Mario Draghi’s speech to the European parliament on Thursday wasn’t just notable for what he had to say about the scarcity of eligible collateral and the impaired transmission mechanism for monetary policy.
This also stood out.
What I believe our economic and monetary union needs is a new fiscal compact – a fundamental restatement of the fiscal rules together with the mutual fiscal commitments that euro area governments have made.
Just as we effectively have a compact that describes the essence of monetary policy – an independent central bank with a single objective of maintaining price stability – so a fiscal compact would enshrine the essence of fiscal rules and the government commitments taken so far, and ensure that the latter become fully credible, individually and collectively.
We might be asked whether a new fiscal compact would be enough to stabilise markets and how a credible longer-term vision can be helpful in the short term.
Our answer is that it is definitely the most important element to start restoring credibility. Other elements might follow, but the sequencing matters. And it is first and foremost important to get a commonly shared fiscal compact right. Confidence works backwards: if there is an anchor in the long term, it is easier to maintain trust in the short term. After all, investors are themselves often taking decisions with a long time horizon, especially with regard to government bonds.
Other elements might follow, but sequencing matters.
Is Draghi saying the ECB will go all out and produce its big bazooka if the Eurozone agrees to closer fiscal union and budgetary oversight from Brussels with a big stick to beat the non-compliant?
It certainly chimes with September’s paper from the ECB, ‘The Stability and Growth Pact – Crisis and Reform‘.
It should be clear by now why the ECB wants a new fiscal compact. Consider the following nightmare scenario, sketched out by Harvinder Sian at RBS:
The main reason is that ECB QE at this stage, without much tighter rules on budgets and other structural economic policies, would be a monumental error. Just think of Silvio Berlusconi returning to power after the ECB has bought huge size and then doing nothing for another decade and a half.
Yes, imagine that.
Of course, there are other factors that might bring about QE, says Sian, but like the return of Silvio, these really don’t bare thinking about.
The factors that would bring ECB QE earlier than a political deal on fiscal union are (a) deflation or (b) European bank runs. There were rumours that the central bank action yesterday owed to risk of a large European bank being under risk. We have no information here but think that markets will continue to worry over this and are a little concerned the Chief Secretary to the UK Treasury refused three times to answer a question on BBC radio this morning whether a large European bank was in trouble.
But the main hurdle to overcome is closer fiscal union and budget discipline.
Anyway, all of this sets the scene for the December 9 Heads of States summit, which is shaping up to be one of the most important meetings in recent memory.
If there is a credible and timely plan to move budget parameters to a central oversight from Brussels, with binding rules then Germany’s objections on allowing the ECB bazooka in one form or another will weaken, reckons Sian.
At this stage, it is unrealistic for the 9th Dec EU meeting to be the final word on the terms of greater fiscal union, and we will probably be served with another string of Summits in 2012 as part of an iteration process for EMU policy harmonisation.
Second, will the ECB play ball, even if budgets are effectively outsourced? That depends on how watertight the agreement is, but my working assumption is that legal ambiguity will be put to one side and as long as Germany does not object vociferously (which is why we need fiscal handcuffs to mitigate this risk) then the ECB balance sheet will be available, if needed.
Good news then? In the short term, yes. In the longer term, no.
Sian says that if you diagnose the wrong disease then you will prescribe the wrong treatment. And Germany, as we know, thinks the cure is budget austerity, even it runs the risk of killing the patient.
Or as the Paul Krugman puts it:
It really is just like medieval doctor bleeding his patient, observing that the patient is getting sicker, not better, and deciding that this calls for even more bleeding.
A gruesome image, but one Sian agrees with:
Enhanced budget rules can not cure divergence between German trend growth at 2% and Italy at c.1/2%. In fact, budget austerity will lead to a long term depression in such low growth countries unless structural reforms are aggressive (and work) or there is a transfer union.
So what is the solution? If not austerity, what?
This is why I see the need for the IMF to enter EMU for the next 3 to 5-years, so that EMU countries can reform and grow at a more homogenous rate and then hope the region’s politics works over this timeframe too. The IMF obviously does not have the resources for this so the ECB will have to lend to a new IMF facility here or the Bundesbank will have to drop its intransigence over SDR pooling (which was evident at the G20). This is likely at some point but the politics of getting to this result moves slowly.
Very slowly. And time is one thing the Eurozone doesn’t have.
Europe’s grand bargain – FT Alphaville