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Does the European Central Bank’s President Have Any Clothes?

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By Desmond Lachman

Among the more useful lessons that I learnt about how markets really worked during my stint as an economist on Wall Street came from a seasoned, albeit cynical, emerging market bond-trader at Salomon Brothers. He taught me that when the winds are strong even turkeys fly. By which he meant to say, never mind a country’s poor economic and political fundamentals. When global liquidity conditions are favorable and when everyone is stretching for high yielding assets, even in the worst of circumstances that country’s bond prices will rally.

If ever there was a time that this lesson has relevance for the European economic outlook, it is now that Ben Bernanke has intimated that he might soon be taking his foot off the Fed’s money printing accelerator and put an end to the Fed’s extraordinary monetary policy accommodation by 2014. Considering that it has been the Fed’s actions that has helped keep the European sovereign bond market afloat, Mr. Bernanke’s announcement all too likely presages the renewed intensification of the European sovereign debt crisis.

The best of times

It is difficult to recall a time when the winds have been as strong in the global financial markets as they have been over the past year. In July last year, in response to acute pressures in the Italian and Spanish bond markets, Mario Draghi, the European Central Bank president, succeeded in calming markets by pronouncing that the ECB would do “whatever it took to save the euro.” He subsequently substantiated his pledge by having the ECB approve an Outright Monetary Transaction (OMT) program. That program committed the ECB to buy as many short-dated Italian and Spanish government bonds as might be necessary to keep those two countries’ government borrowing costs at reasonable levels. This pledge was made subject to the proviso, all too often forgotten in the markets, that Italy and Spain must first sign up to IMF-style economic adjustment programs before the OMT program was activated.

Mario Draghi’s pronouncement last July was but the first salvo in getting the winds blowing strongly in the global financial markets. It was soon buttressed by the Federal Reserve’s introduction in September 2012 of a third and open-ended round of quantitative easing. That round involved monthly purchases by the Fed of US$85 billion of US government bonds and mortgage-backed securities until such time as substantial improvements were to be observed in the US labor market. As if not to be outdone, in April 2013 the Bank of Japan announced that it too would undertake government bond purchases at the rate of US$70 billion a month with a view to doubling Japan’s monetary base by end-2014.

Success in Europe

With such strong winds blowing in the global financial markets, and with the ECB having convinced traders that it would not allow the euro to fail, the turkeys did fly in the troubled European periphery. As an example, despite an economic collapse and dysfunctional politics, the yields on Greek government bonds plummeted from over 18 percent at the peak of the crisis to barely 8 percent by May 2013.

Of yet more significance for the European economy, favorable global liquidity conditions allowed yields on Italian and Spanish government bonds to decline from an unsustainable 7 ½ percent prior to Mr. Draghi’s “whatever it takes” pronouncement to less than 4 percent by the end of May. And this occurred despite the worst possible outcome in Italy’s February 2013 election as well as the clearest of signs that there was little let up in the severity of the Italian and Spanish recessions, where output is officially projected to contract by a further 1 ½ percent in 2013.

A new test

Now that the Federal Reserve seems to be set on a path to turn off the monetary spigot that has helped sustain the European sovereign debt market, the European Central Bank’s “whatever it takes to save the euro” commitment is likely to be tested soon by the markets. Should the Italian and Spanish government market indeed come under renewed market pressure in the weeks ahead, markets will want to know whether the European Central Bank will indeed buy as many of those countries bonds as are needed to keep those countries’ government borrowing costs within a tolerable bound.

Sadly, it is all too likely that a market test of the ECB will reveal that the ECB and its president have no clothes. Ahead of the German elections in September and of the impending ruling by the German constitutional court about the consistency of the OMT program with the German constitution, the ECB is likely to feel constrained in taking further unorthodox monetary policy action that might alienate German public opinion. More tellingly yet, Mr. Draghi might find that political circumstances in Italy and Spain might preclude both of those two countries from signing up to an IMF-style economic adjustment program with its heavy reliance on domestically unpopular budget austerity and painful economic reforms. And without such adjustment programs, by its own rules the ECB would not be in a position to ride to Italy and Spain’s rescue.

Hopefully, markets will not test the Fed and the recent market volatility will prove to be but a passing phase. However, judging by past episodes when the winds stopped blowing in financial markets, it would be a mistake for global policymakers to premise their policymaking on such wishful thinking.

American Enterprise Institute (AEI) resident fellow Desmond Lachman previously served as director in the International Monetary Fund's Policy Development and Review Department. He was also a managing director and chief emerging market economic strategist at Salomon Smith Barney.