When Mario Draghi delivered his first prepared public remarks as president of the European Central Bank (ECB) in Frankfurt on Nov. 8, he provided several clues about the coming eight years.
Conscious of taking charge in the midst of the bank’s and the euro area’s first major financial crisis, he dwelled first on monetary policy, declaring that it would be dictated by the three principles of "continuity, consistency and credibility." As one could have expected, these principles were framed with reference to price stability and a message that "we will stay the course."
But it was in Draghi’s subsequent choice of words and topic, beyond monetary policy and price stability, that he demonstrated why it is wrong to see the ECB as a "normal central bank" and why the decades-old guidebook for independent central banks can be discarded. The ECB is a central bank like no other. In this crisis, as the sole institution that can affect financial markets, it is a full-blooded political actor with influence beyond monetary policy and unchecked by euro area politicians.
In the next phase, as I explain below, the ECB is speeding toward a confrontation, not with Spain or Italy, but with France.
Knowing that European political leaders cannot curb the ECB’s independence without violating their treaty obligations, Draghi took euro area 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." Such pep-talk is often heard from monetary policy makers, but with national governments increasingly reliant on the bank for the stability of their finances—and mindful of its role in the ouster of the dominant politician in Italy for 20years—Draghi’s words have unusual impact.
Progress is under way on the first two items on Mario Draghi’s wish-list, public finances and structural reforms in the member states. Over the weekend, Spanish voters, despite suffering the highest unemployment rates in Europe, bestowed a historic parliamentary majority to the Partido Popular’s Mariano Rajoy, the leader most committed to further fiscal austerity and structural reforms, not least of the Spanish labor market. This election result follows the pattern set in Ireland and Portugal, where pro-reform governments were installed despite voter unease over their economic hardship.
Some commentators, drawing an analogy with the Tea Party movement in the United States, predicted that irresponsibility would carry the day in Europe. But that has not happened. Populism in Europe remains entrenched on the peripheries of the euro area political landscape. Europe is also confronting many "third rail" issues, such as labor 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.
One last item remains on Draghi’s list—economic governance in the euro area. Because of the political character of this issue and the likely drawn out process of changing the European Union (EU) Treaty, this final problem will prove to be the most intractable.
As suggested earlier, the ECB is a fully political actor. It is faced with the same kind of problem that faces the Federal Reserve or other "normal central banks"— how to restart economic real non-inflationary growth in their national economies while retaining their independence. (The Federal Reserve must also keep its eye on internationally systemic role of the dollar.) The rules for how to do that, however, can be found in what the 1978 Nobel Price Winner in Economics Herbert Simon has termed "bounded rationality," [pdf] i.e. the failure to acknowledge that "like actors" can have multiple utility functions and different goals.
In the United States in 2008-9, the economic crisis compelled the Fed to apply "Powell Doctrine"—overwhelming firepower—to restore shaken market confidence and give time for other government and fiscal authorities to formulate a longer-term response. This is a fairly well established and in some ways mechanical "central bank crisis response function." The central bank comes out with its monetary guns blazing and then sits back and prays that the politicians do the right thing. (The Congressional deficit-reduction supercommittee did not answer anyone’s prayers, of course.)
The ECB, however, does not have the luxury of adopting this tactic within a fixed set of national institutions. No euro area fiscal entity exists, so the ECB cannot perform a "bridge function" until the proper authorities take over. With a euro area fiscal entity decades away, any bridge set up by the ECB would only be a bridge back to its own printing presses in Frankfurt.
Had 10-year interest rates in Italy been capped at 5 percent by the ECB, Prime Minister former Silvio Berlusconi would still be in office. Undertaking a major "bridging monetary stimulus" that some have called for would in similar fashion undermine chances of a permanent political resolution to the euro area’s underlying under-institutionalization problem. Were financing costs fixed at no more than 5 percent, euro area politicians would never take a politically painful decision. Draghi must recognize that this is first and foremost a political crisis, which only political solutions can solve – and he must not let the politicians off the hook.
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.
Bear in mind also that while the ECB is arguably the most powerful central bank in the world, Frankfurt 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 euro area governments, despite these constraints. The initial Greek crisis in May 2010 led to the "grand bargain" [pdf] between the ECB (which agreed to set up the bond purchasing effort known as the Securities Market Program) and euro area governments. Their agreement produced €440 billion in resources for the newly created European Financial Stability Facility (EFSF), which proved to be an effective "euro area fiscal agent" when the problem was Greece, Ireland and Portugal.
The EFSF is inadequate when the problem becomes Italy and Spain, however. The stalled ratification process of a proposal to expand the EFSF this fall showed that there was no political will in the euro area to do so. The ECB now faces a new round of "strategic bargaining" with euro area governments to complete the partially built euro area institutional house. The issue now is how the ECB might influence the political process toward a "quantum leap" in European integration, as repeatedly advocated by former ECB president Jean-Claude Trichet and other policymakers.1
The main weapon (or bazooka, as former Treasury chief Henry Paulson called it) in the arsenal of the ECB is the Securities Market Program ( 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 euro area 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 to get the ECB to take action driven by its estimate of the next couple of quarters’ nominal GDP growth, the ECB is thinking not about the next two quarters but about the design of the political institutions that will govern the euro area 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.
The ECB is in a strategic game with Europe’s democratic governments that recalls such classic writings as B. H. Liddell-Hart’s "Strategy" from 1967. Drawing on the military history since Greek-Persian wars of the fifth century B.C., Liddell-Hart explains how all strategies of war should be to obtain a better peace. In this situation, that means the ECB focusing on creating permanent euro area institutions. The ideal strategist adjusts ends to serve means, exercises restraint and avoids excesses that might damage longer-term after-the-war prospects. (Some might say, of course, that this strategy is risking excessive damage to the euro area 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 euro area 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 percent yields, for example). Rather you constantly seek the dislocation of the opponent’s mind until this dislocation (10 year interest rate above 6-7 percent) renders the delivery of a decisive blow practicable.
How should we expect the ECB to engineer its desired "quantum leap" toward European integration? It is clear that the bank’s prerequisite for that leap is fiscal discipline. As stated by ECB Executive Board Member José Manuel González-Páramo’s speech in Madrid on November 4, the euro area 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 euro area 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."
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 euro area. (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 euro area. 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 euro area? 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, go big and protect France and its bond market.
On the contrary, what better way to remind the French about the need for more euro area rules, discipline and automatic sanctions than do nothing in the face of a market selloff 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 euro area fiscal rules—to become more German.
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 selloff 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 be to 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.
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 [pdf], 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 euro area countries like Finland and the Netherlands—with their calls for a "euro area 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 to the ECB’s liking thus marks the end of French political opposition to fiscal sanctions.
It is of course hard not to feel sympathetic to the Spanish, who will have done everything the ECB asked them to do. But as the strategic focus now switches from the euro area periphery to France, Madrid will receive no real "policy reward for good behavior" from Frankfurt, something lamented by outgoing Prime Minister Jose Luis Rodriguez Zapatero. But in the ongoing strategic struggle to exorcise de Gaulle’s ghost from EU institutions, such niceties will probably have to wait.
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.