When Mario Draghi delivered his first prepared public remarks as ECB President on 8 November 2011, he provided several clues about the coming eight years.
- No surprises on monetary policy, where he announced "continuity, consistency and credibility" as the touchstone, with these principles framed with reference to price stability.
Then came the important part. His choice of words and topic demonstrated why it is wrong to see the ECB as a "normal central bank", why the decades-old guidebook for independent central banks can be discarded.
- Knowing that European political leaders cannot curb the ECB’s independence without violating their treaty obligations, Draghi took Eurozone politicians head on.
He scolded them for their lack of progress on reform, demanded action and called for "[s]olid public finances and structural reforms and…. a much more robust economic governance of the union going forward." Mindful of the ECB’s role in the ouster of Silvio Berlusconi, Draghi’s words have unusual impact.
In short, the ECB is a central bank like no other. In this crisis it is a full-blooded political actor. As the sole institution that can affect financial markets, its influence goes beyond monetary policy and is unchecked by Eurozone politicians. As I explain below, the ECB is speeding toward a confrontation, not with Spain or Italy, but with France.
The ECB’s wish list
Progress is under way on the first two items on Mario Draghi’s wish list, public finances and structural reforms in Eurozone nations.
- Despite the highest unemployment rates in Europe, Spanish voters gave a historic majority to the Partido Popular’s Mariano Rajoy – the leader most committed to further fiscal austerity and structural reforms, not least of the Spanish labour market.
- In Ireland and Portugal, pro-reform governments were installed despite voter unease over their economic hardship.
Some commentators, drawing an analogy with the Tea Party movement in the US, predicted that irresponsibility would carry the day in Europe. But that has not happened. Populism in Europe remains entrenched on the peripheries of the Eurozone political landscape. Europe is also confronting many "third rail" issues, such as labour market reform in Spain, public pensions in Greece, public wages in Portugal and privileged services professions in Italy. Addressing these structural problems is more important to the prospects of economic growth in Europe than the short-term outlook.
The second item on Draghi’s list is improved economic governance in the Eurozone. Because of the political character of this issue and the likely drawn-out process of changing the EU treaties, this final problem will prove to be the most intractable. It is here where the ECB is playing its subtlest stratagems.
The institutional asymmetry and keeping up reform pressure
The ECB is a fully political actor. It faces the same problem as the Fed – how to restart economic real non-inflationary growth while retaining independence. During the Global Crisis, the Fed applied the "Powell Doctrine"—overwhelming firepower—to restore shaken market confidence. This was to buy time for other government and fiscal authorities to formulate a longer-term response. This is a classic central bank play. The central bank comes out with its monetary guns blazing and then sits back and prays that the politicians do the right thing.
The ECB, however, does not have the luxury of adopting this tactic since it is not facing a well-defined counterparty.
- No Eurozone fiscal entity exists, so the ECB cannot perform a "bridge function" until the proper authorities take over.
- With a Eurozone fiscal entity decades away, any bridge set up by the ECB would only be a bridge back to its own printing presses in Frankfurt.
It is easy to say, of course, that the ECB is not doing enough, and that if only it behaved like the Fed three years ago, all problems would be solved. But this would also be profoundly naïve — and of course beneficial to financial market participants looking to secure their year-end bonuses.
For example, had 10-year interest rates in Italy been capped at 5% by the ECB, former Prime Minister Silvio Berlusconi would still be in office – thus undermining chances of a permanent political resolution to the Eurozone’s underlying under-institutionalisation problem. More broadly, if financing costs were capped at 5%, Eurozone politicians would never take a politically painful decision.
Draghi must recognise that this is first and foremost a political crisis. Only political solutions can solve it. This means he must not let the politicians off the hook.
The ECB’s strategic bargains
While the ECB is arguably the most powerful central bank in the world, it cannot directly compel democratically elected European leaders to comply with its wishes. So far, the ECB has been reasonably effective in its strategic bargaining with Eurozone governments, despite these constraints.
The initial Greek crisis in May 2010 led to the "grand bargain" between the ECB (which agreed to set up the bond purchasing effort known as the Securities Market Programme, or SMP) and Eurozone governments. This agreement produced €440 billion in resources for the European Financial Stability Facility (EFSF). This proved to be an effective "Eurozone fiscal agent" when the problem was limited to Greece, Ireland and Portugal. But now it is inadequate, as the problem includes Italy and Spain.
