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Draghi must find way for eurozone's central bank to deal with crisis while obeying EU treaty
European Central Bank president Mario Draghi has already taken Europe's monetary authority into uncharted territory.
Now, with the debt crisis in Europe threatening further disaster, he may have to push it even farther into the unknown to save the euro.
The 17 countries that use the euro are struggling as economies across the region face deepening recessions. Spain and Italy, the two chief trouble spots, are threatened with a financial collapse that could tear the 13-year old currency union apart and rock the global economy.
Spain's bond borrowing costs, or yields, have hit record highs recently as it tries to prop up its stricken banking sector and meet requests for financial aid from its regional governments. That has raised fears the country may be the next to seek a bailout from the other eurozone countries, following Ireland, Greece, Portugal and Cyprus. Italy, attempting to keep a handle on its debts in a stagnant economy, is also feeling the heat.
Then last Thursday, Draghi sharply raised expectations for more central bank action when he vowed the ECB would do "whatever it takes" to save the 17-country euro, and that "believe me, it will be enough." Markets jumped on the news, expecting that the bank could soon intervene in bond markets to drive down the borrowing costs that are threatening Spain and Italy.
In the days following Draghi's comments, politicians across Europe have added their voices to pledges of action for the eurozone. First came a joint statement from Angela Merkel of Germany and France's Francois Hollande, followed by another from Merkel and Italy's Mario Monti. This was followed by the head of the eurozone's finance ministers group, Jean-Claude Juncker, and German finance minister Wolfgang Schaeuble.
All eyes are on Draghi to see what the ECB can deliver.
The eurozone governments have come up with 138 billion ($169.97 billion) to bail out small countries Greece, Ireland and Portugal. But Italy and Spain are too big to bail out. Together, the third and fourth largest eurozone economies have some 2.5 trillion in debt. A default on their widely held bonds would devastate banks and markets around the globe.
The pressure is on the central bank because Europe's other remedies have limited firepower. The eurozone's current bailout fund, the European Financial Stability Facility, does have some 440 billion in lending power, but most of that is already committed to bailouts for Greece, Ireland and Portugal. A new, permanent, fund the European Stability Mechanism would have some 500 billion, but has yet to be ratified by eurozone member countries and even then is months from coming on line. And 100 billion of that is already committed to rescuing Spanish banks from collapsing due to bad real estate loans.
Governments, their deficits swollen by the crisis, don't have more money.
That leaves the ECB. When he took over at Europe's monetary authority in November 2011, the eurozone was close to breakdown with borrowing costs for Spain and Italy at worrying highs and the flow of funds between the region's banks had but dried up. Under Draghi's leadership, the ECB unleashed an unprecedented 1 trillion in cheap credit to steady the banking system and cut its benchmark interest rate to a record low of 0.75 percent.
Yet Draghi and the 23-member governing council face a key constraint: they must contend with the demands of fear-stricken financial markets on one side and the restrictions imposed on the bank by its founding treaty on the other.
The 1992 treaty gives the bank an overriding mandate to control inflation first, and only then to seek other goals such as growth. It is forbidden from supporting the finances of eurozone governments. That's different from other central banks, such as the U.S. Federal Reserve and the Bank of England, which have broader crisis-fighting powers, and have used them, buying securities to increase the supply of money in the economy.
The Fed is also meeting this week and could decide to take more action to stimulate a weakening economy. Market speculation has focused on whether it will do another round of bond purchases to expand the supply of money in the economy, though many analysts think it will hold off.
Jonathan Loynes, chief European economist at Capital Economics in London, says Draghi's remarks last week were a "pretty strong signal" the bank might intervene in government bond markets with limited purchases aimed at lowering countries' borrowing costs, as it has before on a limited basis. Markets, however, appear to hope for that plus more, a comprehensive new approach.
"My guess is, the markets will be disappointed," Loynes said. "There was a lot of emphasis on those three words, 'Whatever it takes.' "But there are three other words that are just as important: 'Within our mandate.'"
Draghi has given some observers the impression he is more flexible in regard to restrictions placed on the ECB under the EU treaty than his predecessor Jean-Claude Trichet.
