Eurozone: Draghi’s new deal

About halfway through the speech, Mario Draghi stumbled. The European Central Bank president had reached a passage in his prepared remarks about the worrisome trend in inflation afflicting much of the continent. With inflation at a five-year low, it is a topic Mr Draghi talks about often, and a subject that his audience – the world’s top central bankers at last month’s Jackson Hole conference – knows well.

But Mr Draghi’s usual fluent, Italian-accented English faltered a touch as he delivered several paragraphs with a very different texture – rambling and highly technical. Then he uttered a line that would send a potent message to global financial markets and political leaders across Europe. The ECB’s governing council, he said, “will use all the available instruments needed to ensure price stability in the near-term”.

Mr Draghi was off his text. The remarks surprised many of Mr Draghi’s colleagues on the council, but their impact was delayed: European markets were closed, the addition was not in the speech on the ECB’s website, and the Jackson Hole audience focused on his comments about austerity. The next Monday, however, eurozone governments’ bond yields fell and equity markets around the world rallied in anticipation of more monetary easing when the ECB board meets tomorrow.

Few central bankers are more aware of the power of their words than the ECB’s urbane president. Another of Mr Draghi’s ad-libs, made two years ago, that the ECB would do “whatever it takes” to save the euro is seen as a masterstroke that halted the downward economic spiral that had gripped the continent.

The confidence inspired by that speech lasted until a few months ago, when worries about the eurozone began to resurface. Mr Draghi’s Jackson Hole remark was his most direct acknowledgment yet that investors had begun to lose faith in the ECB’s ability to hit its inflation target – the cornerstone of its policy framework. And he suggested that the eurozone’s monetary guardians were willing to do more to prevent it from falling into Japanese-style stagnation.

Yet his pledge came with a caveat. Conditions had become so bad that, while the ECB could act, it could not do it all alone. Mr Draghi signalled the ECB was reluctant to reach for its most powerful tool – mass government bond buying, or quantitative easing – without the co-operation of European governments.

At the height of the crisis central bankers saved the day, cutting interest rates and providing plentiful supplies of cheap money to stave off a financial meltdown. But the lacklustre performance of the global economy since then has highlighted the limits of monetary policy. While central bank cash has helped asset prices soar, productivity and growth remain anaemic in advanced economies.

“QE’s critical,” says Krishna Guha, vice-chairman at ISI Strategy. “But it’s not transformative.”

For the first time, the ECB president proposed what amounts to a fiscal and monetary compact with the currency area’s lawmakers. The only way to defeat the region’s low inflation and double-digit unemployment was, he said, “a policy mix that combines monetary, fiscal and structural measures at the union level and at the national level”.



Guntram Wolff, director of Bruegel, a Brussels think-tank, says it was a message Europe needed to hear: the eurozone economy is in a mess so grave that mass bond-buying alone cannot revive it.

“He is saying that the eurozone needs easier macroeconomic policies and structural reforms, and that the two need to go hand in hand,” Mr Wolff says. “You need both; without reform all of the fiscal and monetary ammunition will just evaporate.”

Six years after the collapse of Lehman Brothers, the currency area’s economy remains smaller than it was at its pre-crisis peak. Its recovery has ground to a halt. Inflation, at less than a fifth of the ECB’s target of just below 2 per cent, threatens to wreak havoc by exacerbating high debt burdens in some countries.

For that to change, Mr Draghi signalled that governments in the eurozone’s three largest economies – Germany, France and Italy, none of which grew at all between the first and second quarters of this year – needed to act alongside the eurozone’s monetary guardian.

The message: Paris and Rome must reform their economies, removing barriers to the creation of businesses and jobs. Countries with the flexibility to spend more while staying within EU deficit rules should do so, creating what Mr Draghi described as “a more growth-friendly overall fiscal stance for the euro area”.

Though the ECB president did not name names, that suggestion was widely interpreted as a call for Germany, the eurozone’s dominant economic power, to raid its fiscal coffers.

“The part of Mr Draghi’s speech on the fiscal stance was an innovation,” says Lucrezia Reichlin, a professor at London Business School and a former head of research at the ECB. “The idea of co-ordination between
monetary and fiscal policy from a euro area perspective is a hint to Germany.”

France, already used to the ECB’s grumbles that it should do more to restructure the economy, received Mr Draghi’s calls warmly.



President François Hollande’s embattled government seized on the speech. “It is the position held by the president for the past two years,” insisted prime minister Manuel Valls in a speech on Sunday aimed at rallying the rebellious ruling Socialist party behind Mr Hollande.

The French president, who met Mr Draghi in Paris on Monday, is acutely aware that France’s credibility is very low, weakening its pleas to Brussels and Berlin for more budgetary leeway and a demand boost from the EU and Germany. During his two years in office, pledges to reduce the budget deficit below the EU’s designated limit of 3 per cent have come and gone with each budget projection. After securing a two-year delay from Brussels to 2015, it is already clear, with growth stalled, that France will not meet that deadline either.

Only now is the government gearing up to rein in its vast public spending bill, via €50bn savings over the next three years, and to take steps to loosen rigidities in the economy. (France said yesterday it will miss targets to trim public spending.)

