Photo Gallery: Draghi Disappoints the Markets

Foto: Michael Probst/ AP

Buying Bonds against the Crisis How the ECB Plans to Use Its Bazooka

The European Central Bank has come up with a new plan to buy the bonds of debt-ridden countries in a bid to fight the euro crisis. Under the new approach, the ECB would only intervene if governments commit to reforms. But experts criticize the plan as dangerous and undemocratic. By SPIEGEL Staff

Until recently, Mario Draghi was regarded as a man who understood the markets. The head of the European Central Bank (ECB) worked at investment bank Goldman Sachs for years, and he had studied under such renowned economists as Paul Samuelson and Franco Modigliani. At receptions in Frankfurt, the German banking capital, the elegant Italian was as adept at discussing the latest accounting guidelines as he was at talking about golf handicaps. He was known in the financial world as "Super Mario."

That reputation has been tarnished since last week. Shortly after Draghi began a highly anticipated press conference  last Thursday, following a meeting of the ECB Governing Council, stock prices plunged and there was talk of "frustration," "irritation" and "cold showers" in the world's financial centers. A broker on New York's Wall Street railed that the ECB chief had treated investors like a bunch of "idiots."

In fact, Draghi had done the worst thing a central banker can do to traders: He had disappointed their expectations. Stock and bond prices had been going up for a week after Draghi had suggested,  at a conference in London, that the ECB would soon be buying up Southern European sovereign bonds on a large scale once again.

But when Draghi appeared before journalists in Frankfurt last Thursday, there was no talk of quick purchases, but rather of "conditions" for the debtor countries. The central bank chief mentioned various "options" that could be extensively reviewed by commissions and possibly implemented at some point -- "could" being the operative word, rather than "must." Instead of "Big Bertha," as Draghi otherwise likes to call his rescue programs, this time he was offering the markets something with a somewhat smaller caliber.

Hasty Compromise

Now the latest idea to rescue the monetary union threatens to turn into yet another flop. What Draghi presented last week was not a carefully prepared strategy, but a hastily negotiated compromise that satisfied no one. The plan doesn't go far enough for Southern European countries, while Jens Weidmann, president of the German central bank, the Bundesbank, voted against it, fearing for the ECB's independence.

The plan does have its advantages, but because Draghi did such a poor job of selling it, the drawbacks are now its salient feature. The approach is poorly compatible with the central bank statutes, increases liability risks in the euro zone and places the monetary watchdog in a dangerous dual role. The ECB would become something of a secondary government in Europe while at the same time becoming more dependent on politicians.

In the future, there can be no question of the ECB being a fiercely independent institution modeled after the Bundesbank, as it was originally intended to be. If Draghi prevails, the central bank will become a kind of adjunct to the European finance ministers, which could ultimately lead to higher inflation. "The ECB has a clear mandate to guarantee price stability," warns Jürgen Stark, a former member of the ECB Executive Board. "Every additional responsibility compromises this core function."

Draghi, however, is convinced that his proposal was unavoidable, due to the escalation of the euro crisis in recent weeks. At a major crisis summit in late June, euro-zone leaders had agreed to concrete steps to form a banking union. Soon afterwards, the euro-zone finance ministers approved a €100 billion package to rescue the ailing Spanish financial sector. But the effects of those measures soon fizzled out.

Yields on Spanish and Italian government bonds went up, reaching a worrying 7.6 percent for long-term Spanish bonds. Yields on short-term bonds also rose sharply.

There have been other alarming developments, as well. Some €163 billion in capital left Spain within the first five months of the year. Foreign companies and investors have pulled out their money, invested less in Spanish securities and issued fewer loans to industry. The major Swiss bank Credit Suisse estimates that Italy and Spain will lose about €700 billion a year at the current rate of capital flight.

Stemming Capital Flight

Draghi decided that this couldn't continue. In a bid to stem the capital flight from Southern Europe, Draghi, at his memorable appearance in London, not only announced new measures to combat the crisis, but also promised that they would be sufficient, no matter what happened. The world's markets immediately interpreted the announcement as a signal that the ECB would soon return to buying up large quantities of Southern European government bonds.

