Analysis & Opinions - Belfer Center for Science and International Affairs, Harvard Kennedy School
Don't Waste Draghi
A Spanish-language version of the op-ed appeared in El Pais on November 18, 2012 and can be accessed here: http://elpais.com/elpais/2012/11/09/opinion/1352486211_663914.html
This translation was provided by the author.
A year ago, these pages were filled with predictions of Euro-pocalypse—brought about by a combination of Greek profligacy, German apathy, and Silvio Berlusconi. The end was not nigh. Today Greece has a coalition government committed to reform, Germany cleared all hurdles for a permanent Eurozone rescue mechanism (ESM), and Berlusconi gave way to Mario Monti.
Pessimists now argue that the current stability will be short-lived because it relies too heavily on European Central Bank support. They predict the ECB will lose credibility when an electorate chooses a government that jettisons reform while still demanding central bank support.
Can Europe deal with what could be deemed "Silvio return risk"? It can—but only if Germany does not delay on banking union and Spanish PM Rajoy matches Monti's courage in the face of temporary unpopularity.
In making the case for "Outright Monetary Transactions" on Thursday, President Draghi made it clear that the ECB does not aim to fund governments, but to address evidently broken transmission mechanisms. Countries like Spain's are currently doomed if they do rescue banks and implement structural reform and doomed if they don't. In contrast to Sweden's adjustment in the 1990s, it is Sisyphean to reform in a low-growth global environment while investors tighten credit. OMT offers respite. The fact that there was only one vote against it at the September Governing Council—that of Bundesbank president Jens Weidmann—means that at least one German supports this argument, not to mention other hawks.
Impressing the irreversibility of the euro upon markets will require a new conditionality program for Spain and possibly Italy, but it will not wholly remove them from capital markets—an important legal difference.
Behind these announcements lay a grand bargain. Through two years of crisis, European political leaders had made a habit of doing too little, too late. But the June 28 Summit was fundamentally different. The effective quid pro quo for further ECB support was clear progress toward a banking union and German acquiescence to an eventual federalization of bank recapitalization funds.
Alas, the risks are now more political than economic. Last week, a German-Dutch-Finnish finance minister declaration put into question the fast-track toward common bank supervision and the federalization of so-called "legacy assets," the elephant in the room for Spain. Now that a summer rally has cooled off urgency, it is useful to recant how perilously close to the brink Europe came earlier this year.
In early May, inconclusive Greek elections led to a worrying acceleration of deposit withdrawals from undercapitalized Hellenic banks. Anxiety spread to Spain, where the nationalization of Bankia had been hurriedly announced. Iberian TV showed a worried depositor berating a government minister. Soon blogs were claiming that ATMs in Barcelona were empty. Within 24 hours, fears of a bank run had spread to Italy and Portugal.
This panic made painfully clear that the uneven funding and regulatory playing field for European banks are EMU's Achilles heel. German banks certainly enjoy the inflow of safety-seeking assets, but a cross-border bank run would eventually engulf them, too. Back in 1931, the Credistanstalt crisis spread overnight from Austria to the rest of Europe. That banking crisis also swept the monetary orthodoxy of the time, forcing Britain off the gold standard.
Europe still does not have the tools to deal with this risk: OMT can reduce spreads, but it cannot prevent Spaniards from switching from "Spanish" to "German" euros.
That is why delays on common bank supervision—the first step toward banking union, to be followed by resolution and deposit insurance schemes—are unacceptable. There will be fraught debates over the cajas and Landesbanken, not to mention inevitable British objections. But impetus from Germany is the only way to eliminate the risk of a sudden systemic failure.
Europe's twin threat is populism. True, electorates have defied predictions by voting for pro-European parties in Greece and the Netherlands. Yet we can expect to hear more from True Finns, Syriza, the Front National, and the Northern League, to name but a few of the parties who trade on popular dissatisfaction with the inevitable pain of reform. Crucial elections in Italy are just over half a year away; jockeying for position has already begun.
Draghi's OMT gives the populists' opponents a new weapon: support while structural reform takes hold. As he implied on Thursday, purchases are rewards for the countries implementing good reforms. Conversely, the ECB can stop OMT if it judges national policies to be "deserving" of punitive rates. Draghi should not hesitate to use this power to preserve credibility: while monetary policy operates within democracy, it is not itself be democratic.
It is ultimately up to political leaders to use the breathing room furnished by OMT to make the case for fixing Europe's intergenerational imbalances. Entrenched interests and over-expanded welfare that create unsustainable burdens for future generations may be temporarily democratic because those affected are not old enough to vote. They are also inherently unfair as well as economically deleterious in a Continent with dubious demographic trends. If preserving integration entails healthcare co-pays for wealthy Spaniards and less protection for anachronistic Italian unions, so be it.
What Edmund Burke called the "contract between generations" needs repairing across the developed world. So European politicians must make the case for reform more forcefully. Monti's boldness in the face of declining poll numbers earlier this year was exemplary, and it has paid off both financially and politically.
In this context, Spanish PM Rajoy should worry less about losing impending Galician and Basque elections and more about how to use a troika program to implement structural reform without alienating his electorate. Why not accept the opposition's constructive offer to cooperate and avoid delays in requesting help?
The pro-European Portuguese and Greek governments, meanwhile, deserve support. Should they fall and give way to populists, Europe as a whole will suffer. Unlocking unused EU structural funds can readily offer better growth prospects. Why delay?
After September 2013, Germany will be in a better position to lead toward what follows from banking union: fiscal and political union. A third Merkel term, potentially in a grand coalition with Peer Steinbrück's Social Democrats, can make fiscal union happen not as a permanent transfer union but as a globally-competitive federation. But make no mistake: banking union cannot wait that long. Nor can reform.
Europe is not yet saved: core countries must not give into politically expedient delays and peripheral governments must better sell reform. Otherwise the OMT will be squandered—and the pessimists may yet be proven right.
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