The Draghi put on trial
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.