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.


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yiannaki 08/06/2012
1. One european financial denominator today ?
My compliments for this article. To my opinion it reconfirms the impossibility to have one financial denominator today in Europe. The different quality of the social and by that economic systems in North and South Europe do prevent that. We better stop thinking and acting this situation was, is and will not be the problem for the next 25 years / 2 generations. We better do split the euro in a North and a South currency. And do give the South countries time to restructure their social and by that their economic system. If they want to ! So please do stop this schizophrenic one-euro-policy. Of course this will hurt. Specially the southern countries. But they should have assessed this risk themselves before implementing the euro.
HoratioJones 08/07/2012
2. No Firing Pin
That a few stone age monetarists at the Bundesbank can prevent the ECB from using normal monetary authority to respond to a serious crisis is what makes it virtually certain that the Euro experiment will result in tremendous and unnecessary economic pain and suffering and, ultimately, in dissolution. The only hope is that politicians will override this short-sightedness and correct the design flaws of the ECB. The pseudo-Gold standard that the ECB is forced to apply is the same medicine that led to the great depression. It is this regime itself that makes countries vulnerable to default and leads to risk premia that are destabilizing.
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