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MENDOZA IN THE NEWS

After Pledge of Help for Euro, Pressure Is On for Bank Chief

by Jack Ewing
Publication: The New York Times

July 29, 2012


 Mario Draghi demonstrated last week how a few choice words from a central bank chief can make or break fortunes, even those of whole nations.

Now the president of the European Central Bank faces the much more complicated task of delivering on last week’s promise to do “whatever it takes to preserve the euro.”

He will have a chance to give substance to that bold statement on Thursday when the bank’s governing council meets.

With expectations so high, anything short of a decisive display of financial firepower could send financial markets back to the panicky behavior of only a week ago — when the thin trading of summer was exaggerating stock market gloom and bond investors were bidding up the borrowing costs of Spain and Italy to potentially destructive levels.

Mr. Draghi’s vow last week and his assurance that “it will be enough” sent stocks up worldwide and drove Spanish borrowing costs down from their lofty levels.

Investors concluded that Mr. Draghi was signaling a major policy action, like huge purchases of government bonds to raise demand for debt from Spain and Italy and keep their borrowing costs at sustainable levels.

Nearly identical statements by Chancellor Angela Merkel of Germany, President François Hollande of France and Prime Minister Mario Monti of Italy in recent days further raised expectations, though it was unclear if they all had the same policies in mind.

Controlling the bond market may not be as simple as it sounds, though, even for an institution that has the power to print money. Nor, analysts said, are there many other easy or effective options for the European Central Bank, which serves the 17 European Union nations who use the euro.

Under its current charter, the central bank faces more restrictions on its ability to buy government bonds and stimulate the economy than the Federal Reserve does.

While the European bank is supposed to defend price stability above all else and is barred from financing governments, the Fed’s mandate puts more emphasis on promoting employment, and it has bought hundreds of billions of dollars’ worth of Treasury securities.

But even the Fed, whose policy-making committee meets Tuesday and Wednesday, is struggling to find ways to help the economy when its main tool, managing a benchmark interest rate, is close to zero. And the central bank’s benchmark interest rate, which has been cut three times since Mr. Draghi took his post last fall, is at a record low, at 0.75 percent. But in Europe, those low rates have not been passed on to business and consumers in countries like Spain and Italy because their banking systems are dysfunctional.

“They are in regions below 1 percent where the interest rate is basically impotent,” said Jeffrey Bergstrand, a professor of finance at the University of Notre Dame in Indiana and former Fed economist. “The only thing that can help is fiscal stimulus,” he said — in other words, government spending by countries like Germany that can afford it.

That may, in fact, be the message that Timothy F. Geithner, the Treasury secretary, delivers Monday when he meets his German counterpart, Wolfgang Schäuble, on the resort island of Sylt off the German coast. The United States has repeatedly pressed euro zone governments to be much more forceful in battling the crisis, which has been a drag on the global economy.

The European Central Bank has bought bonds before under a program begun by Mr. Draghi’s predecessor, Jean-Claude Trichet. But that failed to hold down borrowing costs for countries like Spain because the bank had not committed enough money or show enough determination. Any new round of bond-buying would have to be more impressive.

“What can they do and what would bring about a sustained turnaround in market confidence?” said Jacques Cailloux, chief European economist at Nomura in London. “There I struggle to find something that would really be convincing.”

In theory, the central bank could cap bond prices simply by declaring that it would not tolerate market interest rates for Spain above, say, 7 percent. Any speculator who might want to bet against Spanish debt would confront the risk of big losses if the central bank bought bonds in grand style on the open market to drive down yields, the effective interest rates.

If the threat was credible enough, the bank might not actually have to carry it out.

That, however, is where the task becomes more tangled. For the central bank to be sufficiently intimidating, it would have to violate some existing taboos.

For example, it would have to abandon its practice of offsetting its bond purchases by taking in equal amounts in commercial bank deposits. By absorbing deposits, the bank takes as much cash out of the system as it puts in via bond purchases. By keeping the supply of money in the economy approximately even, it tries to avoid the appearance that it is printing money.

But already, the bank has struggled some weeks to attract enough interest-earning deposits from commercial banks to cover the bond purchases it has already made, valued at 212 billion euros, or $260.7 billion.

The European Central Bank would also probably have to stop treating itself as a privileged creditor — something it did this year during the Greek bailout. By refusing to absorb losses on Greek bonds as private creditors were forced to, it may have unintentionally raised borrowing costs for other troubled countries.

Investors concluded that, if any country could not meet its obligations, private creditors would once again bear all the pain.

A decision to accept losses on the bank’s holdings of Greek bonds would be a significant policy shift, though, and raise other difficult questions. Certainly the Greek government would rejoice if its debt load dropped by 20 billion euros or so — or even more if the European Union also took losses on its holdings.

But in Germany, where the public debate is still focused on teaching Greece a lesson, the reaction would be outrage. The rumblings of discontent could already be heard Friday, a day after Mr. Draghi’s “whatever it takes” pledge. The Bundesbank, Germany’s powerful central bank, reiterated that it remained opposed to bond purchases because they push the central bank into the realm of financing governments, a violation of its charter.

Dissent by Germany, the euro zone’s biggest financier, would raise questions about the bank’s resolve and very likely blunt the effectiveness of bond market intervention. That has been a problem in the past.

“Technically it’s easy,” Charles Wyplosz, a professor of economics at the Graduate Institute in Geneva, said of the bank’s putting a cap on government borrowing costs. But “there will be an uproar in Germany,” he quickly added. “The politics are too complicated.”

Mr. Draghi, a clever economist and seasoned policy maker, may devise a way through this political and legal minefield. He has so far avoided a public dispute with Jens Weidmann, the Bundesbank president, and the two are said to enjoy a collegial relationship, perhaps leaving room for compromise.

Analysts have suggested, for example, that the European bailout fund, the European Financial Stability Facility, could be deployed to buy Spanish and Italian bonds. Unlike the central bank itself, the bailout fund is empowered to buy bonds directly from governments. It would also assume the job of making sure that Spain and Italy fulfill promises to reduce debt and restructure their economies.

Then, the thinking goes, the central bank could buy bonds on the open market as needed to put added downward pressure on borrowing costs.

But this mechanism would take time to carry out, which raises the question of what other, quicker steps the bank could agree to at its meeting on Thursday to satisfy the expectations that Mr. Draghi has raised.

The benchmark interest rate, cut to 0.75 percent from 1 percent in early July, could be cut again — to 0.5 percent or even 0.25 percent.

The central bank, though, has direct control only over the rates at which it lends to commercial banks. The effect on the interest rates that businesses and consumers actually pay would probably be minimal, especially in countries like Greece or Spain that need help most. Banks in those countries are focused on just surviving and are not lending much.

There might be other benefits, though. Already, the euro has declined in value against the dollar partly in response to the interest rate cut in early July. Economists differ on how much a weaker euro really helps exporters, whose products become less expensive in dollar terms.

“Given the situation in the euro area and the rest of the world, there can be no better news than that the euro is finally depreciating,” Mr. Wyplosz said, though he cautioned that weak global demand could blunt the effect.

Perhaps the most important impact of another cut would simply be to signal that the central bank is willing to break new ground to save the common currency — even if it is not totally clear what surprises Mr. Draghi may have in store.

The July cut “was a very strong signal the E.C.B. was more flexible,” Mr. Cailloux said. “It is open to more cuts if needed and not ruling out unconventional measures.”