The only problem was that the step was precipitous and poorly prepared. The ECB president had left large parts of the central bank leadership in the dark about his foray. In addition, he initially had no idea what the new bond-buying program would actually look like. Draghi had only vaguely discussed his ideas with a few of his fellow Executive Board members. The governors of the national central banks, such as Bundesbank President Weidmann, only learned of the plan through news agencies. And no one was notified in advance in the European capitals, either. Klaus Regling, the head of the temporary euro-zone bailout fund, the European Financial Stability Facility (EFSF), also had no advance warning, despite playing a key role in Draghi's plans. Draghi had had "nothing precise in mind," says an official at the central bank's Frankfurt headquarters. "It was a rash remark."

The central bank's website revealed just how taken by surprise the ECB was. Usually, it immediately complements important pieces of news with explanations and comments, and posts transcripts and statements, so that markets and the public can form their own opinion. But following Draghi's London appearance, journalists and analysts searched in vain for material on the ECB website. It was only after a considerable delay that the ECB posted a transcript of Draghi's speech on its site -- and nothing else.

Not surprisingly, Draghi's first task after returning home from London was to placate his critics. He called many of the 17 ECB governors to explain himself. On Monday of last week, he even met in person with Bundesbank head Weidmann, who also lives in Frankfurt, to discuss his plan.

The discussions were sobering, and Draghi was forced to recognize that simply reviving the dormant purchasing program for government bonds was not an option. There would have been too much resistance to such an undertaking, both at the Bundesbank and other European monetary authorities.

Keeping Up the Pressure

By the end of January, the central bank had spent over €200 billion on buying government bonds, including large numbers of Spanish and Italian bonds, to bring down interest rates. But the program turned out to be only moderately successful. Interest rates went up again after a short reprieve. At the same time, the billions from Frankfurt reduced the pressure on governments to carry out reforms.

This had to be avoided if the program were to be repeated, Draghi's colleagues demanded. ECB Executive Board members Jörg Asmussen of Germany and Benoît Coeuré of France began to develop a version of the program that could placate critics' doubts. The effort also involved Thomas Wieser, permanent chairman of the Euro Group Working Group, as well as senior German officials Thomas Steffen of the German Finance Ministry and Nikolaus Meyer-Landrut of the Chancellery. Finance Minister Wolfgang Schäuble, who met last week with his American counterpart Timothy Geithner on the German resort island of Sylt, was also kept constantly in the loop.

The group came up with a classic compromise: The ECB will intervene in the bond markets so as to fulfill Draghi's London promise, but it will also require the countries benefiting from the action to continue with reforms.

The plan will work as follows. In the future, crisis-hit countries will not automatically receive unconditional support from Frankfurt. Before the ECB can buy, say, Spanish or Italian bonds, the governments in Madrid and Rome will have to submit a request to the European bailout fund. The fund will then become active in the so-called primary market. This means that it will buy bonds directly from the countries in question, which the ECB is currently prohibited from doing.

The European Central Bank will support the program by buying the affected countries' bonds from investors and banks on the secondary market, thereby supporting prices and keeping interest rates low.

For the affected countries, the plan requires that they submit to a restructuring program like the ones already in place in Greece, Portugal and Ireland. This enables the ECB to tie its aid to conditions. The ideas amount to expanding the financial clout of the bailout funds by piggybacking them on the ECB's unlimited firepower.

Considerable Reservations

When Draghi presented the plan to the ECB's Governing Council last week, its members added another feature. Under the old purchasing program, the ECB acquired long-term bonds. Now the central bank will concentrate on buying shorter-term bonds, because this can be justified by citing the goals of monetary policy.

In theory, Draghi could implement his new rescue tool immediately. But whether it can truly operate successfully is far from certain. There are considerable reservations, both in Germany and in Southern Europe.

So far, the government in Rome has strongly resisted filing an official request for assistance in Brussels, and it regards demands that it do so as an impertinence. The Spaniards, for their part, could only bring themselves to request aid for their troubled banks.

In Germany, too, Draghi's plan is by no means popular. On the contrary, there are great concerns that it will lead to the Frankfurt central bank abandoning even more of the principles that are considered sacrosanct in Germany.

Expanding Its Powers

The Maastricht Treaty defines the ECB as a Europeanized version of Germany's Bundesbank, politically independent and committed to maintaining stable prices as its primary goal. The Frankfurt-based institution has certainly achieved its goals since the introduction of the euro, with the average inflation rate in Germany being lower than in the days of the deutsche mark.

But during the crisis of recent years, the ECB has moved further and further away from its German role model. It has expanded its powers to their limits, if not beyond.

