What’s at stake: Last week was dominated by Thursday’s ECB Governing Council meeting and Mario Draghi’s subsequent press conference, where he clarified some of the statements made earlier in London. In particular, he gave a precise idea about what commentators had previously referred as “a grand master plan” or “the two-pronged approach” where ECB intervention on the secondary market would be conditioned on countries making first a request to the EFSF and accepting the strict conditions and supervision attached to it. While there is still uncertainty about how things will play out – the board gave “a determined guidance for the committees to design the appropriate modalities for such policy measures” over the coming weeks – the change of approach from implicit (illustrated by the now infamous letter to Berlusconi from last year) to explicit policy conditionality was important enough to generate surprise and excitement among several ECB watchers.
What Mario Draghi said
In the Q&A session following his Introductory Statement Mario Draghi said that “the guidance that we have given to the committees of the ECB differs from the previous programme” [since] “we have explicit conditionality here”. “The first thing is that governments have to go to the EFSF”, but “to go to the EFSF is a necessary condition, but not a sufficient one”. “When governments have actually fulfilled the necessary conditions, namely have undertaken fiscal and structural reforms and applied to the EFSF with the right conditionality. At that point, we may act, if needed.”
Karl Whelan points that the ECB would focus on the acquisition of short-term debt and, unlike in the past, would state how much it was purchasing. Finally, ECB will re-examine its policy of insisting on being treated as senior to private bondholders.
The new doctrine of explicit policy conditionality
Erik Nielsen argues that the ECB de facto introduced a new doctrine in central banking; namely that of explicit policy conditionality for its actions. Nielsen writes that he cannot recall another example of a central bank telling its democratically elected officials that there will be a threshold in terms of their policy stance below which the central bank will simply throw in the towel and accept that markets (dysfunctional or not) have made it impotent with respect to its ability to steer policies to fulfill its mandate. So, what, for Italy and Spain, used to be peer pressure or informal conditionality, will now become formal conditionality. If it leads to better policies by governments, if the EFSF/ESM appreciates those efforts and if this comforts the general public (and the media) in core Europe and therefore frees the hands of the ECB to do what they have to do to restore a proper transmission mechanism, then he can see not only the light of the end of the tunnel of this crisis, but the opening itself. But it seems that the ECB has seriously raised the stakes for the eurozone and might one day face a serious dilemma: In a future scenario where a government cannot reach agreement with the EFSF/ESM, do they stick with their new doctrine and refrain from intervening and accept what could well be sovereign default, or do they risk their credibility and reverse to their previous doctrine of intervention if the dispute is small enough (or the country big enough), thereby seriously challenging their own future?
Yanis Varoufakis (HT Simon Wren-Lewis) writes that Mr Draghi has, possibly unwittingly, undermined 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. 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 privatization 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.
Antonio Fatas writes that this is not ideal but understandable. Some national governments would love to see the ECB intervening in financial markets to reduce their risk premium without having to involve any supervision from European authorities. But the political reality is that intervention by European institutions requires some risk sharing to be successful. And risk sharing requires some recognition that we are all in the same boat and as such the decision on the directions in which the boat has to go have to be made together.
The Economist’s Charlemagne argues that the ECB must perform a delicate balancing act: between its potential power to print vast amounts of money and its unusually narrow legal mandate to maintain price stability; between the interests of creditor and debtor states; and between maintaining market pressure on countries to reform and preventing them from being pushed into insolvency.
Lorenzo Bini-Smaghi writes that politicians and commentators cannot ask for more Europe, then complain about the loss of sovereignty. If the survival of the euro requires further political integration, as many suggest, then member states need not only to share more decisions at European level but also to accept more interference by EU institutions in areas previously held to be the preserve of national authorities. High quality global journalism requires investment. The real issue is the democratic legitimacy and accountability of the institution responsible for the relevant decisions – in this case, the Eurogroup. Either the Eurogroup is considered legitimate, or it should be made legitimate, as soon as possible.
The ECB as a LoLR to governments redux
Kevin O’Rourke writes that the reason why economists like Paul de Grauwe have been asking for ECB intervention is so that an Italian bailout becomes unnecessary; now it seems that Italy will only get ECB intervention if it enters a bailout programme. The whole thing seems upside down, and people are playing with fire here. Despite its large debts, Italy wouldn’t be having these difficulties on the market if it wasn’t in EMU: to ask a big, important country with a sense of its own dignity to give up sovereignty — and potentially enter the same death spiral as Greece, and now apparently Spain — simply so that it can remain in a single currency that isn’t working seems like a bit of a stretch.
Karl Whelan writes that there are two ways that the ECB could allow such a lender of last resort to come into existence. The first option is for the ECB to purchase bonds in the secondary market. This allows primary bond investors to buy government bonds safe in the knowledge that a market for the bonds will continue to exist. The second option that can produce a sovereign lender of last resort in the euro area is the provision of a banking license to the ESM bailout fund combined with the ECB accepting this fund as an “eligible counterparty”. Karl Whelan disagrees strongly with the ECB’s current approach on the banking license issue. During the press conference, Draghi said he was puzzled people kept raising this question and pointed to this legal opinion from the ECB, which states that “Article 123 TFEU would not allow the ESM to become a counterparty of the Eurosystem”. However, this is a blanket statement rather than an opinion. While part 1 of Article 123 rules out monetary financing of governments, part 2 states: “Paragraph 1 shall not apply to publicly owned credit institutions which, in the context of the supply of reserves by central banks, shall be given the same treatment by national central banks and the European Central Bank as private credit institutions.”
Sony Kapoor writes that this set of interventions does not constitute a game-changer. With a banking license for the ESM ruled out, the only real ‘bazooka’ option that has not been explicitly ruled out is something Re-Define suggested last year as a compromise: “The ESM could indemnify the ECB against any credit losses on its purchases of sovereign bonds”. Economically, this is similar to the ESM bank model as the credit risk is taken on by the ESM and the funding comes from the ECB. However, unlike the ESM bank idea, which has explicitly been ruled out by key political actors not least Draghi himself, this idea has not been vetoed, yet.
The impact on Target 2 balances
Gavyn Davies writes that Draghi’s latest idea – ECB purchases of short dated bonds under a reactivated Securities’ Market Programme – will not increase the scale of official capital inflows into Spain, since they will (mostly) be undertaken by a Spanish entity, the Bank of Spain. This means that reactivation of the SMP will not eliminate the need for Target 2 imbalances to continue rising, which ultimately could undermine confidence in the single currency still further. In order to prevent that, more drastic action to raise official capital flows into Spain, like providing a banking license for the ESM, would be required.