Can ECB President Mario Draghi reshape Europe?

September 5, 2012

European history is marked by geopolitical watersheds, mostly involving generals and kings.

Are central bankers about to join the list?

When European Central Bank President Mario Draghi holds his monthly briefing Thursday, he is expected to announce details of a new effort to tackle the euro zone’s ongoing financial crisis — and potentially push Europe closer toward the economic and political union that has been the region’s ambition since World War II.

Preliminary details, hinted at by Draghi in earlier statements and in comments leaked after a closed-door session with the European Parliament this week, indicate the bank is prepared to embark on potentially unlimited purchases of bonds issued by Spain, Italy and any other euro-zone countries that lose the confidence of global investors. The aim would be to reassure markets that the bonds of euro-zone governments are safe to buy, which in turn could hold down the borrowing costs of struggling countries and rebuild faith in the currency union’s ability to remain intact.

It may not be as epochal as Julius Caesar crossing the Rubicon, but analysts say Draghi and the ECB are at a critical juncture as they prepare to possibly reshape and broaden the bank’s role in ways that would have been inconceivable before the current crisis.

The euro zone’s founding treaties prohibit the ECB from financing governments, and the central bank’s primary mission of controlling inflation makes it hesitant to “print money” the way the U.S. Federal Reserve has done in recent years to combat the U.S. financial crisis and recession.

So the ECB plan is likely to carry several conditions — fig leafs some say — to keep it within the bank’s conservative mandate of controlling inflation and interest rates.

Countries, for example, would have to commit to enacting strict controls on their government deficits and would have to ask for help from the region’s new bailout fund before the ECB would intervene in its bond markets. That new bailout fund, the European Stability Mechanism, may in turn have to begin buying bonds at government auctions before the ECB can act. The ECB would buy only shorter-term bonds of three years or less so it is not seen as offering long-term promises to any country.

Draghi has argued that alarmingly high borrowing costs in Italy and Spain are out of line with economic fundamentals and that the ECB should ensure the countries are not penalized because investors are nervous about the future of the euro zone as a whole — something he and others believe is happening.

Some analysts see a seismic event in the offing: an implicit guarantee that the ECB will backstop any government that gets into trouble, just the sort of collective commitment that many officials and economic analysts have argued is necessary to end the crisis.

Thursday’s meeting “could be the most ground breaking one in the ECB’s history,” ING analyst Carsten Brzeski wrote in a preview of the session. With Draghi’s pledge in July to do everything necessary to preserve the euro, “the ECB has already passed the point of no return,” Brzeski said.

The bond buying program would, in effect, amount to a form of price control — in this case a control on the price of government debt. Government price controls are often hard to enforce and, some economists argue, never work in the long run — eventually market forces prevail.

In this case, the ECB is wagering that markets have got it wrong, that the “real” price of borrowing by the Italian or Spanish governments is substantially lower than the 6 percent and 7 percent interest rates that are being charged and are considered unsustainable for governments. The International Monetary Fund has made the same argument, estimating those countries may be paying a premium of as much as two percentage points simply because of the broader risks investors associate with the euro zone — the fear that an Italian bond bought in euros may suddenly be denominated in a greatly devalued lira.

The ECB expects that if it starts buying those bonds itself on the secondary market — not at the government’s initial bond auction but from existing investors — that “convertibility risk” will disappear, rates will fall and European government bond markets will return to normal.

But how to set the price? Should the target interest rates on government bonds be announced or kept under wraps? Does Italy get the same rate as Spain?

Under an earlier, more narrowly tailored program, the bank bought more than $250 billion of various country’s bonds. The commitments that may be made on Thursday could dwarf that first program.

“To be able to dictate prices, the ECB and the [European bailout fund] would have to be willing to stand up as buyers of last resort for the entire bond market,” Carl Weinberg, chief economist at High Frequency Economics, said in a recent analysis. In the case of Italy and Spain alone, that amounts to around $3 trillion in outstanding debt, according to Weinberg. “We don’t think they have the moxie, the mandate or the firepower to do so.”

Expectations for Draghi are now so high that if he stops short, he risks a different comparison: Napoleon at Waterloo.

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