Memo to Draghi: Dead Central Banks Don't Have Credibility

Memo to Draghi: Dead Central Banks Don't Have Credibility

Karl Whelan, Contributor
7/05/2012
Mario Draghi today uttered what I think was perhaps the most depressing sentence of the euro crisis so far. Draghi dismissed out of hand the idea that Europe’s bailout fund, the European Stabilisation Mechanism, could be given a banking license that would allow it to borrow from the ECB, declaring

I don’t think there is anything to gain destroying the credibility of an institution by asking it to behave outside the limits of its mandate

In case you’re in doubt here, the institution whose credibility he is worrying about is his own.



This is a depressing outburst for a number of reasons. Draghi said today that the current bailout funds are “adequate to cope with the risks, the contingencies we can envision now”. However, with a current total capacity of €700 billion, these vehicles are far too small to fund Italy and Spain over the next few years, making a self-fulfilling run on these countries close to inevitable.
A banking license for the ESM would allow it to borrow from ECB to potentially purchase trillions of euros worth of government bonds. Faced with the presence of such a buyer in the market, speculators betting against Spain and Italy would lose their shirt. Indeed, merely by coming into existence and credibly entering the market, ESM bank would likely make money on its government bond investments. ESM bank also probably would not need to scale up to trillions of euros. The mere fact that it could reach such a size should allow it stabilise government bond markets.

Put simply, a banking license for the ESM is one of the few viable options remaining that can help to hold the euro together. Though not perfect, it would provide Italy and Spain with the kind of “bond buyer of last resort” that the Fed has provided for the US government and the Bank of England has provided for the UK government.

In addition to the role it could play to calm the sovereign debt crisis, the ESM bank proposal has the advantage relative to other proposals such as Euro bonds of being easily implemented. A special purpose vehicle could be set up at short notice and the bank could be put to work immediately. No new risk-sharing mechanisms would need to be put in place – the government guarantees behind the ESM would provide a large capital backstop for the operation – and no amendments to the EU treaty would be required.

Mr. Draghi’s dismissal of this proposal will now make it far harder to implement because the ECB can choose simply to not accept a bank as an “eligible counterparty”.

The other depressing aspect of this statement is the lack of intellectual substance in Draghi’s objection to this plan. It does not require the ECB to act beyond the limits of its mandate. It is perfectly legal for the ECB to make loans to government-owned banks and the terms of the collateralised loans for this bank would be the same as for all other banks.

The economists who originally proposed this plan, Daniel Gros of CEPS and Thomas Meyer of Deutsche Bank are two of Europe’s leading economists and they understand the European institutions inside out. Their paper on this topic provides a clear case that the proposal is perfectly legal.

It could be that Draghi is referring to the ECB’s price stability mandate, meaning he is concerned that the money printing required to implement the ESM bank plan will unleash inflation. Well, it’s not clear that the ESM bank plan actually requires printing trillions of euros. Even if it did, the ECB’s balance sheet has already reach €3 trillion without a sign of an incipient inflation problem, mainly because Europe’s economy remains in the doldrums. If inflation did take off, the ECB has many tools at its disposal that it can use to offset this development, starting with raising interest rates from their new low of 75 basis points.

Today’s ECB rate cut of 25 basis points is a welcome development. However, the fact that this rate cut was considered uncertain even though Euro-area unemployment is now at an all-time high says a lot about how the ECB operates. Without an effective back-stop for troubled sovereigns, the euro may not hold together. Mario Draghi can muse in retirement about how credible his ECB would have been if it had managed to stay in existence.