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Draghi’s difficult legacy

Published in The National Business Review (Auckland), 1 November 2019

November 1 was the beginning of a new era for the European Central Bank. Former French finance minister and IMF director Christine Lagarde is the new president of the ECB. She succeeds Mario Draghi, who leaves the central bank after eight years at the top.

To understand Lagarde’s challenges, it is worth assessing the legacy of the Draghi years. That is easier said than done.

Draghi will forever be remembered for one sentence. He said it outside the eurozone, namely in London in July 2012: “Within our mandate, the ECB is ready to do whatever it takes to preserve the euro. And believe me, it will be enough.”

This sentence calmed markets enough to stop the speculation about a potential Greek exit from the common currency. It also stopped the contagion of the crisis to other European countries.

In Draghi’s view, this would count as his greatest success. He single-handedly kept the euro alive in times of crisis.

The problem is that to achieve it, Draghi had to take measures that will burden his successors, starting with Lagarde, for years and decades to come. The ECB is a much more politicised organisation than when Draghi started. Its internal divisions are visible as never before. But, perhaps most worryingly, there is no exit path from its ultra-loose monetary policy.

It is somewhat ironic that Draghi’s most famous sentence started with the words “within our mandate.” That was a nod to his German critics who regularly criticised the ECB for operating outside its powers. However, doubts remain whether Draghi really acted within the ECB’s mandate.

According to article 127 of the Treaty on the Functioning of the European Union, the ECB’s primary objective shall be to maintain price stability. Beyond that, and without prejudice to that objective, it supports the general economic policies of the European Union.

ECB’s job?

Strictly speaking, nothing in this legal mandate would justify Draghi’s “whatever it takes to preserve the euro.” As markets were sending strong signals against the continuing euro membership of individual members, was it up to Draghi’s ECB to fight them? Or should that have ultimately been a political decision? It was a political decision to admit Greece into the eurozone against any economic sense. Therefore, it should have also been a political decision to deal with the country as it stumbled toward the exit.

At the time, Europe’s politicians were hopelessly divided and impotent to deal with the crisis. This left it to Draghi’s ECB as the only European institution both willing and able to act. But it is a different question whether that was really within its mandate.

It is another, entirely different, question still whether that was the right decision. Yes, the euro survived. But the nature of the ECB’s political intervention has changed the character of the euro toward a more political currency. Besides, Greece’s economy might have recovered much better outside the eurozone.

So, Draghi preserved the euro, whatever it took. But was that really a good thing?

Draghi may have gone beyond the letter, or at least the spirit, of the treaty law that established the ECB. Not just for saving whole countries from sovereign default, he also did what he could to preserve the European banking system.

Again, he would argue, this was the responsible thing to do. A full-blown banking crisis in one of the eurozone’s member states would have been dangerous to the economic and financial stability of Europe. It would have been especially dangerous in a large member state such as Italy.

However, Draghi’s cures stretched the ECB’s mandate to the limits. During his presidency, he enabled Italian banks to access cheap funding from the ECB on the implicit understanding they could use it to buy higher-yielding Italian government bonds – and pocket the difference. In this way, the ECB supported both the ailing Italian banking sector and the highly indebted Italian government. The problem is that it resolved neither Italy’s banking crisis nor its public finances. It is a problem postponed, not resolved.

Toxic legacy

Draghi’s ultra-loose monetary policy is a toxic legacy for his successor. So firmly has he locked in negative interest rates and the expectation of even lower future rates that Lagarde would find it almost impossible to get out of this setting – that is if she even wanted to.

It is telling that even the French representative on the ECB’s executive board, Benoît Cœuré, made his opposition to Draghi’s loose monetary policy public. The policy also led to the resignation of Germany’s representative, Sabine Lautenschläger, from the ECB.

Lagarde faces a mammoth task to heal these divisions within the EC, but that task will only get harder as Europe’s economic prospects get worse. She will also then test the limits of Draghi-style policy: How much bigger can the ECB’s balance sheet grow? At just under €5 trillion, it is almost five times bigger than 15 years ago. And how much lower can interest rates go? As long as cash is an alternative, there will come a point when depositors would rather take their money and put it in a vault.

None of this will be Draghi’s concern any more. But this is his legacy. He might be remembered as the central banker who defended the euro while planting the seeds of its eventual destruction.

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