Mario Draghi’s monthly monetary policy press conference, held Thursday, served as a useful rehearsal for what is likely to be a markedly more nerve-jangling experience — his October 24 appearance before the German parliament to reassure lawmakers about his new bond-buying program.
Much of the German establishment is opposed to the outright monetary transactions (OMT) scheme. Under the initiative, the European Central Bank (ECB) would buy the bonds of troubled euro zone governments that had applied for aid from the European Stability Mechanism, the euro zone rescue fund, in return for strict policies of austerity and reform.
Critics in Germany and elsewhere have two main objections.
The first — that the creation of new money to buy these bonds could, gradually but inexorably, create hyperinflation and render the euro worthless — is understandable in a country that suffered this fate in the 1920s. The 1920s crisis was a repeat — in a more extreme form — of the inflation crisis of the 1760s, when Frederick the Great of Prussia debased the currency to pay for the Seven Years War. Breakneck inflation is a deep-rooted fear.
Draghi did not directly wade into the debate over whether increases in the monetary base are bound to increase inflation or not. However, his gloomy assessment of the euro zone economic outlook gave ammunition to those who argue that though there are many things to worry about when contemplating the poor state of the euro zone economy, runaway inflation is not one of them.
Draghi said he expected economic activity “to remain weak in the near term and to recover only very gradually thereafter.” He added that inflation — which is currently at 2.7 percent — putting it above the 2 percent maximum considered acceptable by the ECB — looked set to fall below 2 percent next year. It could, moreover, fall further than expected if “financial market tensions” hit euro zone economic growth harder than anticipated. The German nightmare scenario of runaway inflation is, therefore, understandable but unlikely.
The second great German nightmare is that the OMT will end up financing incurably diseased national economies almost in perpetuity. This is both understandable and eminently feasible. Draghi’s consistent line, both for OMT and for previous emergency bond-buying operations, has been that such support will only come as a reward for fiscal rectitude and free-market reforms.
On Thursday he insisted it was “essential that governments continue to implement the necessary steps to reduce both fiscal and structural imbalances and proceed with financial sector restructuring measures.” Moreover, the ECB would exit OMT programs not only “once their objectives have been achieved,” but also “when there is a failure to comply with a program” — abandoning bond purchases if countries do not stick to their side of the bargain.
His defenders argue that this shows a strict and prudent sense of moral hazard. In their eyes, there is a good reason why Draghi consistently demands austerities that bring national economies close to, but not over, the dividing line that separates tough economic times from outright economic collapse. He wants to help governments as little as possible to prevent them from believing they can live forever on ECB aid without having to put their houses in order. Draghi has therefore become, by this reckoning, Europe’s fiscal policeman.
There are, however, two possible criticisms of this policy and both have important implications for institutional investors.
The first is that he is being too strict and that this strict policy is dooming financial markets for perhaps the rest of the decade to the regular bouts of panic and euphoria that have governed them since the euro zone crisis began last year. This is predicated on two propositions. One is that the peripheral economies can endure the extreme fiscal detox that the ECB prescribes. The other is that, should a government apply for OMT assistance, Draghi will never turn off the tap. As a result of these doubts, critics say, investors will continue to price in a hefty risk premium on peripheral bonds.
The second possible criticism is the diametric opposite: that Draghi is being too kind, because the more euro zone government bonds the ECB buys, the bigger the crisis when the ECB has to put this policy into reverse.
Ari Bergmann, head of Penso Advisors in New York, which advises institutional investors on tail risk events, says that if Draghi agrees on an outright monetary transactions program with Spain — seen by analysts as the most likely applicant — “he has pushed back the day of reckoning for a while, but the risks are that much greater.”
While others might liken Draghi to a fiscal policeman, Bergmann describes the ECB as “the garbage can of Europe — buying bonds no one else wants.” This, he thinks, puts those euro zone governments producing the garbage in a bind.
“Let’s assume Spain will not be able to stand by its commitments agreed with the ECB under the OMT program, perhaps because social unrest prevents this,” says Bergmann. “If the ECB stops buying and decides to sell, Spain will not be able to fund itself” — because no investor will be prepared to step into a bond market, which the ECB itself has abandoned. Branded with the imprimatur of Draghi's disapproval, the Spanish sovereign market would collapse. The outcome would be either a Spanish default or a redenomination of Spanish sovereign bonds with Spain leaving the euro zone — and an economic crisis across the euro zone that would hit Germany too.
Draghi is no doubt pondering his replies to this and other equally tricky questions as he prepares for his parliamentary grilling in three weeks’ time. His response will be watched as closely by institutional investors as it will by the anxious German public.
