Will ECB’s Draghi go for gold in money printing?

A joke making its way around London during the Olympics: “What will the Greeks do with their gold medals? Send them to a pawnshop in Germany.”

The British can be forgiven their sense of schadenfreude amid the fiscal travails of their continental neighbours. The UK, after all, is not a member of the eurozone.

However, an economic meltdown in the heart of Europe – an almost inevitable outcome in the event that the single currency area falls apart – would wreak havoc on Britain, the US, China and just about everyone else.

This is why the global markets breathed a collective sigh of relief last week when European Central Bank president Mario Draghi was uniquely blunt for a central banker. So, what exactly did Mr Draghi say that spurred a 400-point gain in the Dow Jones industrial index?

His pledge that the ECB will do “whatever it takes” to preserve the euro was not the crux of the matter – such rhetoric is too vague to impress sceptical traders; in any case these words have been used before. Rather, it was his comment that sky-high bond yields in Italy and Spain “hamper the functioning of the monetary policy transmission channel” that got the market’s attention.

Mr Draghi’s technical-sounding language cloaked what is actually a potent statement. If the ECB concludes that soaring borrowing costs across Europe’s Mediterranean rim are fundamentally blocking its ability to manage the eurozone’s monetary policy, then the ECB is justified – at least in theory – to take whatever actions it sees necessary to bring those yields down.

In other words, quantitative easing (QE) on a massive scale. Or, put even more plainly, money printing.

But a week later little has changed. Mr Draghi's comments on Thursday lacked any information on when the bond buying might start, how much the ECB could spend or for how long.

Markets responded with Spanish and Italian bonds again rising above 7% and 6% respectively, while sharemarkets dropped.

Half-hearted buying
The ECB has bought sovereign bonds over the past several years, explicitly citing the concept of “monetary policy transmission” as the basis for those purchases.

However, to appease Germany – whose Bundesbank is implacably opposed to the policy – the ECB’s purchases have been half-hearted. And even that proved to be too much for the German representative on the ECB’s executive board, who resigned in protest in 2011.

In his latest comments, Mr Draghi reiterated that the ECB would resume bond-buying but on shorter-term bonds and on conditions governments first access rescue funds.

One of the so-called “nuclear options” would be for the ECB to set a maximum target for eurozone sovereign yields – let’s say, 5% – and it would then expand its balance sheet as necessary to achieve that objective.

Needless to say, Madrid and Rome would be ecstatic about such a policy. On the other hand, Berlin would be outright livid. It is therefore worth asking: Does Mr Draghi have the ability to push through an even looser monetary policy amid withering opposition from the Germans?

As a purely legalistic matter, the answer is yes. Within both the executive board and the (broader) governing council, the hard-line inflation “hawks” are in the minority. In addition to Germany – which is increasingly regarded as a permanent naysayer in ECB circles – Finland, Austria and probably the Netherlands are in the same camp.

The rest – comprising well over half of the members – are, in varying degrees, in favour of money-printing. The most recent convert to that cause is France, the eurozone’s second-largest economy, following the election of President Francois Hollande in May.

Outright break
As a practical matter, things are more complicated. In the event of an outright break between the ECB and the Bundesbank, Germany can make life very difficult for the ECB and the European Union authorities more broadly.

For example, since Germany is widely seen as the ultimate guarantor of the bailout funds for Greece, Portugal, Ireland, and (presumably) Spain, in theory Berlin could pull the plug on the entire arrangement. Of course, this would set off an economic cataclysm, in which Germany itself would be engulfed.

Still, it is something for Mr Draghi to keep in mind as he decides how far he can go.

The Bundesbank, for its part, sees its role as a guardian of the ECB’s original mandate, which certainly did not envisage micromanaging sovereign bond yields. As Bundesbank president Jens Weidmann put it in an interview earlier this year: “There have to be voices who identify the limits of what a central bank can do.”

That is consistent with Germany’s long-standing stance that profligate Club Med countries must put their own fiscal house in order, and backdoor bailouts via the ECB are unacceptable.

Given the political context within which Mr Draghi must operate, therefore, it is hard to avoid the conclusion that there is an element of wishful thinking in the global markets’ response to his recent comments.

A truly game-changing policy shift – something along the lines of an open-ended commitment to bond purchases – is much easier said than done. Unless and until there is concrete action to back up Mr Draghi’s words, they will be just that – mere words.

Pavel Molchanov is a financial analyst in Texas. Email: pavel@alumni.duke.edu