The European Central Bank’s Clay Feet

By Desmond Lachman 

The president of the ECB should not believe his own hype: Europe’s economic crisis is far from over.

The Book of Proverbs teaches that pride goes before the fall. Mario Draghi, the president of the European Central Bank (ECB), should take heed of that lesson. For at the very same time that he is trumpeting the great success of his “whatever it takes to preserve the Euro” statement made last year, the European economic periphery is again showing the clearest signs of economic and political distress.


Sadly, aside from declaring that the European crisis is over, Mr. Draghi is doing little to respond to these distress signals. This makes it likely that Europe will again experience a full blown economic crisis before the year is out. It also makes it all too probable that Mr. Draghi’s declaration of victory in the Euro crisis will prove premature and that his credibility will end up greatly diminished.
Mr. Draghi does have some justification for feeling satisfied with the ECB’s performance over the past year. In July 2012, Europe was quite literally peering over the abyss and the very survival of the Euro was in serious question. Underlining the gravity of the crisis was the fact that Italian and Spanish government borrowing rates had soared to over 7 percent, levels that were clearly not sustainable over the long run. Just one year later, in response to the ECB’s bold policy initiatives, those borrowing costs have been reduced to affordable levels and the tail risk of a Euro break-up appears to have passed.
The rabbit that Mr. Draghi managed to pull out of his hat to save the Euro was the ECB’s introduction in September 2012 of an Outright Monetary Transaction (OMT) program. Under that program, the ECB committed itself to buying unlimited quantities of European peripheral government bonds with maturities of up to three years in order to keep government borrowing costs for those countries at affordable levels. The ECB’s commitment was made subject to the important condition, which is often forgotten in the markets, that it would only begin to buy the sovereign bonds of a country that had first negotiated an IMF-style economic adjustment program with the European Stability Mechanism.

The Toxic Policy Mix and the Periphery
Until the recent rise in European interest rates, financial markets responded very favorably to Mr. Draghi’s OMT initiative without the ECB having to spend a single Euro on bond purchases. However, the same cannot be said for the economies of the European periphery, which have continued to wither under the toxic policy mix of budget austerity and a domestic credit crunch within a Euro straitjacket. After experiencing six quarters of economic contraction, making it the longest European post-war economic recession, the overall European economy is projected by the ECB itself to decline by a further half percent in 2013. Meanwhile, the economies of Italy and Spain, which are already in a virtual economic depression, are officially expected to contract by more than 1.5 percent this year.

If Europe’s economic and political situation continues to deteriorate, it will only be a matter of time before markets test the ECB’s commitment to buy as many of the troubled European periphery’s bonds as needed.

All too predictably, the deepening of Europe’s economic recession has been accompanied by a marked deterioration in its politics. Across the European economic periphery, support for centrist parties is crumbling, with unstable coalition governments now in place in Greece, Italy, and Portugal. At the same time, there has been a veritable political backlash against the externally imposed policies of budget austerity and structural reform, which are increasingly perceived by the public as leading these countries ever more deeply into economic recession. This austerity fatigue is now throwing into question the periphery’s political willingness to stay the IMF-EU course of many more years of budget austerity and economic reform needed to restore public debt sustainability.
Mr. Draghi must know that if Europe’s economic and political situation continues to deteriorate, it will only be a matter of time before markets test the ECB’s commitment to buy as many of the troubled European periphery’s bonds as needed. He also must know that in the present political environment prevailing in Italy and Spain, the governments of those countries are in no position to sign up for an IMF-style economic adjustment program, which is a precondition for Mr. Draghi to activate the ECB’s bond-buying program.
Considering that the ECB would very likely come up short if it were to be tested by the markets, one would have thought that Mr. Draghi would be doing everything in his power to kick-start a European economy still mired in recession. At a minimum, one would have thought that he would be taking aggressive policy action to reduce interest rates and to get credit flowing again in Europe’s very troubled periphery. Similarly, one would have expected that Mr. Draghi would be pushing for some form of quantitative easing in order to induce a much needed depreciation of the Euro.
Perhaps Mr. Draghi will become more proactive after the German elections scheduled for September 22, when he might again be politically less constrained to act. If he waits much longer, however, he could very well find himself being forced to deal with a major intensification of a European crisis that he has never tired of assuring us has long since been resolved.