The sublime irony of Draghi’s dilemma

Published in Business Spectator (Melbourne), 28 August 2014

It is an utterly ironic situation for Europe. Every bit of bad news for its economies is good news for asset markets. And with every new crisis that hits European governments, one man and the institution he leads gets a little bit more powerful: Mario Draghi, the president of the European Central Bank.

The past few weeks have been horrible for Europe in many respects. Growth figures have been dismal in major eurozone economies; there are foreign policy crises in Europe’s many backyards from Ukraine to Syria, from Israel to Iraq; and France’s chronic crisis of political leadership just got a whole lot worse after Prime Minister Valls effectively forced his hapless President Hollande to sack the entire cabinet.

In short, Europe is facing severe problems on different fronts and lacks adequate answers to any of them. Amid this state of confusion, however, stockmarkets have climbed upwards. In the last fortnight, stock indices like the DAX, the CAC40 and the IBEX 35 realised substantial gains. How do these developments go together?

The most plausible explanation is that the worse Europe looks, the more likely another intervention by Draghi’s ECB becomes. Draghi himself, of course, added fuel to such speculation in his Jackson Hole speech last week. Not only did he criticise European governments for their adherence to austerity policies (which raises the question: when did Draghi last check European deficit figures?), but he also hinted at future bond purchases by his bank in plain central banking language: quantitative easing.

The prospect of such increased monetary activism is enough to excite markets into forgetting about Europe’s structural problems. But that is precisely the problem, and it is not the first time the ECB has made Europe’s situation worse by administering new medicine.

As I wrote a few weeks ago, Draghi’s intervention in 2012 mainly served to put the euro crisis on hold without solving it (The calm before the euro storm, August 14). What Draghi might do next would amount to the same albeit on a different, much larger, scale. In 2012, it was all about preventing the implosion of the euro; in 2014, it is about preventing Europe’s slide into perma-depression.

Remember that despite Draghi’s big rhetoric (“Whatever it takes”), the ECB did not actually have to let action follow its words. The announcement to defend the euro against speculative attacks was enough to quell the storm two years ago.

If the ECB now goes on the offensive and implements the long talked about quantitative easing, it would require real action. It would also have to be of a substantial size in order to really impress markets. Having talked up the potential for ECB action, if Draghi now only delivered a QE fizzer, this might be counterproductive from his point of view. He has to go big and has to be bold if he wants to have an effect on inflation expectations and short-term growth stimulus.

Yet seen from another perspective, such ECB ‘shock and awe’ would have some most unwelcome side effects. One only has to imagine what it would mean for France’s development.

The past few days of political chaos in Paris were a good reminder of what is wrong with France. For the past two and half years, President Hollande has been stumbling around his country rather than leading it. He started his term with the introduction of a 75 per cent top income tax rate and did not realise that what France really needed instead was a more welcoming attitude to business and entrepreneurship.

When Hollande, battered by disastrous elections results and abysmally low personal approval ratings, finally installed Manuel Valls as his new prime minister, his presidency was already in crisis. But at least the more market-friendly Valls was a signal that Hollande was now trying to move towards some economic reforms. The concession he had to make, however, was to give prominent cabinet posts to some left-wing stalwarts from his socialist party, including economics minister Arnaud Montebourg.

Montebourg’s appointment was a disaster waiting to happen, and barely four months later his open opposition to economic reforms and budget consolidation, garnished with some crude anti-German rhetoric, led not just to his sacking but the replacement of the entire cabinet. That, of course, does not solve the problem.

From now on, Montebourg will be working against these policies from outside government, thereby potentially preparing his own run for the presidency in 2017, and risking a split of the socialist party.

The political events of the past week have turned President Hollande from a lame duck into a dead duck. His political capital is spent, his party lies in tatters, his ability to implement anything is practically non-existent. At the same time, the French economy remains moribund, unemployment at record levels, public deficits high and economic growth absent.

What, given this background, would a massive monetary intervention by the ECB really achieve for France? If it went according to plan, it would increase inflation expectations, trigger some economic rebound, fuel stock markets, weaken the euro exchange rate and stimulate exports.

For a moment, this may appear to have turned France around by putting it on the road to recovery. But would it really?

The moment that the French economy shows any signs of life, economic reforms would be even harder to implement. It will take a proper crisis to make France move towards anything even remotely resembling reform. With a bit of growth injected, only the traditionalist, structural conservatives of all parties would be strengthened. It would give a licence to all those political forces that never believed in balanced budgets and reduced government intervention anyway.

This is Mario Draghi’s dilemma. He has the power to move European economies, but the very same policies he advocates also stall the chances of real, long-term recovery. There is a danger that he will have to prescribe ever stronger doses of his medicine in order for them to have any short-lived effects at all. But the longer this process goes on, the more it looks as if Draghi’s medicine is administered to a corpse.

With all of Europe’s woes, the ECB now looks like the last institution able to move the continent’s economy. But even the ECB cannot achieve what Europe really needs to make it viable in the long run: painful but effective economic reforms.

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