Mario Draghi’s promise to save the euro could prove hard to keep

July 30, 2012

Last Thursday, the head of the European Central Bank, Mario Draghi, gave a big, earth-shaking speech in which he promised to do "whatever it takes" to save the euro. Euphoria burst out across the continent. Financial markets went crazy with optimism.


This is basically like high school, except the global economy is at stake. (Geert Vanden Wijngaert/AP)

But was any of it justified? According to a new report in Der Spiegel, none of Draghi's colleagues at the European Central Bank knew he was going to say any such thing. No measures had been discussed. No resolutions agreed to. But the markets reacted as if Draghi had a detailed and decisive plan sitting right there in his back pocket:

The audience treated the remark as just another platitude coming from a politician. But International financial traders understood it as an announcement that the ECB was about to buy up Italian and Spanish government bonds in a big way. So they did what they always do when central banks suggest they might soon be firing up the money-printing presses: They clicked on the "buy" button. ...

Meanwhile, experts at the central banks of the euro zone's 17 member states had no idea what to do with the news. Draghi's remark was not the result of any resolutions, and even members of the ECB Governing Council admitted that they had heard nothing of such plans until then.

The crucial issue here is whether Draghi and the European Central Bank will use its unlimited firepower to reduce borrowing costs for Spain and Italy. In theory, that will give the euro zone time to fix its structural flaws, restore economic growth and whittle down the deficits of individual countries. (That's not as easy as it sounds.) If the ECB doesn't intervene, then Spain and Italy risk falling into a death spiral of unsustainably high interest rates — the situation Greece, Portugal and Ireland all found themselves in. And Spain and Italy are too big to bail out the way Greece or Portugal were.

That's the logic. What's the plan? Bloomberg's Jana Randow and Matthew Brockett interviewed some ECB officials and found that this seems to be what Draghi had in mind:

Draghi’s proposal involves Europe’s rescue funds buying government bonds on the primary market, flanked by ECB purchases on the secondary market to ensure transmission of its record-low interest rates, the officials said. Further ECB rate cuts and long-term loans to banks are also up for discussion, one of the officials said.

The Treaty of Lisbon forbids the ECB from lending money directly to countries like Spain and Italy. But what the central bank can do is buy up Spanish and Italian bonds in the secondary market, under the Securities Market Programme. The ECB has done this before, but only in limited quantities (which, as Richard Portes of the London Business School explained, seems to have increased market uncertainty). If Draghi promised to buy up bonds, then fewer people would worry about lending money to Spain and Italy — they could always, after all, foist off their bonds on the central bank.

Now comes the hitch. German officials don't like this plan. They don't want the ECB to buy up endless supplies of risky bonds, and they don't want to ease the pressure that Spain and Italy feel to cut their deficits. And German opposition matters: Germany's Bundesbank is the largest shareholder in the ECB. It doesn't have a direct veto, but criticisms by the Bundesbank might make financial markets worried that the ECB will eventually scale back its bond purchases. And that would defeat the whole point of Draghi's plan, which is to restore market confidence.

So, according to press reports, Draghi is now trying to persuade Bundesbank President Jens Weidmann to go along. Der Spiegel offers up some telling details on how Draghi has attempted to woo skeptical central bankers in countries such as Germany, Netherlands and Belgium, in his various attempts to save the euro. But in the past, that's often meant that the ECB's interventions have had to be halting and partial, in order to please everyone. And that's often made them less effective, because as soon as the ECB stops intervening, panic resumes.

The end result is that Draghi's charm seems to be wearing thin:

But now Draghi's maneuvering is starting to annoy many central bankers. "You never know where he stands," complain representatives of creditor and borrower countries alike. ... That's the tragic aspect of Draghi's rescue idea: What is intended to keep the monetary union together could actually drive it even further apart.

So there's still a decent chance that Draghi might not be able to do "whatever it takes" to save the euro. Joseph Cotterill has more on the jockeying, backbiting and negotiations among Europe's fractious central bankers. The ECB's governing council meets this Thursday.

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Sarah Kliff · July 30, 2012