The ECB now faces a new round of "strategic bargaining" with Eurozone governments to complete the partially built Eurozone institutional house. The issue now is how the ECB might influence the political process towards a "quantum leap" in European integration, as repeatedly advocated by former ECB president Jean-Claude Trichet and other policymakers.1
The ECB’s leverage
The main weapon (or bazooka, as former Treasury chief Henry Paulson called it) in the arsenal of the ECB is the SMP. Unlike the Fed, which can take away the punchbowl when the economy overheats, the ECB can shut down the party altogether by turning off the gas and electricity. As witnessed recently in Italian bond markets, the ECB used the SMP to keep Italian interest high enough to force politicians to move in the desired direction with impressive speed.
The central bank’s strategy is aimed at getting recalcitrant Eurozone policymakers to do things they otherwise would not do. It is a "political strategy," not dictated by IS-LM models predicated to return the economy quickly to full employment equilibrium. Despite the best attempts of markets and financial commentators, the ECB is not acting by its estimate of the next couple of quarters’ nominal GDP growth.
The ECB is thinking about the design of the political institutions that will govern the Eurozone for decades. It is thinking strategically. Thus, it is best to ignore any advice given to the ECB on short-term economic forecasts, or even how other central banks would have conducted themselves in this crisis.
Wars to obtain a better peace
The ECB is in a strategic game with Europe’s democratic governments that recalls the writings of B. H. Liddell-Hart’s "Strategy" from 1967. Liddell-Hart explains how all war strategies should be aimed at obtaining a better peace.
In this situation, that means the ECB focusing on creating permanent Eurozone institutions. The ideal strategist adjusts ends to serve means, exercises restraint and avoids excesses that might damage longer-term post-war prospects. (Some might say, of course, that this strategy is risking excessive damage to the Eurozone economy.) But the strategy is predicated on conserving resources, as the ECB is doing by not buying more bonds than it has to. It prefers an indirect approach of working through third parties (say, the Eurozone sovereign bond market pressure), and constantly takes actions that offer alternate objectives to put your opponent on the horns of a dilemma.
Its philosophy is that you never offer your opponent certainty (by pre-committing to buy all Italian debt at 5% yields, for example). Rather, you constantly seek the dislocation of your opponent’s mind until this dislocation (10-year interest rates above 6-7%) renders the delivery of a decisive blow practicable.
How the quantum leap in EZ institutions will happen
How should we expect the ECB to engineer its desired "quantum leap" towards European integration? It is clear that the bank’s prerequisite for that leap is fiscal discipline. As stated in ECB Executive Board Member José Manuel González-Páramo’s speech in Madrid on 4 November, the Eurozone needs "to establish institutional arrangements which provide credible incentives for sound fiscal and macroeconomic policies in a monetary union….First, to ensure fiscal discipline, all planned deficits of more than 3% of GDP and those in excess of a country’s medium term objective would need to be approved by all Eurozone governments. Second, past fiscal slippages would be automatically corrected in upcoming budgets without any room for discretion via the introduction of constitutional rules similar to the German "debt brake." Third, all Member States would also agree to implement fines and sanctions in a quasi-automatic mode."
The French obstacle
What to make of this? Here I would assert that now that Berlusconi is gone, the key strategic obstacle going forward will be France.
It is France that, historically and in its Gaullist tradition, has resisted any kind of binding fiscal rules and automatic fiscal sanctions in the Eurozone (Charles de Gaulle, after all, wrote the French Constitution enshrining an "Imperial Presidency" for the Fifth Republic.) Paris has consistently rejected any such limits on its fiscal and economic policies, contributing to a lack of restraint and discipline pervading the Eurozone. It is this legacy that looms as the ECB’s next strategic target before the next phase of reforms to be discussed at the EU summit in December.
What can we expect the ECB to do to try to "dislocate the French resistance" to binding fiscal rules in the Eurozone? There are several things that Frankfurt will not do. It is not surprising that in the "bazooka-less world," accelerating financial market uncertainty is spreading from the periphery to France. (Indeed without dramatic domestic policy reforms, France looks more like Italy than Germany.) But the ECB is not about to change its policy, to go big and protect France and its bond market.
