The week when Mr Draghi greatly diminished the office of ECB President and sacrificed the fiscal-monetary policy distinction

03/08/2012 by

First came the impressive declarations: The ECB will do whatever is necessary to ensure that those who go short on the euro, who bet on its disintegration, will lose. “And, believe me”, he added “it will be enough”. He also, rather significantly, uttered the term ‘convertibility risk’ (code-words for the risk that funds kept in some part of the Eurozone will be forcefully converted to some new, devalued, currency) and pledged to eradicate it. No wonder, the markets responded with considerable enthusiasm.

Then came the moment to put up or forever lose his credibility. Alas, probably under incredible pressure from the Bundesbank, he opted for the latter. Citizens and investors felt a wave of desperation hit them and all the gains from the grand declarations fizzled out. Since then, some analysts went back to what Mr Draghi said during the Thursday press conference and read between the lines some evidence of actions-to-come that may offer relief to the struggling Eurozone. They are clutching at straws, I am very much afraid.

What was the ECB’s position before Draghi’s heroic declarations? It was that it cannot arrest the crisis unless member-states act as part of a Grand Deal on how to effect a Eurozone-wide fiscal policy. Then and only then, the ECB would bolster their efforts through its own monetary operations. Clearly, that position led markets to believe that the Eurozone had no credible plan for dealing with the Crisis, as the cart (fiscal union) was being placed before the horses (serious ECB-centred intervention to stop the death embrace between insolvent banks and insolvent nations).

And what is the Draghi position after Thursday’s crucial ECB board meeting? That the ECB is ready to buy bonds in the secondary market once member-states act as part of a Grand Deal on how to effect a Eurozone-wide fiscal policy. In other words, no change whatsoever. None! In this sense, the ECB’s position which was initially deemed inadequate was reiterated as fresh policy a few days after its President pronounced himself ready to implement a radically new policy. The end result is, simply, the loss of the ECB President’s credibility. Or, to put it differently, if Mr Draghi were once again to make a similarly large pronouncement (along the lines “we shall slay this dragon, whatever it takes”), there is no doubt that the market fillip that will follow will be much weaker than that we experienced last week. Thus, the office of ECB President has been diminished.

As if that were not enough, Mr Draghi has, possibly unwittingly, undermined one of the ECB’s cherished principles, without replacing it with some fresh (possibly more appropriate) principle. Which principle? The principle that the ECB does not meddle in fiscal policy and stays well within its remit of maintaining price stability and a healthy monetary policy transmission mechanism. Consider this statement by Mr Draghi:  The “…guidance that we’ve given to the committees of the ECB differs from the previous program because … we have explicit conditionality here. And as a necessary condition, an adherence by governments and by euro area governance to its commitments.” Let’s unpack this. The previous program he refers to is the flurry of purchases of Greek, Portuguese and Irish bonds during 2010/11, the purpose of which was to stabilise these countries’ spreads and avert their insolvency. That program failed miserably, in the end, even though it did manage to slow down for a while the rate of increase of these interest rates. What Draghi is now saying is that, unlike those purchases which the ECB made without imposing conditionality on the three countries involved, any new purchases will come with strings attached; i.e. with a Memorandum of Understanding between the ECB, the EE and the member-state whose bonds the ECB will be purchasing in the secondary markets. This is, in my view, the end of any pretense to keeping monetary policy separate from fiscal policy. In effect, the ECB gives itself the task of enforcing into member-states particular (and highly austerian) fiscal policies.

The issue here is not whether one agrees or not with austerity. The issue is that the degree of austerity, and the extent to which policies like privatisation of the electricity grid of a nation must be pursued, was never supposed to be the business of the Central Bank. These were matters for democratically elected governments. During 2010/11, when the ECB was purchasing stressed bonds, it did so on the basis that the debt crisis of these member-states was threatening the ECB’s capacity to determine interest rates in places like Greece and Ireland. Thus, it intervened in the secondary bond markets in order to repair these monetary policy transmission mechanisms. Meanwhile, whatever conditionality was imposed on Greece, Ireland and Portugal was imposed by the troika in the context of the loans provided to these countries by means of guarantees backed by the taxpayers of the surplus countries. In short, the principle of keeping fiscal policy and monetary policy separate was, more or less (and despite Axel Weber’s protestations), intact.

Now, however, Mr Draghi is proposing to scrap this principle by tying up his impending intervention in the secondary market for Italian and Spanish debt to particular austerian fiscal policies by Rome and Madrid. This abandonment of the formal divide between fiscal and monetary policy may not be a bad thing, per se. But let us be honest about it and call a spade a spade. The reason why a smidgeon of honesty is necessary here is because, now that the ECB has decided to go boldly into the realm of fiscal policy, it might as well push for fiscal policies that work; as opposed to the austerian ones that do not.

For example, given its new boldness, there is nothing to stop the ECB from declaring that it will set a limit of 3.5% to all spreads within the Eurozone, promising to buy however many bonds of any member-state whose spread from the bund exceeds 3.5%. What stops it now from making this declaration? The answer is: the myth that this would amount to crossing the Rubicon that divides monetary policy (the ECB’s tool) from fiscal policy (the area of responsibility of elected governments). But surely this argument holds no longer now that this Rubicon has been passed by an ECB President who says that he will use the ECB’s power to print in order to impose particular fiscal policies on the member-states that will be favoured by the ECB’s intervention!

In summary, in a few days, the hapless Mr Draghi managed to diminish the power of his office and permanently to blur the divide between fiscal and monetary policy without even opting for a foray into fiscal policy that may help the euro survive. Infinite are the ways in which Europe’s leaders manage to injure our common European home. May they cease and desist before it is too late.

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