The Things That Draghi Didn’t Say in His Milan Speech

On Thursday, November 15, ECB head Mario Draghi gave an interesting speech in Milan, at the Bocconi University’s ceremony for the new academic year. Interesting both for what he said and for what he didn’t say. The narrative of the crisis was more or less as follows.

In the past few years, markets underestimated the consequences of the irresponsible economic policies (fiscal policies in Greece, Italy, Spain and Ireland credit) and lack of structural reforms (Greece, Portugal, Italy) in many Eurozone countries, but now the chickens have come home to roost and markets have freaked out: interest rates reflect the expectation that the peripheral countries will leave the Euro. This has fragmented the inter-bank market in Europe and prevented the ECB’s low interest rates policy to be transmitted to households and businesses in the peripheral countries. The ensuing credit crunch in these countries has triggered a vicious circle of reduced consumption, investment, GDP, tax revenue, higher deficits and further increases in interest rates. This spiral occurred, according to Draghi, despite the budgetary consolidation and structural reforms that were implemented in many countries.

To break this vicious circle, said Draghi, the ECB has adopted the non-conventional policy OMT (outright monetary transactions), which means that the ECB will eventually buy government bonds on the secondary market in unlimited amounts, limiting intervention to bonds with a residual maturity not exceeding three years, and will completely sterilize these transactions so as not to raise the money supply, and keep inflation from rising. The program will also require the beneficiary country to adopt the policies of fiscal consolidation and reform that are deemed appropriate. Draghi noted that this policy is not in conflict with the ban for the ECB to monetize sovereign debt, and, as proof, he mentioned recent polls showing that inflation expectations are not rising.

Draghi admitted that OMT will buy valuable time, but not infinite time. He listed  the institutional reforms already made in Europe: the fiscal compact, the ESM, unconventional policies of the ECB,  OMT and LTRO, but said that further progress was necessary along four dimensions: a banking  union bank with a single supervisor, a fiscal union, an economic union to foster growth and competitiveness and a political union.

Draghi, however, failed to mention four important things:

  • That the Fiscal Compact has resulted in a simultaneous fiscal tightening in the Eurozone, implemented both by countries who needed it to stabilize the debt, as well as by those who didn’t, deepening the recession in  Europe (at least IMF admitted that they had underestimated the recessionary effects of budget consolidations!);
  • That the unconventional monetary policies that are put in place near the “zero bound interest rates” have expansionary effects only if they raise long-term inflation expectations, in such a way as to reduce long-term rates and encourage investment. So, OMT is designed to pander to the inflation fears of Germany, at the expense of its impact on the real economy;
  • That the banking union faces the strong risk of dilution as the Banque de France and the Bundesbank do not want to give away the supervision powers over national banks; and
  • That the proposed economic and political unions belong to the realm of dreams.

In short, Draghi did not acknowledge that the ECB faces huge political constraints and that the European crisis is far from over.