Draghi Unlimited

21. January 2013 by Herman Brodie

Draghi auge mini

That Mario Draghi’s name was recently mentioned as a potential Italian prime minister is measure of how much the man is presently revered in politic0-economic circles. His management of the eurozone crisis and, just as importantly, of the ECB’s Governing Council, has rightly earned him high praise – Man of the Year, no less.

Right from the outset of his mandate, he had to see off morally and intellectually threadbare criticisms about being a director at Goldman Sachs at the time the bank was helping Greece to window-dress deficits; about conflicts of interests arising from his membership of the exclusive club of international bankers, the Group of 30; and even about being Italian.  Draghi also put his indelible stamp on the central bank by reversing the interest rate decision of his predecessor, Jean Claude Trichet, and abandoning the Frenchman’s ridiculous ‘vigilance’ code-words.

One legacy he did inherit from his predecessor was a penchant for infuriating the German representative on the Governing Council with his unconventional policy choices. Trichet employed the thin-end-of-the-wedge technique until the gentleman from the Bundesbank resigned. Draghi simply fired up his steamroller and flattened the current boss of the German central bank, Jens Weidmann. But, it worked. People like Draghi, not so much because he gambled, but because he won.

Draghi’s success owes much to his recognition that beyond the risks associated with the heavily over-indebted eurozone periphery, investors were also pricing in a risk that the eurozone would disintegrate with member states returning to their legacy currencies.  This ‘break-up’ risk premium was not justified in his view, but added to the woes of the financially-stressed South and reinforced a negative spiral. This risk premium had to go. He also knew how to do it – every central banker knows how to dissolve an unwarranted risk premium. One has to use the U-word: unlimited.

In a financial market populated by agents with limited resources, any agent who is able to do something without limit has an obvious advantage when it comes to influencing behaviour. Central banks are the only market participants who can operate without limit, and even this is only possible in the case where their action is supported by the printing of their own money. For example, a central bank can intervene indefinitely in the currency market to weaken its own money by printing and selling it. If it tries to buy its own money to prevent a market price fall, it will discover its actions limited by the amount of foreign currency reserves it has to sell in exchange. This explains why a single hedge fund was once able to break the mighty Bank of England, while the little Swiss National Bank (SNB) has been able to fend off all the marauding hoards. Everything depends on the U-word.

Even though not a single euro had to be printed or deployed in Draghi’s unlimited bond buying promise, the market’s knowledge that it could and would was enough to drive the break-up risk premium down. The result is that financial conditions in the eurozone are now on the mend (where is Weidmann now?).  In this context, the SNB deserves some part of the praise, as it reminded investors of the meaning of the word unlimited. Had the Swiss lost their nerve while defending the exchange-rate peg versus the euro, had a single bead of sweat appeared on the forehead of the SNB chief, had the Bank printed one franc too few, Draghi’s policy would have cost a great deal more.

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vposted on 21. January 2013 at 10:35 am

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One comment

  1. There are other objections of course – inflation data are never revised, whereas GDP numbers are, sometimes drastically. So central bankers could be aiming at a historical number that might change significantly (most economists expect UK GDP to be revised higher for the period since the credit crisis). But perhaps the greatest criticisms are reserved for the damage this might do to monetary policy credibility – does not caring about the mix of inflation and growth increase the risks of inflation drifting further away from 2%? And some have suggested that countries that have followed a NGDP regime have experienced higher volatility of both output and inflation compared to those that target inflation alone.

    Comment by Jayson Stevenson on January 26, 2013 at 7:35 pm

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