The Draghi put on trial

Financial Mirror (Cyprus) - - FRONT PAGE -

In the sum­mer of 2012, Euro­pean Cen­tral Bank Pres­i­dent Mario Draghi pledged to do “what­ever it takes” to save the euro, in­clud­ing pur­chas­ing “un­lim­ited” amounts of strug­gling gov­ern­ments’ bonds. The move, which has come to be known as the “Draghi put,” almost im­me­di­ately re­duced bor­row­ing costs for Spain and Italy, and is widely touted as hav­ing pulled the eu­ro­zone back from the brink of dis­as­ter – with­out ever us­ing the so-called “out­right mon­e­tary trans­ac­tions.”

That may sound like a re­sound­ing suc­cess: the mere an­nounce­ment of the OMT scheme was enough to end the mon­e­tary union’s ex­is­ten­tial cri­sis.

But, ac­cord­ing to the Ger­man Con­sti­tu­tional Court, the pol­icy vi­o­lates Euro­pean Union treaties – a rul­ing that the Euro­pean Court of Jus­tice is now re­view­ing. The ECJ’s decision will have im­por­tant im­pli­ca­tions for the eu­ro­zone’s fu­ture, for it will de­fine what au­thor­ity, if any, the ECB has to in­ter­vene in a debt cri­sis.

And yet, in a fun­da­men­tal way, the cur­rent de­bate about OMT misses the point. Rather than ask­ing whether the ECB’s man­date al­lows it to in­ter­vene in a debt cri­sis, EU lead­ers should be ask­ing whether it should.

The Bun­des­bank’s po­si­tion on this ques­tion is well known; a leaked sub­mis­sion to the Con­sti­tu­tional Court last year de­clared un­equiv­o­cally that, “It is not the duty of the ECB to res­cue states in cri­sis.” But there is a strong case for al­low­ing the ECB to act as lender of last re­sort.

One key ar­gu­ment for forc­ing cen­tral banks to ad­here to strict in­fla­tion tar­gets is that it elim­i­nates the temp­ta­tion to use “mon­e­tary fi­nanc­ing” (pur­chases of gov­ern­ment bonds) un­ex­pect­edly, ei­ther to stim­u­late the econ­omy or to in­flate away its debt. After all, such ac­tion rarely works: mar­kets an­tic­i­pate it and raise in­ter­est rates to com­pen­sate lenders for ex­pected in­fla­tion. The re­sult is typ­i­cally both high in­fla­tion and high bor­row­ing costs.

What is worse, the ar­gu­ment goes, the ex­pec­ta­tion of mon­e­tary fi­nanc­ing would drive gov­ern­ments to bor­row ex­ces­sively. This could trig­ger a vi­cious cir­cle of mount­ing debt and un­con­trol­lable in­fla­tion, with dev­as­tat­ing con­se­quences.

Th­ese are con­vinc­ing ar­gu­ments. But they fail to ac­count for one crit­i­cal fac­tor: his­tor­i­cal con­text.

If a debt cri­sis re­sults from gov­ern­ment profli­gacy and mis­man­age­ment, rather than from a mar­ket fail­ure, it is true that the cen­tral bank should not in­ter­vene.

If, how­ever, the cri­sis re­sults from a co­or­di­na­tion fail­ure among in­vestors – when each in­vestor re­fuses to roll over the gov­ern­ment’s debt for fear that oth­ers will do the same, lead­ing to a de­fault – mon­e­tary pol­icy can play an im­por­tant role.

In­deed, by putting a floor on the price of sov­er­eign debt and any ac­com­pa­ny­ing in­fla­tion, cen­tral-bank in­ter­ven­tion would re­duce the real value of the debt and fa­cil­i­tate re­pay­ment. More­over, as the OMT an­nounce­ment demon­strated, a cred­i­ble prom­ise to use mon­e­tary fi­nanc­ing in the event of such a cri­sis can pre­vent it from aris­ing in the first place – with no in­fla­tion­ary ac­tion re­quired.

With­out cen­tral-bank in­volve­ment, in­vestors’ pan­icky prophecy would be self-ful­fill­ing, with the re­sult­ing spike in bor­row­ing costs mak­ing it im­pos­si­ble for the gov­ern­ment to re­pay its cred­i­tors. In other words, pro­hibit­ing the cen­tral bank from act­ing as lender of last re­sort can push sol­vent economies into a need­less debt cri­sis, un­der­min­ing out­put and em­ploy­ment. By most ac­counts, this is pre­cisely what hap­pened to Spain and Italy in 2012.

In this con­text, the Draghi put was a highly de­fen­si­ble ac­tion. Re­fus­ing to con­sider any amount of mon­e­tary fi­nanc­ing, and con­tin­u­ing to ad­here to a strict in­fla­tion tar­get, would have been much more dif­fi­cult to jus­tify.

To be sure, cen­tral-bank in­ter­ven­tion is not the only way to quell self-ful­fill­ing crises in the eu­ro­zone. Fis­cal trans­fers, whereby eu­ro­zone coun­tries com­mit to pro­vide funds to their dis­tressed coun­ter­parts, could also work. But this ap­proach is far less prac­ti­ca­ble, and thus less cred­i­ble.

Op­po­nents of cen­tral-bank in­ter­ven­tion are right about one thing: mon­e­tary fi­nanc­ing car­ries se­ri­ous risks. In or­der to en­sure that it is as safe and ef­fec­tive as pos­si­ble, it must be used pri­mar­ily in the event of self-ful­fill­ing debt crises.

In terms of in­sti­tu­tional de­sign, it is thus op­ti­mal for the cen­tral bank to main­tain a strong com­mit­ment to keep­ing in­fla­tion low in nor­mal times and to be will­ing to in­ter­vene in a cri­sis. The ECB’s use of OMT sat­is­fies both cri­te­ria.

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