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2012-08-07 11:39:38
Aug 3rd 2012, 10:55 by A.L.G. | Frankfurt am Main
A YEAR ago this week Italy s prime minister, Silvio Berlusconi, received a terse letter from two men who held his country s fate in their hands: Jean-Claude Trichet, the-then president of the European Central Bank (ECB), and the man who has since taken over the job, Mario Draghi (then governor of Italy s central bank). It contained a list of measures Italy had to adopt urgently, from budget-cutting to structural reforms, to regain the trust of investors who were dumping Italian bonds. Mr Berlusconi began to comply and, though the bargain was never explicit, the ECB began buying its bonds to bring down Italy s borrowing costs. But no a sooner had market pressure on Italy relaxed a bit than Mr Berlusconi started to backtrack.
The experience of August 2011 goes some way to explaining Mr Draghi s caution this week, when he declared the ECB was ready to resume buying bonds in the coming weeks but only if vulnerable countries asked for help first from the official euro zone rescue funds and submitted to a reform programme. Markets swooned just as fast as they had rallied a week earlier, when Mr Draghi tantalisingly told investors in London "the ECB is ready to do whatever it takes to preserve the euro - and believe me, it will be enough." Plainly the markets don t think Mr Draghi has done enough to dispel fears that the euro will break up, despite his brave talk of the euro being "irreversible". Putting on a brave face, Mr Draghi said he had no regrets about his London speech. But even if the euro zone can get through August without a major crisis, September is going to be hard.
Mr Draghi's response was not the instant and massive response that investors had hoped for. In truth, it was always rash to expect the ECB to put up unlimited amounts of money to support euro-zone states. The ECB must perform a delicate balancing act: between its potential power to print vast amounts of money and its unusually narrow legal mandate to maintain price stability; between the interests of creditor and debtor states; and between maintaining market pressure on countries to reform and preventing them from being pushed into insolvency.
Seen in this way, Mr Draghi s pronouncement shows more political subtlety than market traders give him credit for. He tries to correct several failures of past bond purchases under the so-called Securities Markets Programme, not least the short-lived effect on markets (despite the acquisition of more than 200 billion worth of bonds) and the erosion of political support for the ECB s actions. Two German members of the board have resigned in dismay at the unorthodox measures and Mr Draghi made no secret off the fact that the current head of the Bundesbank, Jens Weidmann, had placed a formal "reservation" on the latest move.
Above all, Mr Draghi needs to avert two forms of moral hazard if he decides to bring out the big bazooka: one sort is the risk of letting leaders of profligate countries such as Italy off the hook of reforms; the other is the danger of allowing creditors to shirk the need for more burden-sharing by hiding all the risk on the ECB s balance sheet. So stung by the experience with Mr Berlusconi, the ECB does not want to get involved in directly imposing economic reforms on states and chastising them when they fall short. That should be done by the member-states themselves. Hence the insistence on prior conditionality.
Second, combining structural and budgetary reforms with bond-buying improves the chance that ECB will have a more lasting effect. Third, by having the rescue funds act first, it provides political cover for the ECB s action. Fourth, by concentrating on the short end of the yield curve, Mr Draghi can more easily argue that his actions are in keeping with traditional monetary policy, rather than providing an indirect means for the ECB to finance bust governments. The three-year liquidity provided to banks under the Long-Term Refinancing Operations is already collateralised with sovereign bonds. So buying short-dated bonds is not so different, says the ECB.
So with the governments covering the front line and the flanks, Mr Draghi hopes to be able to concentrate more massive firepower on a narrower front. The ECB s involvement would ease worries that the rescue funds would quickly start running out of money. More importantly, the ECB may feel it has the space to act more decisively. Asked whether the commitment to resume bond-buying operations "of a size adequate to reach its objective" meant the ECB was ready to commit unlimited resources, Mr Draghi did not demur. He told a packed press conference that this would be one of the many "modalities" to be considered by various ECB committees in the coming weeks. However he did firmly rule out the idea of boosting the rescue funds by giving them a banking licence so they could borrow from the ECB. That would be illegal in the current configuration, Mr Draghi said.
Another delicate modality is how, precisely, Mr Draghi proposes to make good his commitment to address investors fear that a big intervention by the ECB would downgrade the bonds held by others. Experience shows that, when Greece s debt was restructured earlier this year, the ECB insisted on its bonds being treated as senior. The ECB took no losses, while private bondholders took a 70% hit.
In its policy, Mr Draghi is aligning himself with the stance of the German government: more European help is conditional on more reforms at home. It is a message that Mr Berlusconi s technocratic successor, Mario Monti, was hoping he would not have to hear. But there are two contradictions in Mr Draghi s stance. First, he may criticise markets for failing to understand the robustness of the euro zone and fearing the collapse of the single currency. But by being seen to be so grudging in his help, he seems to lack the courage of his convictions. He too wants to limit the ECB s liabilities. Second, the emphasis remains on compelling individual countries to conduct painful reforms. Yet Mr Draghi is among the loudest proponents of the idea that the euro zone also suffers from profound design flaws.
In London last month he compared the euro to a bumblebee, which can fly seemingly in defiance of the laws of physics. The bumblebee era is over, he said, and it was time for the euro zone to become a normal bee. But he plainly thinks that forcing the pace of reforms to the euro-zone structure, in contrast to his demands for structural reforms in national economies, is beyond the remit of a central banker. But without that metamorphosis, the euro remains reversible.
Note: Charlemagne will be on leave until late August.