Early in the morning of June 29 2012, after agreement was reached at the European Council both about banking union, a growth pact and a mechanism for bond market stabilization, Italy’s Prime Minister Mario Monti could be heard exclaiming, “Europe’s mental block is broken”. A month later Mario Draghi declared that the ECB was ready to do “whatever it takes” to preserve the euro. Between the December 2011 agreement on the Fiscal Compact and the finalization of the ECB’s OMT bond market support program in September 2012, the acute and general phase of the eurozone crisis was finally brought to an end.
What Europe’s “block” – mental or otherwise – consisted of and how it was overcome remains a subject of fascination, at least for some of us. Going back over the footnotes for my forthcoming book on the crisis I’ve come to feel that two interviews that Mario Draghi gave to the Financial Times and the Wall Street Journal in December 2011 and February 2012 are quite revealing. The interviews cover his first four months as president of the ECB, they bracket the first phase of the Long-term Refinancing Operation through which the ECB eventually pumped 1 trillion euro into the European banking system, as well as the fiscal compact of December 2011.
Draghi features in many ways in recent European history. There is super Mario, the American Draghi, a “maximum force” interventionist, the man with the “big bazooka” who saved the Euro. There is Draghi the Florentine diplomat smoothing Europe’s path as he shuttles between Frankfurt and Berlin. There is the Draghi of the European left, the servant of the markets, the ex Goldman Sachs banker with an uncanny resemblance to Dr Evil.
The Draghi we can glimpse in the WSJ and FT interviews is rather different from all of these. The Draghi we see is
- the inheritor of the Italian crisis of the early 1990s.
- an economist who couples together questions of macroeconomic balance, fiscal sustainability, capital markets and a program of structural reform aimed a transforming the European social bargain.
- a grand strategist of European integration.
He is on the other hand neither a Bocconi boy, nor a Bernanke style advocate of central bank activism.
The Wall Street Journal interview from February 2012 contains the two most striking punch lines. The first is on the macroeconomic impact of austerity.
WSJ: But some people say Greece is really suffering depression-like conditions, GDP off 15% or 16% peak to trough. What is your view of these austerity policies in the larger strategy right now, forcing austerity at all costs in order to bring the budget deficits down?
Draghi: This is actually a general question about Europe. Is there an alternative to fiscal consolidation? In our institutional set up the levels of debt-to-GDP ratios were excessive. There was no alternative to fiscal consolidation, and we should not deny that this is contractionary in the short term. In the future there will be the so-called confidence channel, which will reactivate growth; but it’s not something that happens immediately, and that’s why structural reforms are so important, because the short-term contraction will be succeeded by long-term sustainable growth only if these reforms are in place.
WSJ: Austerity means different things, what’s good and what’s bad austerity?
Draghi: In the European context tax rates are high and government expenditure is focused on current expenditure. A “good” consolidation is one where taxes are lower and the lower government expenditure is on infrastructures and other investments.
The crucial point here is that Draghi does not deny that fiscal consolidation is contractionary. He rejects the idea of expansionary austerity associated with the “Bocconi boys“. Indeed, he makes a point of saying that “we should not deny” the likely contractionary effect – truth in advertising. Indeed, for Draghi the urgency of structural reform follows precisely from the need to counteract the contractionary effect of fiscal consolidation.
And Draghi is similarly forthright when it comes to the likely impact of structural reforms.
WSJ: Which do you think are the most important structural reforms?
Draghi: In Europe first is the product and services markets reform. And the second is the labour market reform which takes different shapes in different countries. In some of them one has to make labour markets more flexible and also fairer than they are today. In these countries there is a dual labour market: highly flexible for the young part of the population where labour contracts are three-month, six-month contracts that may be renewed for years. The same labour market is highly inflexible for the protected part of the population where salaries follow seniority rather than productivity. In a sense labour markets at the present time are unfair in such a setting because they put all the weight of flexibility on the young part of the population.
WSJ: Do you think Europe will become less of the social model that has defined it?
