by Ben Carliner
The Onion famously announced the election of Barack Obama with the headline: Black Man Given Nation’s Worst Job. It noted that the position “comes with such intense scrutiny and so certain a guarantee of failure that only one other person even bothered applying for it.” On November 1 an Italian, Mario Draghi, became President of the European Central Bank, a job so terrible that the only other candidate for the position — Germany’s Axel Weber — had to resign as head of the Bundesbank in order to avoid being appointed the ECB’s new boss.
How did this job become such a hot potato? The Eurozone is experiencing a classic run. The Greek debt crisis was a shock to the capital markets. Doubts began to grow about other borrowers, and investors began to run for the exits. These fears were compounded by a design flaw at the heart of the monetary union. Eurozone members all suffer from Original Sin — they borrow in what is effectively a foreign currency — leaving governments, and not just banks, vulnerable to runs.
Solvent but illiquid borrowers are now at risk of collapse simply because investors are scared. They are not sure which banks are hiding large losses on their balance sheets, or whether Italy will be able to grow its way out of its debt burden. Such doubts can become a self-fulfilling prophecy. If borrowing costs keep rising, illiquidity could lead to default. Runs are not a new phenomenon. We know how to stop them: a lender of last resort — the very raison d’être of central banking.
The ECB has, unfortunately, been unwilling to explicitly backstop sovereign governments. Why? One possibility is moral hazard, or the risk that the ECB will let politicians off the hook and allow them to avoid meaningful reforms. Once again, the crux of the issue is confidence. Perhaps the real reason the ECB has been so reluctant to backstop sovereigns is because it doesn’t trust Europe’s politicians.
In a monetary union, countries that lose competitiveness cannot rely on a currency devaluation to bring down the prices of their goods on world markets. They must devalue internally — by cutting wages and making structural reforms. Politicians who hope to be reelected are often reluctant to take such harsh medicine.
Earlier this summer, yields on Italian bonds began to rise as contagion spread to the world’s third largest bond market. This intensified pressure on the Italian government to enact a broad package of economic reforms and austerity measures.
In the meantime, liquidity began drying up for many European banks, forcing the ECB to take decisive action by purchasing sovereign bonds. Fundamental structural reforms were put off soon after the ECB’s intervention succeeded in (temporarily) driving down yields.
Did this experience convince the ECB that whatever negotiating leverage it had over national governments would be lost as soon as it credibly committed to backstopping sovereign debt?
If so, this is a dangerous game the ECB is playing. What Europe needs now is confidence, not confidence games. The ECB is not wrong to be worried about moral hazard. But there is a word to describe the ECB’s negotiating tactic of threatening to allow financial mayhem: it is a bluff.
In the end, maybe this is why the job of heading up the ECB became such a hot potato. Any threat to allow EU capital markets to disintegrate in a systemic financial crisis is no threat at all. The ECB will have to step in and buy massive amounts of sovereign bonds. Mr Draghi will surely come in for harsh criticism for doing what is necessary, but the ECB has little negotiating leverage over national governments, and its bluffs will be called.
Ben Carliner received his master’s degree in 2004. He is a writer and economic analyst living in Washington, DC. You can read his blog on economics, finance and monetary policy at bencarliner.blogspot.com.