Draghi’s Dilemma: How to Meet
European Central Bank Governor Mario Draghi has raised expectations ahead of this week’s ECB Governing Council meeting.
In a speech last week, Draghi promised that “within its mandate” the ECB would do “whatever it takes to preserve the euro”. On the face of it, this is a far-reaching commitment. But the ECB faces two constraints which make a game-changing intervention unlikely in the short term.
The first constraint is the prohibition on monetary financing of governments in the Maastricht Treaty. This makes any ECB intervention in sovereign-debt markets controversial—particularly in Germany—and renders some proposed crisis-management tools illegal.
The second constraint is that, whenever the ECB takes action to lower sovereign-borrowing costs, it reduces pressure on governments. At a time when some countries have not even ratified the fiscal compact or the European Stability Mechanism (ESM)—let alone agreed on credible plans for a banking union or “genuine” economic and monetary union—it is important for the ECB to maintain some leverage.
This makes for a delicate balancing act. The ECB needs to keep enough tension in the system to encourage governments to push ahead with reforms, but not so much that the system (and real economy) implodes. Nonetheless, given the unprecedented nature of Draghi’s intervention, it seems almost inconceivable that the ECB will not announce some form of action this week. The question is what?
The ECB has a range of policy tools at its disposal and will probably end up deploying most of them before the crisis is over. Unfortunately, the most effective are also the most controversial.
Draghi’s speech last week seemed to point towards a reactivation of the Securities Market Programme (SMP), which involves the ECB buying government bonds in the secondary market with the aim of lowering sovereign borrowing costs. But unless the ECB is willing to intervene on a massive scale—effectively putting a cap on bond yields, which is unlikely at this stage—and/or agree to forego seniority on its purchases, it’s not clear how effective this would be. It would be better for the SMP to work in conjunction with the vehicles set up to support the euro, the European Financial Stability Facility (EFSF) and ESM, thus ensuring policy conditionality for recipients of aid. But that may not be possible in the near term.
If the ECB is not in a position to intervene in sovereign-bond markets at this stage, it will probably have to fall back on a number of second-best options. These might include some form of credit easing (i.e. purchases of bank debt or corporate bonds), changes to the ECB’s collateral framework and perhaps even a rate cut. However, in this event, it will be important for the ECB to indicate its willingness to support future bond purchases through the EFSF and ESM, and signal more flexibility in other areas.
The views expressed herein do not constitute research, investment advice or trade recommendations and do not necessarily represent the views of all AllianceBernstein portfolio-management teams.
Darren Williams is Senior European Economist at AllianceBernstein.