On the contrary, what better way to remind the French about the need for more Eurozone rules, discipline and automatic sanctions than to do nothing in the face of a market sell-off and let French sovereign bonds begin to resemble those of Italy and Spain? Ultimately, the French desire for their bonds to track German bonds will force it to yield to Eurozone fiscal rules—to become more German.
French protestations: Opposition is futile
Faced with this problem, the French establishment will protest loudly. They will plead for the ECB to restore calm and bail France out by providing liquidity to the EFSF or turning it into a bank. Probably the US and UK press and financial markets will take their cue from the French. There will likely be stories about discord over the role of the ECB. But such squabbling will most likely strengthen the ECB as European disunity accelerates the sell-off in French bonds.
French opposition is likely to be futile. It is telling that there is little coherent French political response to the renewed discussion about EU Treaty revisions, for example. France has nothing to offer other than the already discarded ideas for the EFSF. Meanwhile, the ECB and the German strategic position on this issue are aligned. France’s silence is deafening, and the coming revision of EU treaties may well occur without French input or with French acquiescence. The meek French response is probably related to the upcoming French elections, in which President Nicolas Sarkozy may argue in favor of the indispensable Franco-German alliance and run on fiscal austerity and stability. There is no way the Elysee Palace can afford to break with Germany and the ECB now.
Will Germany and the ECB part ways?
It is also safe to ignore all talk about a split between the ECB and Germany. Read instead the recent Christian Democratic Union (CDU) Party Declaration, adopted nearly unanimously by more than a thousand delegates. It calls for "automatic sanctions being beyond the realm of political decisions" and making the Stability and Growth Pact adjudicated by the European Court of Justice. (Note also how the CDU endorses "ECB sovereign bond purchases as having been necessary…. and acceptable as a last resort." It is difficult to imagine a more explicit endorsement of the ECB’s strategy by Germany’s conservative party!). Other AAA-rated Eurozone countries like Finland and the Netherlands—with their calls for a "Eurozone debt guardianship" – share this view, leaving little doubt about the focus of a likely EU short-term "emergency" treaty change.
The focus on fiscal discipline is to the ECB’s liking; this marks the end of French political opposition to fiscal sanctions. The ongoing strategic struggle is to exorcise de Gaulle’s ghost from EU institutions.
The EU Summit
Europe is entering the political end-game with the expected launch of a process to amend the EU Treaty at the summit on 9 December 2011. In that sense, Europe is finally getting close to having the equivalent to the US Congress’s “second TARP vote”.
The contemplated changes to the treaty will concentrate on strengthening the fiscal rules and surveillance for the Eurozone. The precise formulation will remain uncertain until days before the meeting, but it seems evident that, in this matter, the largely overlapping ECB and German positions will win the day.2 Last week’s European Commission proposals for new economic governance rules point in the same direction.
As always, numerous trial balloons will ahead of the summit be floated strategically in the media by policymakers to increase or decrease the financial market panic.3 The really big political question, however, is, given how the Treaty change agenda has been set largely according to ECB and German demands, what strategic quid pro quo should the rest of the Eurozone demand from Frankfurt and Berlin?
- David Cameron seems intent on securing an opt-out for the United Kingdom from the EU Working Time Directive.
- The Irish government, which seems certain to have to hold a referendum (and hence has some political bargaining power), is looking to secure cheaper funding from the EFSF to replace the very high-yielding National Asset Management Agency promissory notes issued to recapitalise Irish banks.
It is crucial for the longer-term stability in Europe that Germany is compelled by other leaders to be magnanimous at this peak time of its influence in Europe.
1. See Jean-Claude Trichet’s speech in Aachen June 2nd 2011 at http://www.ecb.int/press/key/date/2011/html/sp110602.en.html, and more recently ECB Executive Board Member José Manuel González-Páramo’s speech in Madrid on November 4, 2011 for a detailed description of how the ECB defines a "quantum leap" in economic governance.
2. It would however be a mistake from this overlap between the ECB and German policy positions to infer that Frankfurt and Berlin form a close alliance, as they have clashed violently on other important issues, like private sector involvement (PSI) during this crisis.
3. Typically, German policymakers will try to lower expectations for EU Summit deliverables in order to surprise on the upside and minimize their need to “write a check,” while other EU leaders will try to maximise financial-market expectations ahead of a summit in order to threaten German representatives with “huge market disappointment” unless something big (and expensive) is agreed to.