. Northern creditors recoiled as they increasingly doubted the ability of the blighted economies to repay the debts they had amassed. As with many debt crises in emerging economies in the post-war period, the euro crisis was born of the preceding boom’s excesses. When Greece was bailed out in 2010 its current-account and fiscal deficits as a share of GDP far exceeded Argentina’s at the time of that country’s default in late 2001 (see article). But this debt disaster was in some ways harder to escape than those seen in the developing world: the beleaguered European economies no longer had the safety valve of devaluation to boost net trade and offset the contractionary effects of fiscal austerity. Should the ECB have done more in the boom to avoid today’s desperate hangover? Mr Trichet points to unpopular decisions to start raising interest rates, for example at the end of 2005. He also reminds critics that the bank deplored the actions of Germany and France when, having broken the terms of the stability and growth pact in the first half of the 2000s, they successfully avoided punishment. Had sanctions been properly applied, future excessive borrowing by other countries might have been curtailed. Yet the ECB chose to ignore the dangers in the credit surge which allowed the build-up of current-account imbalances on the periphery. Indeed it egged on the integration of financial markets that spurred the financing. It believed, wrongly, that countries within a monetary union no longer faced balance-of-payments constraints. And if bond markets failed in their vigilante role by treating Greek sovereign debt as if it were German, the ECB did just the same when it came to the collateral it accepted for lending to banks. In 2005 Mr Trichet was boasting of the way that bond yields were moving in lock-step across the euro zone, ignoring the different prospects of its constituent economies and feeding the credit boom. Ever weaker union But it is on his handling of the debt crisis, rather than his role in the events which precipitated it, that Mr Trichet will most likely be judged. This may not be wholly fair. Most of the blame for the extraordinary deterioration in the crisis—a little local difficulty in Greece early last year, now a threat to the global economy—must rest with Europe’s politicians, who have repeatedly failed to get ahead of the curve in combating market fears. A case in point is the European Financial Stability Facility (EFSF). An emergency summit on July 21st agreed to beef up this bail-out fund’s resources and gave it new powers. But it has taken almost three months to ratify the deal. That vacuum has forced the ECB, the only institution in the euro area capable of intervening promptly and decisively, into territory far outside its custom and practice. Such forays have proved increasingly controversial inside and outside the bank. And its shaky standing on this new terrain leaves it open to criticism both for doing too much and for doing too little, too late. From the outset of the crisis the central bank has conducted a discreet slow-motion rescue of banks in ailing economies like Greece and Ireland, which were being bled dry by capital flight and became more and more reliant on liquidity from the ECB. The ECB used the power that such support gave it over the banks to push reluctant governments in Ireland and Portugal to accept the inevitable: a bail-out from euro-area creditors in conjunction with the IMF. That rescue has exposed the ECB’s balance-sheet to big risks, since it has accepted as collateral ever dodgier government debt proffered by the troubled banks. True, it imposes a (small) haircut. But the ECB has been forced into operations it would once have abhorred on the grounds that they put it firmly into fiscal, rather than monetary, territory. It justifies its acceptance of junk-rated Greek debt by invoking the official but untenable view that the country is still solvent. The ECB has even more reluctantly intervened in secondary markets to buy the bonds of ailing governments (see chart 3). The purchases through this "securities markets programme” (SMP) started with Greece in May 2010 and were then extended to Ireland and Portugal, totalling around €75 billion ($103 billion) this spring. Mr Trichet and his colleagues argue that the SMP is needed to give traction to monetary policy in those troubled economies. This is unconvincing casuistry to those who see the purpose as simply lowering yields for countries that have lost the confidence of investors. That seems a better explanation for the ECB’s wading into the markets again in early August to prop up the far bigger bond markets of Spain and Italy when the antics of Silvio Berlusconi’s government had undermined investors’ confidence. There is palpable distaste within the ECB for shifting into fiscal territory in this way; it prompted Jürgen Stark, a board member, to resign in September, making him the second German