Draghi: The European social model has already gone when we see the youth unemployment rates prevailing in some countries. These reforms are necessary to increase employment, especially youth employment, and therefore expenditure and consumption.
WSJ: Job for life…
Draghi: You know there was a time when (economist) Rudi Dornbusch used to say that the Europeans are so rich they can afford to pay everybody for not working. That’s gone.”
“The European social model has (sic) already gone …”. This is the bombshell of the WSJ interview. But, placed in context, what Draghi is talking about is the inequality generated by insider/outsider barriers in European labour markets. It is hypocritical under such conditions to proclaim the virtues of a European model. Of course, such structures are only part of a complex of factors generating inequality and they do not explain the huge surge in youth unemployment after 2008 (unless the point is that such rigidities make Europe unresponsive to shocks). But, in this regard as well, Draghi’s position is essentially the conventional wisdom of a 1990s centrist complete with memories of the “bad old days” of the 1970s.
The FT’s team of Lionel Barber and Ralph Atkins conducted their interview on 14 December 2011 just after agreement was reached on the Fiscal Compact. The interest in this case lies less in punch lines than in the clear view we gain of Draghi’s understanding of the politics and economics of the eurozone crisis at the end of 2011.
One point that emerges clearly is the urgency of the LTRO operation. The ECB was seriously worried in December 2011 about a major credit squeeze triggered by the need of European banks to refinance the short-term funding to which they had resorted since the 2009 credit stop. The huge dollop of liquidity injected by way of LTRO was preemptive and Draghi is at pains to insist that it was facultative.
“The important thing was to relax the funding pressures. Banks will decide in total independence what they want to do, depending on what is the best risk / return combination for their businesses. One of the things that they may do is to buy sovereign bonds. But it is just one. And it is obviously not at all an equivalent to the ECB stepping-up bond buying.”
Over the winter of 2011-2012 with German conservatives on the warpath further bond buying by the ECB was taboo. The FT would return to the question of European QE, but this initial observation about the link between bank funding, balance sheets and the purchase of sovereign bonds led on to a further observation by Draghi:
“Last week, we had the results of the European Banking Authority (EBA) “stress tests” exercise. But ideally, the sequence ought to have been different: We should have had the EFSF in place first. This would have had certainly a positive impact on sovereign bonds, and therefore a positive impact on the capital positions of the banks with sovereign bonds in their balance sheet. So the ideal sequencing would have been to have the recapitalisation of the banks after EFSF had been in place and had been tested. In fact, it was done the other way round, so the capital needs identified by the EBA exercise reflect stressed bond market conditions. That may exert pressure on banks to achieve better capital ratios by simply deleveraging.
Deleveraging means two things; selling assets and/or reducing lending. In the present business cycle conditions, I think the second option is by far the worst. I understand regulators have recommended to their banks that they shouldn’t go this way, so let’s hope they follow this advice.
FT: Couldn’t somebody just say to the EBA, look, just hold off now, this is completely unhelpful?
MD: I think the press statement by EBA somehow hints at that, because they say that there wouldn’t be another exercise next year. To be fair to EBA, the shape of the exercise was decided at a time when the biggest economic threat seemed to be the banking system’s lack of credibility. People feared banks’ balance sheets concealed fragilities that in the end would strain the economies. So they started this exercise thinking that, being transparent, and marking-to-market sovereign bonds, would strengthen the credibility of the banking system and reduce risk premia. At the end, it did not work that way because of the sequencing. But I wouldn’t say it’s EBA’s fault.”
The issue of sequencing emerges as key to Draghi’s entire view of the Eurozone crisis. What is at stake is the fact that by dawdling over the European Financial Stability Facility (EFSF), which was supposed o stabilize sovereign bonds markets, but pressing ahead with bank stress testing, the Eurozone added to instability. The uncertainty in the sovereign bond market was transferred to the bank balance sheets, where it was then exposed by the stress tests.