This is evidenced, in particular, by the question of whether the ECB should be allowed to buy the bonds of ailing countries to bring down yields. Legal experts disagree on the issue, but it is indisputable that the more bonds the central bank acquires, the stronger its actions run counter to the principle that it should not be allowed to finance government budgets.

Experts are understandably critical. "The ECB is in the process of distancing itself more and more from the stability culture of the Bundesbank," says Georg Fahrenschon, president of the Association of German Savings Banks. Claudia Buch, a member of the German Council of Economic Experts, which advises the German government, warns: "If the ECB were to buy even more government bonds, it would assume a redistribution function. The ECB lacks both the mandate and the democratic authority to do so."

The liberal interpretation of the rules by monetary watchdogs is also problematic because it harms the ECB's credibility -- and credibility is a central bank's most important asset.

A Giant Gamble

With the Draghi plan, the Frankfurt monetary watchdogs are making a giant bet. For their plan to work, it is imperative that the Mediterranean countries recover economically in the coming years. If the desired turnaround does not materialize, the purchasing program will quickly reach dizzying proportions. The combined debt of Spain and Italy alone amounts to almost €3 trillion.

In the last four years, the ECB's total assets have almost doubled, to €3 trillion today, partly because it has made almost unlimited liquidity available to banks.

So far, the weak economic situation in the euro zone has ensured that the money boom has not led to higher prices. But this could change very quickly as soon as the economy recovers. Whether the ECB will then remember its promise to take the additional billions out of the market is debatable. The more euros are in circulation, the more difficult it becomes to get them back and keep prices under control.

Many experts are also asking themselves whether the ECB even wants this anymore. Experience has shown that the fight against inflation can be waged more effectively if it is a central bank's only objective.

Secondary Government

But over the course of the euro crisis, the ECB has assumed so many additional functions that it now seems more like a secondary government. Last fall, Draghi was personally involved in driving Italy's scandal-ridden Prime Minister Silvio Berlusconi out of office. As members of the so-called troika, ECB officials are dictating how the Greeks, the Portuguese and the Irish should implement reforms such as weakening employment protection legislation and liberalizing the taxi industry.

Soon the central bank will also assume an important role in the planned joint supervision of the financial sector in the euro zone. Then it will have a say in determining which banks should be restructured or liquidated.

What makes the issue especially problematic is the fact that the ECB's Governing Council, the central bank's key decision-making body, which includes both the six members of the Executive Board and the 17 presidents of the national central banks, lacks the democratic legitimacy to perform its new tasks. The members are not voted into office, nor are they accountable to anyone.

It's no surprise that, in light of the ECB's expanding powers, the voices of those demanding a reform of the Governing Council are getting louder. "It cannot be the case that Germany is liable for about 30 percent of the ECB's risks but has only one vote," says Michael Fuchs, deputy chairman of the conservatives' parliamentary group. "Germany must be given voting power that corresponds to its share of ECB capital."

The demand doesn't stand a chance, because putting it into effect would require a unanimous vote by all members of the currency zone to amend the treaties. Nevertheless, it also highlights a constant in the history of the efforts to save the euro: Measures that are intended to hold together the monetary union often end up driving it even further apart.

Lack of Decisiveness

This could also hold true for the new Draghi plan, as was evident last Thursday, when the Council argued over an important aspect of the plan. The debate revolved around the question of whether the ECB should recover the money it uses to buy bonds elsewhere, in order to prevent inflation. This was the approach it used in its first bond purchase program.

A large share of the central bankers from Southern Europe said that the money should be left in the market in the future. Citing academic studies, they argued that the central bank could only recover up to about €300 billion of its cash injection. In other words, if the ECB announced that it intended to collect back all the additional money it had injected into the market, it would establish this amount as an upper limit, which would harm the credibility of the bond purchase program.

The opponents, most of them from northern countries of the euro zone, cited the risk of inflation. If the ECB were to print unlimited amounts of new money to buy bonds, they argued, this would inevitably lead to rising prices.

For the normally restrained central bankers, it was a heated debate, but there was no clear outcome. The arguments went back and forth, but the central bankers could not agree on a joint position that day.

It seems safe to predict that the ECB will hardly be a paragon of decisiveness in the coming weeks and months. According to one member of the ECB Governing Council who did not want to be identified, that will cause "plenty of frustration in the coming weeks."


Translated from the German by Christopher Sultan
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