Why there's more in Draghi's may-day speech than markets realise

Mario Draghi (Photo by Monika Flueckiger/ World Economic Forum, via Wikipedia)

At first sight, Mario Draghi’s performance on Thursday was an utter disappointment. As expected, he held out the prospect of future bond purchases by the ECB.

However, he did not mention any amounts, dates or interest rate target. For the cursory observer, his statement was vague and woolly. Once again, it looked like European policy makers relying on words rather than deeds. It was all about “may” and “could”.

The dearth of detail turned financial markets off.  However, from my perspective, the disappointment about Draghi’s may-day speech is a bit over to top.

If you take a closer look at Draghi’s speech, things start to look differently. Between the lines the message was perfectly clear. The Bundesbank might not like it, but the ECB will intervene in the bond markets in the foreseeable future. And big time.

From my perspective, the most important piece of the speech was Draghi’s implicit acknowledgement that the ECB has a target rate for bond yields. Draghi described the current yields as unacceptable and he stressed that the ECB “may undertake outright open market operations of a size adequate to reach its objective”.

He did not reveal where the ECB’s pain barrier is. However, the mere acknowledgement that the ECB has a certain threshold in mind is quite something. If Draghi means what he says, it follows that the bank is ready to buy bonds without any limits.

Without any doubt, more details and immediate actions by the ECB would have been desirable. However, the good news is that Europe’s central bank is moving in the right direction despite fierce opposition from the Bundesbank.

And Draghi has good economic arguments on his side. If policymakers are interested in preserving economic stability in the Euro zone, they currently don’t have a lot alternatives to bond purchases at the moment.

The trouble is that markets are in a panic mode and just to not work rationally at the moment. Countries like Spain, Italy and Portugal have made quite some progress with regards to fiscal consolidation and structural reform. However, financial markets to not acknowledge this at all. Is is even stressed by the German council of economic advisors, traditionally the holy grail of economic orthodoxy.

According to IMF estimates, the sovereign risk premiums in Spain and Italy are at least 200 basis points higher than justified by fundamentals. The countries are trapped in negative feedback loops. Rising bond yields, declining GDP, growing fiscal deficits and too much austerity reinforce each other. Yet more austerity  and structural reforms are not sufficient to break this vicious circle.

Stopping the malicious overshooting on the bond markets is the ultimate rational of bond purchases by the ECB. It’s not about financing public deficits by printing money, as a lot of commentators in Germany suggest. Judged by fundamentals, the sovereign bond market in Europe is just playing up. Given its economic significance, this must not be tolerated.

The Bundesbank and a lot of observers in Germany claim that such intervention was at odds with the ECB’s mandate. From my point of view, this argument  does not hold the water. In fact, quite the opposite is true. If the ECB stands idle, the whole monetary transmission mechanism might break down. If this happens, the ECB cannot control inflation anymore and would not be able to fulfil its remit to stabilise the level of consumer prices.

In Germany, a lot of people worry that bond purchases will trigger inflation. However, this fear is  misguided as well. As long as these instruments are only used in extraordinary times like today, inflation isn’t in the cards. Southern Europe is suffering from a severe recession, even the German economy has started to tank. Bank lending is depressed, high and rising unemployment as well as inordinate levels of private debt dampen consumer spending.

The currency area is at the brink of a severe recession. Deflation rather than inflation is in the cards for Europe at the moment, especially if the Euro crisis keeps worsening. Disturbingly, fiscal policy and traditional monetary policy has run its course.

Draghi’s management of expectations was iffy and the ECB should act more swiftly and decisively. The delay was  probably was due to fierce opposition by the Bundebank.  Draghi has to appease the German orthodoxy because he cannot afford that another German central banker resigns. If that happened, most of the media in Germany as well as the public opinion in German would go wild. Hence, strategically speaking, gaining some time seems like a smart move. Conquering the Bundesbank requires a war of attrition rather than a Blitz.

Apart from strategic considerations, however, it might help if the Bundesbank had a look at the economic arguments once in a while. This should lead to the conclusion that bond market interventions are just necessary. For good reason, the institution is besotted with the idea of monetary stability. However, they haven’t understood yet that they have to waive their qualms against bond purchases precisely for that reason. Getting the bond markets out of the panic mode is the biggest contribution monetary policy can make to stability within the Euro area.

14 Comments

Filed under Economic Policy, Monetary Policy

14 Responses to Why there's more in Draghi's may-day speech than markets realise

  1. Martin Krafft

    Dear Mr. Storbeck,

    I follow Economics Intelligence with great interest. Today’s article about
    about the between-the-lines in Draghi’s speech disturbed me quite a bit,
    however.

    Two things: first, you write that “markets today don’t behave rationally”.
    They never do, and anyone who thinks they do, is hugely misled, in my humble
    opinion. The models that seek to explain and even forecast markets are woeful
    simplifications and they fall short as soon as something unforeseen comes
    around — which happens quite a lot.