How far can Draghi go? The bank has a meeting this week but could act at any time. Here are some possibilities and their drawbacks:
BUY GOVERNMENT BONDS:
Buying bonds drives up their prices, and pushes down their interest rates or yields. That's because prices and yields move in opposite directions. Starting in May, 2010, the ECB intermittently bought more than 200 billion worth of bonds of shaky governments including Italy and Spain, on the open market.
DRAWBACK: The effort did not do much to calm the crisis. Its impact was blunted because the ECB stressed it was limited in amount and focused only on spreading the ECB's interest rate policy throughout the eurozone. It is opposed by some, including Germany's Bundesbank, which has a seat on the ECB's board, as blurring the bounds between influencing interest rates the ECB's job and helping government finances, which it can't do.
Europe's temporary bailout fund, the European Financial Stability Facility, could buy bonds but has limited resources on its own.
TURNING THE BAILOUT FUND INTO A BANK:
By agreeing to a banking license for the European Stability Mechanism, the bailout fund set up by the countries that use the euro, the ECB would enable the fund to borrow from the ECB and use that money to buy the bonds of troubled governments from investors on the open market.
Because the ECB can create as much money as it wants in order to lend, the ESM could in theory raise several trillion euros if it had to. And because the ECB is not helping out governments directly, it can be argued the practice would not fall foul of the treaty.
"That is the No. 1 concrete thing they could do," said Karl Whelan, an economist at University College Dublin and former staff economist at the Federal Reserve. "There is nothing illegal about it. People would stop staying the eurozone doesn't have the firepower to fund Spain and Italy. It would be the end of that concern."
DRAWBACK: Nonetheless, Draghi and others say the idea is still too close to financing governments. He made a forceful statement July 5 that the move would violate the ECB's mandate and "destroy its credibility."
Still, the ECB has reversed course on other issues during the crisis.
LEND TO BANKS:
The ECB could expand its lending to banks for short-term loans. It would do that by agreeing to ease its rules on what types of collateral it could take for banks for these loans. It has already done this several times before and also given banks unlimited credit.
It could also make a third offer of cheap, three-year loans to banks, after two rounds that handed out 1 trillion in December and February. Some banks used the money to buy government bonds. That's allowed under the ECB treaty because the ECB can loan any amount to banks just not to governments.
DRAWBACK: Banks holding too much government debt is already one of the key risk factors in the crisis. A government default would hurt banks and cut off lending to the wider economy. More lending could make that worse.
Analysts say the ECB has room to cut the main refinancing rate it charges banks for loans from the current all-time low of 0.75 percent. It could also push the rate it pays banks for deposits currently zero into negative territory, a move aimed at pushing them to lend funds rather than stash them with the ECB. This could help bolster currently weak growth which would help government tax revenues and make it easier to pay debts and lower costs to shaky banks.
DRAWBACK: Rates are already very low and it's not having much effect on business activity and borrowing.
Some observers say Draghi's actions and decisions have been influenced by his training at the Massachusetts Institute of Technology, where he got a PhD in 1977. He was two years ahead of Ben S. Bernanke, now Fed chairman.
Draghi also spent years in the real-world realm of politics in his native Italy, serving as the top civil servant at the Italian Treasury in the 1990s. He worked to shape up the country's finances so it could join the euro. He also had the unusual for a central banker experience of working at a high-powered investment bank, serving at Goldman Sachs from 2002 until he became head of the Bank of Italy in late 2005.
Others say Draghi's pragmatism and flexibility may be overestimated and that he remains committed to the spirit and letter of the ECB's treaty.
"There's a part of me that wants to think that Draghi is a pragmatic, MIT-trained Keynesian... a pragmatic guy who will do whatever is necessary to get it done," said fellow MIT alumnus Whelan, referring to the British economist who believed government spending could help economies recover. But "the evidence is kind of mixed. He's done some things that are more flexible than his predecessor. But we don't know to what extent that is just because he's dealing with more dire circumstances."
The vehement rejection of an ESM bank suggests Draghi "can be quite dogmatic about the role of the ECB when he wants to be."
"So I think the jury is still out on Mr. Draghi."