All eyes were glued to yesterday’s press conference from European Central Bank (ECB) President Mario Draghi. The news flow seemed positive as each headline crossed the wire. Interest rates were cut for the second consecutive month. The collateral requirements for bank lenders would ease further. Unlimited loan availability for banks would be lengthened to 3 years. While these policy tools were well received, it was the one notable omission of another that panicked the market.
Because bond yields have edged up for many European countries, speculation has circulated the marketplace that the ECB would attempt to bring down the cost of borrowing for its indebted countries. As bond yields increase, it becomes too expensive for nations to borrow from the credit market. When the 10 year yield on Greek, Portuguese, and Irish bonds surpassed 7%, each country required a bailout. When Italy approached this same level in November, many expected the ECB to become the lender of last resort. This would involve printing euros to buy the bonds of countries with high costs of borrowing. Because the demand of the ECB would outweigh the supply of the market, bond prices would rise and the inversely-related yields that governments pay would consequently fall.
This tool is far from radical. In the United States, the Federal Reserve Bank has applied this type of bond buying program twice since the financial crisis of 2008. In doing so, it has more than tripled the assets on its balance sheet from $925B in December 2007 to $2.82 trillion today.
Opponents of bond buying argue that it is beyond the legal mandate of the ECB and would deter fiscal responsibility from European governments.
First, the ECB has a legal mandate to ensure price stability. This contrasts with the US Federal Reserve Bank, which has a dual mandate to manage price stability and minimize unemployment. Because the expansion of money supply theoretically creates inflation, commentators have argued that the ECB lacks the legal authority to print the vast sums of euros required to bring down the yields to manageable levels. If Philadelphia’s Charles Plosser, Dallas’ Richard Fisher, and Minneapolis’ Narayana Kocherlakota are the inflation hawks at the Fed, Germany’s Jens Weidmann is their counterpart in Europe. Germany’s concern is understandable. Not only does it represent almost 20% of the ECB’s capital stock, its history explains their concern. It was the 1920s that brought hyperinflation to the country and the consequences that followed. In 1923, prices literally doubled every two days.
Second, it is argued that lowering the cost of borrowing deters countries from balancing their budgets through imposing austerity. After all, if the cost of borrowing is manageable and inexpensive, why not borrow from the credit market at low interest rates?
Despite these two roadblocks, neither argument is conclusive.
Inflation has yet to emerge in the US. In fact, despite the Federal Reserve tripling their assets, the country is barely above its historical average inflation rate. In October 2011, inflation was 3.5% compared to its 3.38% average rate from 1914 to 2010. Furthermore, Mr. Draghi has previously conceded that its price stability mandate is to be maintained “in both directions.” In a region strife with unprecedented youth unemployment, contracting GDP, and plummeting consumer confidence, deflation (rather than inflation) commands greater concern.
Furthermore, an inclusive fiscal compact between all 27 European countries would guard against reckless fiscal budgeting. A centralized authority, responsible for scrutinizing the budgets of its 27 European countries, would have the legal authority to sanction its unruly members. While it appears that this suggestion would require an amendment to the European Treaty (and referendums to approve it), these modifications may be needed for the EU to function properly.
Though Mr. Draghi stated that “other actions would follow” if a fiscal compact were created, he used his press conference yesterday to deny that it meant bond buying. Nevertheless, a lack of market confidence in European debt may force the ECB to change its mind.
