Draghi’s dilemma: How hot is Hell?


August 7, 2012

Last Friday, European markets rallied with European Central Bank President Mario Draghi’s announcement that the ECB would interevene in bond markets if governments formally asked for help to deal with their sovereign debt problems. For countries like Spain and Italy, which are dealing with crippling high interest rates, this was also welcome news.

However, the tone of Draghi’s message and the qualified way it was delivered – relief if necessary but not necessarily immediate relief – may still not be enough to soothe jittery markets unless real action follows soon.

The announcement is seen as a sign that the ECB may finally do the same thing as the U.S. Federal Reserve by monetizing Europe’s debt via a strategy of backdoor “quantitative easing.” In this two step waltz, the European Stability Facility would first have to buy bonds in government debt auctions, which the ECB would then buy in secondary markets.

The ECB can effectively monetize the massive deficits Europe’s spenders like Spain and Italy have run up in recent years by purchasing sovereign debt and providing backstop financing to the banking systems of these countries as the U.S. Federal Reserve did in 2008-09. Or it can do nothing and risk sovereign default and/or a collapse of the financial system and the euro.

The former course is by no means risk free. When central banks provide additional financing to sovereigns and their respective financial systems by monetizing deficits, this can lead to inflation and reduce the value of a country’s currency, which – in the case of the euro – is a shared one.

Given the choice between inflation versus sovereign default and/or a collapse of the financial system, debasing the euro through monetization is clearly lesser of two evils. It is what Iceland did. It is what the U.S. has done.

Draghi’s problem is that the European setup makes it difficult for him to follow his instincts and cold economic calculus by providing the same kind of leadership that U.S. Federal Reserve Chairman Bernard Bernanke has delivered during hard times.

Draghi has to get the Germans on board not least because they have a decisive vote on the ECB’s board, which has to approve anything he does. The Germans don’t have a sovereign debt problem or a banking system problem. They also don’t want to be on hook for any more debt.

For historical reasons — the hyperinflation that precipitated the downfall of the Weimar Republic and Hitler’s rise — they also have a deep-rooted allergy to anything that smacks of printing money that stokes inflation. As Europe’s main creditor, they also stand to lose if financial holdings and assets are devalued by the euro’s tumble.

German Chancellor Angela Merkel’s game of holding Europe’s spendthrift governments’ feet to the fire has stopped working because some like Spain are caught in a debt-deficit-recessionary downward spiral and now face unsustainable borrowing requirements. Spain’s problems underscore that staying the current course is a sure path to disaster in a sovereign and financial crisis of this order of magnitude.

Europe’s leaders and central bankers now have to stump up with a bold solution and do something that is reasonably achievable.

The best that Draghi and the ECB can offer is to buy everybody time to pursue much-needed structural reform. His approach also allows governments to save face because the handout is coming through the backdoor not the front door as would a direct bailout. But backdoor monetization will backfire if governments don’t do what they must do by cutting spending and balancing their books.

Alas, for Draghi, the spectre of Greece’s backdoor bailout hangs over Europe like a dark pall. The Greeks received huge doses of backdoor financing, but never got their act together. They were subsequently forced into a formal bailout and the country is still a mess.

Italy did no better when Berlusconi was in charge (and worse still Berlusconi has his sights set on a political comeback when Italy’s caretaker government steps down).

Draghi can provide the right stopgap monetary policy to offer Europe a stay of execution. But unless his temporary relief is accompanied by major fiscal and structural reforms, Europe will still end up in bad place thereby turning up the heat in hell.

The opinions expressed in this article/multimedia are those of the author(s) and do not necessarily reflect the views of CIGI or its Board of Directors.

About the Author