Draghi cuts and markets flip

Last week marked the second time where new President of the European Central Bank, Mario Draghi, governed an interest-rate decision for the Euro area. And for the second time it was and interest rate cut, implying an interest rate on main refinancing operations of 1.00% effective from 14 December. This ties the lowest level in Euro history, which was effective from 13 May 2009 to 13 April 2011. So, loosely speaking the interest rate is back at the financial crisis level. The decision makes sense given the economic outlook for the Euro area: A continuation of high unemployment and absence of inflationary pressures. It was, however, not a unanimous decision.

At the ensuing press conference, Draghi expanded on the economic outlook and emphasized that some of the prolonged economic contraction was due to the crisis in sovereign debt markets. Also, severe downside risks pertaining to confidence issues in the financial sector were singled out as an important factor. As a direct measure towards the latter problem, the ECB announced a number of temporary initiatives to enhance liquidity in the Euro area (among them a loosening of collateral requirements and reserve ratios for loans with the ECB). As for the sovereign debt problem, Draghi emphasized that all euro-area government “urgently need to do their utmost to support fiscal sustainability” and that a new “fiscal compact” consisting of fiscal rules and fiscal commitments are a precondition. Also, he stressed the need for structural reforms.

Following the press statement, Draghi (and Vice-president Vitor Constâncio) took questions from the press. Not surprisingly, given the sovereign debt crisis, most attention was directed to the fiscal issues. Discussing the “fiscal compact”, Draghi essentially touched upon the issues being negotiated by EU governments these days, namely how to rethink the Stability and Growth Pact. He was to me quite blunt (and correct) when stating, although indirectly, that lack of credibility of rules have been of essence in the current situation, and that a more automatic system of fiscal constraints would be needed for credibility. And only when such credibility is in place, will any kind of fiscal stabilization mechanisms be of relevance. This is quite consistent with what I wrote more than 10 years ago with Roel Beetsma in the paper (published in Journal of International Economics in 2003): “Contingent deficit sanctions and moral hazard with a stability pact“.

After dodging some questions on the economic situation of particular countries, Draghi was asked about the Securities Markets Programme (under which the ECB now holds more than € 200 bn. worth of government bonds). Will it be expanded, continued or what? He then, much to my liking, reminded the press about the Treaty on European Union:

“. . . we have a Treaty and the Treaty states what our primary mandate is, namely to maintain price stability. Also, the Treaty prohibits monetary financing. I am old enough to remember that, when this Treaty was written in the early 1990s, some of the countries around that table were actually doing what you suggest doing now, namely some of the central banks of these countries were financing the government expenditure of their governments through money creation, and the consequences were there for all of us to see. That is why, in a sense, this Treaty embodies the best tradition of the Deutsche Bundesbank, whereby monetary financing has always been prohibited.”

Right on! I have, however, always been wondering how a central bank can purchase government bonds and still be acting within the spirit of the treaty (the legal issue is that when the bonds are purchased on the secondary markets and not directly from the government, then the treaty is not violated by the letter). But the ECB has invented some story about the SMP being necessary for the functioning of the monetary transmission mechanism and thereby for the attainment of price stability. I have never really bought that story, and I think that Draghi (probably unintentionally) was close to stating that he doesn’t buy it himself. Asked specifically about the SMP, and whether similar initiatives could be considered state financing and thus against ECB law, Draghi replied:

“. . . one can construct many different cases. But, as I said before, the key thing is that we should not try to circumvent the spirit of the Treaty. No matter what the legal trick is, I think what matters for the people and what matters for the confidence and credibility of the institution is the spirit of this provision of the Treaty.”

That is probably the closest thing to a confession one can get: “No matter what the legal trick is”. At least I choose to be optimistic in the sense that the ECB has a President that is honest, and also tries to emphasize that fiscal support should not be the doings of the ECB.

The financial markets read it the same way, but took it very badly. The news that the ECB may start to live up to what is actually written in treaties, was met by price drops on several already low-priced bonds. The interest rate on Italian government bonds thus rose around 30 basis points, and the Euro dropped 2 percent vis-à-vis the dollar. Markets are really unpredictable. Would they have become happy if Draghi had promised to intensify purchases of government bonds thereby probably putting an end to serious structural reform efforts?

It is rather amazing how left-wing the markets appear to be on these matters!

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