    More disturbing, however, is that you seem to believe that the ECB is
    following their mandate when they break the EU contract (bail-out) by buying
    bonds of other contries. The argument that if they didn’t do this, they could
    not control inflation is wrong. First, there is no guarantee that they can
    control inflation if they break the rules, and second, there is no guarantee
    that they wouldn’t be able to do it if they obeyed the rules.

    I side with Roman Hertzog, who questions that with respect to § 88, Germany
    should be asking themselves empathically whether the ECB’s behaviour isn’t
    against the German constitution and whether the proper next step would be to
    reclaim souvereignity over the currency with which Germany trades.

  2. Vlad Zamfir

    You act like these bond purchases will only be temporary, when by virtue of the fact that these governments cannot repay their debt and will continue spending more than their revenues, they will have to continue to roll over their debt and issue more bonds indefinitely to avoid default, requiring more bond purchases by the ECB if the market isn’t willing to buy them at Draghi’s target rate.

    Someone will have to take these losses, in real terms. Either the bond prices will fall and the bondholders get hit (and interest rates rise making it harder for these governments to impose losses on creditors by issuing more bonds), or the ECB will make sure these prices stay high (and interest rates low, making it possible for these governments to pretend for longer that they have sound fiscal policies, allowing them to push real losses to the ECB). Even if there is deflation and the inflationary effect of hiding these losses by monetizing bad debt doesn’t lead to a net inflation, this does not solve the problem in real economic terms — governments are able to continue to spend beyond their means, and are able to continue to become more terminally indebted. High interest rates and low bond prices are signals that should make the problems clear and force policy makers to be more disciplined… postponing the day of reckoning when this medicine must be swallowed through central bank policy only makes for more misallocation of capital in the real economy…

    We can’t act like this is a temporary problem, it’s a permanent problem until there is serious fiscal reform for most European countries, and default for a good number of them. The longer we wait, the worse things will be for the real economy in the long run. The sooner we accept reality and face the problems, the less time the people who’ve made bad judgments have to maneuver out of their positions or out of political office, the sooner capital will flow to prudent investors and the sooner the real recovery can begin.

    • How can you state that ” these governments cannot repay their debt and will continue spending more than their revenues” when Spain had a budget surplus before the 2008-9 crisis, and Italy had a primary surplus?
      The idea that the cause of the current crisi is to found in profilgate governments throughout Europe is yet another myth that keeps on living…

      • Martin Krafft

        @Philippe: because the numbers have exploded. The capital moved by the ECB these days is way beyond the pre-crisis budget of Spain and Italy.

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  6. I agree with you. ECB have to (not may or could) intervene in the bond markets, buying bonds if they want to save the Euro.

  7. Peter Pipesmoker

    The above article is probably closer to the truth of what Draghi is trying and has agreed to do .The thing that worries me most is the Germans are in complete denial to the seriousness of the situation .That is not a good sign and hints that suffering amongst peripheral nations doesn’t feature in their thinking at all . Not a good long term sign for a United States of Europe which is not going unnoticed . There seems to be a feeling in Germany that the others irresponsibly partied and can suck it up a bit . They seem to think that problems are being talked up by people who are looking to profit a bit from the Euros difficulties . That may yet prove a fatal viewpoint for the Euro and by extension the EU Project . Yours Peter Pipesmoker Ireland .

  8. Martin Krafft

    @David Toija: Sure, if they want to save the Euro. But the Euro is flawed. It’s the roof built without a house underneath. I think we should try again, but this time do it properly. And stop fighting fire with fire.

  9. Martin Krafft

    @Peter Pipesmoker: Germans are not in complete denial of the seriousness of the situation. The Germans simply don’t see a reason why those people, who invested their money into bonds of countries that didn’t pull their weight and thus had to pay more interest (= more risk), should be paid out with German money.

    There may well be a point about European stability being at risk. However, all that is ever talked about is the financial side of things. I say that the financial side is not endangered, it is *responsible* for what is going on.

    A shared currency can only ever be the result of policy integration. However, the EU folks shortcut that bit and introduced the currency without there being any shared policy. This was shortsighted and robbed each member country of the necessary independence to maintain European balance. The Euro has destroyed this balance.

    Keeping — “saving” — the Euro is what those invested in countries close to bankruptcy want. The indebted countries would obviously also prefer someone else to pay their debts.

    But that would be throwing oil onto a fire.

    The solution cannot be budget cuts and savings, as that will throw the local economies into a turmoil from which they will not recover anytime soon.

    The solution is to give back independence to the countries, to let the European balance be re-established, and then to try again.

    The Euro has failed. Not so Europe or the EU, because we are united by far more than just a currency. That is what politicians need to understand and be brave enough to stand up to.

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