to leave the ECB this year. One of the main worries of the uneasy is that by supporting bond markets the central bank lets governments off the hook. As Italian bond yields fell sharply at the news of the ECB’s first intervention, Mr Berlusconi tried to backtrack on his commitments to intensify austerity. If the ECB has been tepid in its support for countries that are solvent, it has been obstructive in its attitude towards the one euro-zone country that is undeniably bust. Only a drastic reduction in its public debt will allow Greece to get back on its feet. Yet the ECB has hindered this solution by insisting that any write-down must be voluntary. Mr Trichet’s intransigence on this point led to a hopelessly fudged European deal in July which barely reduced Greek debt at all (the supposed 21% cut in the debt’s net present value is in fact closer to 5%). This nugatory improvement will make it much harder for Greece to push through a fully fledged restructuring later because the government will have less legal room for manoeuvre. Given the cross-border exposures within the euro area that have built up in the past decade, the ECB is right to fret about contagion spreading from a Greek default. But the way to avoid such infection is surely to quarantine Greece, not to deny the radical nature of the cure it so evidently requires. And Mr Trichet’s opposition to any default is inconsistent with the ECB’s desire to strengthen the currency block’s fiscal heft. In Germany and other creditor nations such strengthening will be politically possible only if there is a credible sanction against profligate governments. How to train your Draghi In the face of deep scepticism that they can at last rise to the occasion, the euro zone’s governments are shuffling the building blocks of a plan into place. These include a recapitalisation of Europe’s battered banks, which have been undermined by potential losses on their sovereign-bond holdings from the worsening debt crisis, and tighter fiscal control from the centre over the member states. Countries like Spain are constitutionally binding themselves to control their public finances; a sterner version of the stability pact is being created. The ECB has been privately urging the creation of a fiscal authority that can, if necessary, grab the economic and fiscal levers of countries that are serial miscreants for the common good. The degree to which Mr Draghi can lead the bank in pressing successfully for such fiscal change, and thus secure a path for its own retreat into purely monetary matters, may be a key measure of his long-term success. Other tests will be more immediate. Many signs now point to the euro area slipping back into recession, not least because of the rush to intensify fiscal austerity. As a result there is a strong argument that this year’s two rises in interest rates, taking them from 1% in early April to 1.5% in July, need to be reversed. But Mr Draghi may be unwilling, fearing that an immediate rate cut would damage his credibility and reinforce assumptions made on the basis of his nationality. Almost as pressing a question, and one also muddied by nationality, is whether to carry on with the bond purchases. When the ECB restarted the programme in August, it made clear it was a stopgap until the EFSF assumed responsibility. But the now-empowered bail-out fund doesn’t have the necessary clout. Its total capacity of €440 billion (of which only around €280 billion remains, given its commitments to Greece, Ireland and Portugal) falls far short of the trillions that would be needed to shock and awe the bond markets in the face of further worries about the finances of, say, Italy. Various ways to increase its ability to shock and awe have been canvassed. One possibility (of doubtful legality under the Maastricht treaty) was for the EFSF to borrow from the ECB, but opposition from the central bank seems to have killed it off. Instead European politicians appear to be plumping for a form of leverage in which the EFSF would offer a limited first-loss guarantee (of say 20%) on the issuance of new bonds. This would do nothing to allay the fears of investors about existing debt and the banks that hold it. The prospect of having to make good on guarantees in the event of a calamity such as an Italian default is adding to fears about the credit rating of various countries, most notably France. That may leave the ECB with little choice but to step in more aggressively. One of Mr Trichet’s strengths was his mastery at mustering consensus, where possible, on the bank’s governing council. This is a skill that Mr Draghi will sorely need in the face of, say, a worsening in the Greek crisis or further political shenanigans in Italy. Only if he knows he can get the council fully behind him will he be able to undertake the big, bold steps, such as a guarantee of all euro-zone government debt bar that of Greece, that calming panicky markets may require.