Draghi then goes on to offer a multidimensional account of the rise of uncertainty in the sovereign bond market and what needs to be done to restore confidence:
“The first, lies with national economic policies, because this crisis and this loss of confidence started from budgets that had got completely out of control.
The second answer is that we have to restore fiscal discipline in the euro area, and this is in a sense what last week’s EU summit started, with the redesign of the fiscal compact.”
National and Eurozone fiscal consolidation were both essential according to Draghi.
“Improvement in budgetary positions should elicit some positive market response, lower spreads and lower cost of credit. But … it is necessary to have the right euro area design, implementing the fiscal compact, so that the confidence is fully restored. Austerity by one single country and nothing else is not enough to regain confidence of the markets – as we are seeing today.”
Indeed, once markets were panicking, neither national nor Eurozone wide austerity were enough.
“we are in a situation where premia for these [sovereign debt] risks overshot. When you have this high volatility – like we had after Lehman – you have an increase in the counterparty risk. In the worst case, you can have accidents and even if you don’t have accidents, you have a much reduced economic activity because people become exceedingly risk averse.
So the third answer to this is to have a firewall in place which is fully equipped and operational. And that was meant to be provided by the EFSF.”
The explicit acknowledgement of market irrationality (euphemistically referred to as “overshooting”) is significant here. It would provide the basic justification for ECB intervention. But so too is the past tense with regard to the EFSF. The EFSF was thrown together in May 2010. But in December 2011 it was still far from being a functional mechanism for market stabilization or even a credible backstop.
Nor does Draghi limit himself to financial matters. Once again he makes the link to growth and thus to the call for “structural reform”.
“The fourth answer is to again ask: why are we in this situation. Part of this had to do with fiscal discipline, but the other part was the lack of growth. Countries have to undergo significant structural reforms that would revamp growth.”
At this point the FT interviewers appear to have thought that they might persuade the new president of the ECB to widen his criticism of europe’s crisis fighting. On 19 October 2010 Merkel and Sarkozy had spooked the markets with their announcement from Deauville that in future there would be Private Sector Involvement (PSI), i.e. haircuts at the expense of creditors, in any future debt restructuring. This was widely decried as Europe’s “Lehman moment”. Trichet, Draghi’s predecessor, was particularly vocal on this score. A year later the FT was still on the warpath.
FT: And the fifth answer (to the collapse of confidence) is that the idea of introducing private sector involvement (PSI) in eurozone bail-outs was, in retrospect, a mistake?
But Draghi responds with another reference to sequencing.
MD: The ideal sequencing would have been to first have a firewall in place, then do the recapitalisation of the banks, and only afterwards decide whether you need to have PSI. This would have allowed managing stressed sovereign conditions in an orderly way. This was not done. Neither the EFSF was in place, nor were banks recapitalised, before people started suggesting PSI. It was like letting a bank fail without having a proper mechanism for managing this failure, as it had happened with Lehman.”
So far so conventional. But then, Draghi pivots. He is not about to disown Sarkozy and Merkel.
“Now, to be fair again, one has to address another side of this. The lack of fiscal discipline by certain countries was perceived by other countries as a breach of the trust that should underlie the euro. And so PSI was a political answer given with a view to regaining the trust of these countries’ citizens.”
This was, indeed, the key, far too often ignored in Anglophone criticisms of the Deauville announcement. Public opinion in Germany was furious at the bailouts. The SPD leading the opposition in the Bundestag made its cooperation with Merkel’s Eurozone policy conditional on PSI.
But still the FT was not satisfied. This was December 2011. Rumors of a Eurozone disintegration were in the air. Would it not be better, they asked, for countries that were under acute stress simply to exit the Eurozone.
“FT: … that was part of the answer in the early 1990s in Italy – it did have an exchange rate adjustment.
