A recent article on Mario Draghi, the man who succeeded Jean-Claude Trichet as president of the European Central Bank in October 2011, shows that the ECB is on the move. Where it is headed is as yet far from clear, but it is not going to be the same kettle of fish that it was under Trichet, where its main aim in life was to pretend that it was actually the Bundesbank. Draghi talks the Bundesbank talk, and professes huge admiration for German stability—what central banker wouldn’t? But he doesn’t walk the walk, or if he does, he walks it his way, which is not quite the same thing.
In an interview on March 19 with Bild Zeitung editors Kai Diekmann and Nikolaus Blome (published March 23), Draghi was asked directly how “German” he was.
Bild: For Germans, a central bank chief must take a strict line on inflation, be politically independent and favor a strong euro. In that light, how German are you?
Draghi: These are indeed German virtues. But every central banker in the euro area should have them.
Bild: The French president said that Europe should learn from the German model…
Draghi: … he’s right. Long before him I said that Germany is a model. The old European welfare state model is in fact dead, because it had to make debts far too often. The Germans have re-invented it—with no excessive debts.
This last point is absolutely fundamental. George Friedman, the founder of Stratfor, which specializes in geopolitical analysis, is one of many who have pointed out that one of the major challenges that democracies face is finding ways of paying for the promises that get politicians elected. Friedman states the problem facing Europe succinctly in a recent article on German strategic thinking, “The state of the world: Germany's strategy”:
“There were two possible solutions in the broadest sense. One was that the countries in crisis impose austerity in order to find the resources to solve their problem. The other was that the prosperous part of Europe underwrites the debts, sparing these countries the burden of austerity. The solution that has been chosen is obviously a combination of the two, but the precise makeup of that combination was and remains a complex matter for negotiation.
“Germany needs the European Union to survive for both political and economic reasons. The problem is that it is not clear that a stable economic solution can emerge that will be supported by the political systems in Europe.
“Germany is prepared to bail out other European countries if they impose austerity and then take steps to make sure that the austerity is actually implemented to the degree necessary and that the crisis is not repeated. From Germany's point of view, the roots of the crisis lie in the fiscal policies of the troubled countries. Therefore, the German price for underwriting part of the debt is that European bureaucrats, heavily oriented toward German policies, be effectively put in charge of the finances of countries receiving aid against default. This would mean that these countries would not control either taxes or budgets through their political system. It would be an assault on democracy and national sovereignty.”
Europe got into this mess because having massive social programs that provide increased benefits for the average citizen is always a huge plus for any political party, and is almost enough, in itself, to win elections. However, this puts massive temptation in the way of politicians to promise far more than the country’s economy can deliver. Philipp Bagus argues in “The tragedy of the euro” that the whole euro project has been “captured” by those who want a central bank that will move away from a Bundesbank-inspired focus on “sound money” and will, instead, be prepared to roll the printing presses to fund large-scale socialist projects in Europe.
On this view, Trichet was a major obstacle. His obsessive focus on keeping inflation “below, but close to, 2%” (a direct quote from one of his final speeches) meant that the ECB delivered an average of 1.97% inflation for the whole of its first 12 years of existence. It is very hard to imagine that Trichet would have come up with Draghi’s wonderful wheeze for calming down the European sovereign debt crisis.
Under pressure from all sides to permit the ECB to step in and buy unlimited amounts of sovereign debt, to drive down the unsustainable rates of interest being demanded by the markets to hold that debt, Draghi steadfastly refused. That sounds very Bundesbank-like, but what he did instead was to roll the printing presses big time in order to provide Europe’s banks with nearly a trillion euros to date, in the shape of “emergency liquidity.” The banks could borrow massively from the ECB at near zero interest for three years.
Draghi appears to have reached an off-the-record understanding with the major European banks that the quid-pro-quo for this deal is that they, the banks, then use the bulk of the money to buy their own sovereign debt. They are then able to offer this same debt back to the ECB as collateral for further borrowings on a mark-to-market basis. There is something of the whiff of a Ponzi scheme about this, sufficient to have drawn a thundering broadside down on Draghi’s head from the head of the Bundesbank, Jens Weidmann. Questioned about this by Bild, Draghi has an interesting and subtle response:
Bild: In two moves the ECB has put almost €1 trillion into circulation. That’s inflationary, surely?
Draghi: The banks to which the ECB has lent the money have, by and large, not fed this into the economic cycle but have used it to meet old liabilities. So the money in terms of inflation has, so to speak, been neutralized. This action is not inflationary. And we will watch very carefully if and how the money is fed into the economic cycle.
This is what is known as obfuscation and it works splendidly on the Bild editors. Those “old liabilities” are precisely the same old same old, of governments borrowing beyond their means to fund out-of-control, or almost out-of-control social programs. A year ago I blogged about a wonderfully acute paper from the Bank of International Settlements (BIS) which showed that the social benefits and pensions programs of the industrialized nations were on a hugely unsustainable trajectory. Draghi has grasped this point clearly, but it seems that with him the first priority is without question the need to dampen down the sovereign debt crisis. His emergency liquidity program appears to have done that and has been directly responsible for the strong upturn in markets seen since January 2012:
Draghi: The worst is over, but there are also still risks. The situation is stabilizing. The key data for the euro area, such as inflation, the balances of payments and in particular budget deficits, are better than in the United States, for example. Investors are regaining their trust and the ECB has not had to provide support by buying government bonds for several weeks now. It is now up to the governments. They must make the euro area crisis-proof in a sustainable manner.”
In other words, the ECB has done its bit. The Bundesbank might not be happy, but the markets have perked up. For how long remains to be seen, since the fundamental issue of making peripheral countries in the eurozone more competitive and bringing down their unit labor costs to German levels remains to be solved. However, the point is that Draghi found a way forward for the ECB which Trichet wouldn’t have countenanced, and which has left the Bundesbank steaming... Whether Draghi’s path is sustainable remains to be seen.
Further reading on the ECB and quantitative easing:
- Quantitative easing is not only failing, it’s also sparking global unrest, by Ian Fraser
- Steering Between Deflation and Inflation—A Troubled Road for Developed Economies, by Neil Williams
- Mervyn King’s testimony highlights challenges for regulators, by Anthony Harrington
Tags: Bundesbank , central banks , ECB , European Central Bank , Germany , Jean-Claude Trichet , Mario Draghi , qe3 , QEIII , quantitative easing