August is sacrosanct in Europe. It is the time when Europeans holiday, retiring to the beach or their chalets. The continent heaved a collective sigh of relief last week therefore when ECB President Mario Draghi reaffirmed his resolve to preserve the euro.
Prior to Draghi's comments, there were growing concerns that the euro crisis which has gripped the continent for the past two years was about to get worse — much worse. Spain was teetering on the edge, as bond yields again shot up to levels widely believed to be unsustainable. The fear is: if Spain falls, Italy would soon be next.
Markets rallied following "Super Mario's" announcement, and Europeans went back to planning their vacations. But can they relax?
Draghi has raised market expectations of what the ECB is prepared to do to save the euro zone. Will it, for example, start purchasing the debt of troubled euro zone sovereigns in sufficient quantities to dissipate the fears of default that have crept into markets? And if Draghi is prepared to mobilize the ECB's balance sheet in this manner, has he checked with the Germans?
An argument could be made that, with the fiscal adjustments already implemented or announced, the problem facing Spain is one of liquidity, not solvency. That is to say, that at "reasonable" levels of interest rates, these measures are sufficient to ensure that Spain's outstanding obligations will be repaid in full. This was certainly the argument made by the Spanish and German finance ministers last week. In the minds of some, however, the problem is that irrational fear is driving the risk premium, and thus interest rates, higher; to unsustainable levels.
Here's the thing: Most central banks with clear mandates and operational guidelines have the tools and constrained discretion to make credible commitments that would suppress these fears, providing time for the government's adjustment plan to work and restore public finances. (The role of monetary policy in this context is to provide a coordination role, focusing expectations on medium term sustainability and supporting the "good" equilibrium of adjustment and solvency.)
I may be too pessimistic, but it remains to be seen if Draghi and the ECB has the constrained discretion to play that role. I recall a former senior European official once bemoaning the fact that markets were not giving the ECB enough credit; all he wanted was for the ECB to be treated "like any other central bank." Of course, the ECB isn't like any other central bank. The architects of the euro zone constructed a monetary union with monetary policy centralized, but with fiscal policy decentralized, in the hands of its various members. Responsibility for enforcing fiscal discipline was delegated to financial markets, which were supposed to limit excessive borrowing, and the strictures of the Maastricht Treaty, which was duly ignored by key "core" countries.
Financial markets generally operate reasonably well in terms of pricing assets and price discovery. But there can be circumstances in which markets shift madly from optimism to pessimism. Markets that are deep, broad and liquid one moment can become illiquid the next in a panicked run for the exits. Central banks were created for precisely these times: to provide the liquidity necessary to calm markets and restore reason to asset pricing. See, for example, the actions of the Fed in the crisis.
Unfortunately, it is not clear that the ECB has been endowed with the necessary facilities and the capacity to exercise them. And, yet, Mario Draghi is an exceptionally gifted central banker; he is nimble-minded enough to use his existing authority to its limit in support of his objective. That is not in question.
As noted in a previous blog post, what I worry about is that the intersection of the set of policies that would resolve the crisis and the policies that are politically acceptable defines a null set. My worry is that the dramatic, decisive action that is required of the ECB may not be acceptable to certain "core" countries. There is a prospect, therefore, of a potential clash between the ECB and some member states. There is, already, a decision pending from the German constitutional court on the legality of German involvement in euro zone bailouts. That ruling is due September 12.
So, while Draghi's European Vacation put is on, its expiry date is still to be determined.