In Italy, now suffering from its third recession since the crisis began, Matteo Renzi, the country’s 39-year-old prime minister, took office in February vowing to bring new flexibility to the EU’s rules. But while Mr Draghi’s shift in tone on fiscal policy brings him closer to Mr Renzi’s position, the ECB president is thought to favour less flexibility than the Italian prime minister.

Mr Renzi has taken a swipe at Mr Draghi’s criticisms and calls for more centralised control of reform efforts, with the prime minister pugnacious in his defence of Italy’s sovereignty. “I agree . . . when he says that Italy needs to make reforms, but how we are going to do them I will decide,” he told the Financial Times last month.

Mr Renzi has responded to Italy’s economic malaise with what he has called his “1,000-day” reform programme, which includes pledges of structural reforms to be undertaken over three years.

If the ECB president is to pull off his strategy to mend the eurozone economy, it is crucial that he wins the support of German chancellor Angela Merkel. “In Germany what matters is that he has Merkel’s support. If Draghi is keeping her onside, then he’ll be fine,” says Lorcan Roche Kelly, of Agenda Research.

The government of the eurozone’s largest economy, accounting for almost 30 per cent of all of the region’s output, has room to spend. A fall in output in the second quarter has raised concerns that Germany – the bloc’s economic engine – is beginning to run out of steam, bolstering the case for more investment spending by Berlin.

But Ms Merkel’s willingness to raid the fiscal coffers is unclear. Though she left the door open to channelling the budget surplus into investment programmes, she has indicated this could happen only if the economy were strong enough.

Her relationship with Mr Draghi, the strength of which played a vital role in shaping the ECB’s response to the financial crisis, still appears strong. Reports in Der Spiegel, a German weekly news magazine, over the weekend that the German chancellor had taken Mr Draghi to task over his remarks were quickly rebuffed.



Ms Merkel’s office confirmed that a call had taken place between the German chancellor and Mr Draghi, who initiated it. However, her office insisted that claims the chancellor questioned Mr Draghi about his speech “had nothing to do with the truth and the facts”.

The ECB is the only leading central bank to have avoided embarking on quantitative easing. One factor has been German opprobrium over a policy some view as a bailout for the region’s weaker economies. The governing council’s hawks have also used what they view as France and Italy’s fiscal profligacy and resistance to reform as crucial to their argument.

Some analysts view the apparent trade-off between quantitative easing and more reform from France and Italy – and more spending from Germany – as a ploy to buy more time.

“Draghi’s remarks shouldn’t be taken at face value. His call for fiscal easing deflects pressure on the ECB to launch QE, safe in the knowledge that Germany would block any such move,” says Philippe Legrain, an economist and former adviser to then European Commission president José Manuel Barroso. “By arguing that the effectiveness of QE depends on a more stimulative fiscal policy and bolder structural reforms, he was in effect raising new hurdles to it.”

Others question Paris and Rome’s willingness to take steps that could risk alienating the electorate.

“The problem is that the only bit that can move is Mario Draghi,” says Mr Roche Kelly. “The biggest risk he is taking is that he ends up as the boy who cried wolf.”

The ECB will almost certainly act on Thursday. But more incremental policies to ease credit conditions, such as an announcement of a plan to buy asset-backed securities, are a far more likely outcome. Investors desperate for large-scale bond purchases could, for now, find their hopes dashed.

“An outright announcement on QE is not going to come just yet,” Mr Wolff says. “The ECB would like to see some form of political contract.”

Asset-backed securities: A tarnished product primed for a comeback

One policy option available to Mario Draghi that he is almost sure to use is a European Central Bank programme to buy “asset backed securities”, writes Ralph Atkins.

These are financial instruments that package up bundles of loans, tranches of which are then sold to investors. Their reputation was blackened in 2007 when securitised “subprime” US mortgages helped trigger the global financial crisis.

But Mr Draghi sees them as a way of restoring credit flows to distressed eurozone economies. His idea is that securitisation should also be used to pool loans made to job-creating small and medium-sized companies.

If the market were revived, ABS could whet investors’ appetites for better performing assets during an era of ultra-low interest rates.

“ABS channel investors’ ‘hunt for yield’ into loans to the real economy – that is the missing link in the chain,” says Alberto Gallo, strategist at Royal Bank of Scotland.

Rather than repeating the complexity of pre-crisis ABS, Mr Draghi says he wants simpler, more transparent products that “are not going to be a sausage full of derivatives”.

The ECB announced last week that the advisory arm of BlackRock, the US asset manager, would help design a purchasing programme.

A revived ABS market would allow Europe’s weakened banks to shift loans off their balance sheets. But ECB purchases would not be a quick fix for the eurozone’s woes. After the US subprime mortgage crisis, ABS fell out of favour among regulators and the market slumped. There are still not many ABS for the ECB to buy.

Most of the €1.4tn European securitisation market consists of residential mortgage-backed securities, which the ECB may not want to buy through fear of encouraging housing bubbles. Only about €108bn of European ABS are backed by small business loans.

That means an ECB purchasing programme would have to be small scale initially. Moreover, its aim would be to remove obstacles to lending – rather than provide an inflationary stimulus to the economy. It would not be the “big bazooka” many economists believe is needed to prevent the eurozone falling into a dangerous deflationary downswing.




Fonte: FT