MD: If you take that as an example, remember there was no IMF around, there was no EFSF and gross [government bond] issuance in 1992 was a multiple of the figures that we see today. It’s true that Italy moved the exchange rate, but this cuts both ways. It brought a temporary respite to the economy, so that exports could grow, but it also widened sovereign bond spreads because exchange rate risk came on top of sovereign risk. Three or four years down the road Italy still had something like 600 basis point spread with respect to the German Bund. Furthermore, the effect of the devaluation would have been only temporary without the structural reforms (abolition of indexation among others) that followed. … Leaving the euro area, devaluing your currency, you create a big inflation, and at the end of that road, the country would have to undertake the same reforms that were due to begin with, but in a much weaker position.”
But did Draghi really feel, faced with the huge tension that had built up during 2011 that the Eurozone was viable? Were the decisions taken at the Fiscal Pact summit in December 2011 sufficient? In the eyes of most commentators they were totally inadequate. Germany had forced through fiscal consolidation but blocked any major increase in the backstop for the bond markets. Given Draghi’s earlier comments about the EFSF the FT pushed the point.
“FT: It sounds like you’re a bit disappointed then with the outcome of last week’s summit then?
MD: Actually no, because there was confirmation of previous figures on the EFSF’s resources – and of an additional €200bn that could be provided by the International Monetary Fund. What was also overlooked by many is that the date for a first assessment of the adequacy of resources has been brought forward to March 2012 – in just three months’ time, when the leaders ask themselves whether the resources for the firewall will be adequate. In the meantime, the ECB acting as an agent will make the EFSF operational. Important was also the commitment to clearly restrict the PSI to IMF practices, which should reassure the investors. FT: When do you think the EFSF will be operational? MD: Our aim is to be ready to provide agency functions in January next year.”
But did Draghi really believe that this was a viable compromise?
“FT: What do you say to those who say the solution is to have a very big firewall and ultimately put the ECB behind it, because that is the only thing which will tame the markets?
MD: People have to accept that we have to and always will act in accordance with our mandate and within our legal foundations.
FT: But if you look at the wording of the treaty, there is nothing that sets a limit on how many government bonds you buy ….
MD: We have to act within the Treaty. In general, there must be a system where the citizens will go back to trusting each other and where governments are trusted on fiscal discipline and structural reforms.
FT: Once the firewall is in place with the EFSF, perhaps as soon as the beginning of next year, might you actually stop the SMP (securities market programme)?
MD: We have not discussed a precise scenario for the SMP. As I often said, the SMP is neither eternal nor infinite. Let’s not also forget that the SMP was initiated with the view to reactivating monetary policy transmission channels. So as long as we see that these channels are seriously impaired, then the SMP is justified.
FT: Arguably, the monetary transmission channels are more impaired than ever before, if you look at interest rates in Greece or Italy compared with Germany?
MD: The cost of credit is bound to differ because it’s geared to some extent not on our short-term policy rate but on sovereign spreads.
FT: Would the ECB consider putting a limit on yields or spreads, or would that violate the treaty in your view?
MD: Sovereign spreads have mostly to do with the sovereigns and with the nature of the compact between them. It is in this area that progress is ongoing. Monetary policy cannot do everything.
FT: But if the economic situation deteriorated, would you be prepared to embark on “quantitative easing” in the style of the US Federal Reserve or Bank of England, in terms of large-scale government bond purchases to support economic growth?
MD: The important thing is to restore the trust of the people – citizens as well as investors – in our continent. We won’t achieve that by destroying the credibility of the ECB. This is really, in a sense, the undertone of all our conversation today.”
The WSJ interview allows us to glimpse Draghi’s wider vision of the necessity for Europe to reinvent its social model. The FT interview exposed the constraints that governed Eurozone crisis-fighting. There were the economic problems of fiscal discipline, sovereign bond markets and bank stability, all set against the question of long-run growth. But both the substance and the sequencing of crisis fighting was dictated by politics, law and the question of “the trust of the people – citizens as well as investors – in our continent”. Above all – as had become clear at the Cannes G20 in November 2011 – what mattered was the “trust” of the German political system and its tolerance for expanded eurozone firefighting capacities.