What Draghi Can't Promise
A debate is heating up ahead of the European Central Bank's next policy-making meeting on Wednesday: Whether the bank should engage in its own version of quantitative easing, the extraordinary bond-buying that central banks in the U.S. and U.K. have employed in their efforts to boost growth and avoid crippling deflation.
Although consensus is shifting in favor of the ECB making such additional policy moves within a few weeks, it's unclear whether they will be fully effective.
Over the weekend, ECB President Mario Draghi reiterated his willingness to extend the "whatever it takes" approach he has taken toward battling financial malaise in the euro area. Supported by an increasing number of Governing Council colleagues, he said that the central bank would consider all available policy instruments to clip the risk of deflation and to safeguard the region's economic recovery. This has led ECB watchers to expect additional bond-buying -- and might even tempt some to suggest that Draghi's words alone could deliver a beneficial outcome without spending a single euro.
There are reasons to believe, however, that such expectations may end up placing an unrealistic burden on the ECB.
Draghi's recent pledge to use "all instruments" that fall within the ECB's mandate is reminiscent of the powerful speech he made in London in July 2012, at a time when the financial system was riddled with cascading market dislocations that threatened the very integrity of the euro area. His exact words then: "The ECB is ready to do whatever it takes to preserve the euro." The message of resolve was all it took to calm markets and reduce the risk of disintegration. Draghi's words did all the heavy lifting.
Now the situation is materially different. Back in 2012, the ECB faced political opposition arising out of concern that bailing out struggling countries would encourage their financial imprudence. Judging from the preliminary signals out of Germany, there is less resistance to the use of "unconventional instruments" to stabilize inflation, a traditional goal of monetary policy.
Yet, given both economic theory and the experience of other countries, there are two less enabling aspects to keep in mind.
First, the ECB will probably have a lot less control over economic outcomes than it does when supporting individual entities or the overall stability of the financial system. Here it is compelled to use rather blunt and partial instruments. Their impact is at best indirect at a time when the operative transmission mechanism -- the "asset-market channel" -- is impaired. It's simply not clear to what extent purchasing government bonds or even corporate and mortgage bonds might succeed in freeing the flow of credit and boosting demand.
Second, the ECB -- or anyone else, for that matter -- should consider the balance of "benefits, costs and risks," a term that former Federal Reserve Chairman Ben Bernanke used back in August 2010 to frame an important uncertainty about quantitative easing. Even with almost four years of experimentation in the U.S., few can ascertain with sufficient conviction the degree of potential collateral damage and unintended consequences -- particularly when economic and finance ministries, with their more appropriate policy instruments, are sidelined by highly polarized politics.
The ECB is right to consider a "whatever it takes" approach to reducing the risk that deflation will derail Europe's still-tentative economic recovery. That said, it would be understandable if Draghi were to refrain from promising too much.
Back in July 2012, Draghi left no doubt about how effective he expected his "whatever it takes" promise to be. To reinforce his commitment to preserving the euro, he said: "And believe me, it will be enough." Developments since then have justified his confidence about the ECB's ability to stabilize markets.
This time around, there should be no less doubt about his dedication. The policy objectives, however, are considerably broader. The ECB does not have sufficient support from other (national and regional) policy-making entities that possess better tools. As such, Draghi is more constrained in his ability to guarantee the desired outcome.
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