Five years ago, Mario Draghi held his famous »whatever it takes» speech. The idea was to buy governments time to do the necessary reforms. Was the time used wisely?
Draghis pledge to do whatever it takes to preserve the euro was not about buying time for governments. It was rather for the ECB to act as a real central bank and quiet down markets. It is a tragic mistake that the ECB did not do that from the very beginning of the crisis. The job of a central bank is to make sure that financial markets function smoothly, and there was an enormous concern in markets about a possible exit from the eurozone or possible defaults. Most central banks in the world would immediately do whatever it takes which is just a statement without action but saying we are here to back the public debt’s value on financial markets. The predecessor of Mario Draghi did not understand that. Draghis whatever it takes was a normalisation of the ECB after several years of mistake accumulation.
What is the current challenge for the ECB?
As a whole, the eurozone is out of the prolonged recession. So at long last it is growing, albeit very slowly. Inflation is below the target of the ECB, so the ECB keeps doing what it does until it acquires the certainty that inflation is moving up to the target. At that stage, monetary policy will have to change from very accomodative to neutral and eventually to restrictive. Finding the right time is extremely difficult, and the action which needs to be taken is also difficult because we never had negative interest rates or QE before. So this is an experiment that will go on in real time. We have seen the difficulties the Fed had – the ECB will have the same issues, except that they will learn from the Fed which is one year or two years ahead.
It looks like it is more complicated for the ECB as the imbalances within the eurozone are still there. The ECB needs to take government bond spreads into account as some countries could face difficulties because of their debt.
This is a serious difficulty. Right now, all governments have an easy time. The economies grow at zero or negative interest rates. When interest rates start to rise the fiscal situation in a number of countries will worsen which is a major challenge. That’s why many German economists believe the ECB will not move rates high and quickly enough. However, I don’t think that will be the case. The ECB has an inflation mandate, so it has no choice but to raise rates if growth recovers and if it wants to keep inflation in the area of 2%. Like the Fed, the ECB will be willing to tolerate an overshoot in inflation although the ECB will be more politically constrained. But I don’t think it will move like crazy to prevent inflation from staying always under 2% when the recovery comes.
Even if it’s not in the mandate, isn’t it the goal to keep the monetary union together?
That’s the ultimate mandate. There are two different instruments which can be used in combination. The interest rate is the instrument to achieve the inflation target. Then they have various instruments including the pledge to do whatever it takes to prevent pressure in the bond markets.
How is that supposed to work?
Suppose they raise interest rates while the Italian budget suddenly deteriorates and the market gets worried about Italy. I think the ECB would be prudent with interest rates – so rather move a month later than earlier -, but at the end of the day it will move rates because it has to. But it will also use other instruments it takes to stabilize the Italian government bond market.
To what extent do these measures cause moral hazard and excessive risk taking?
The pledge to do whatever it takes is a sort of insurance. Any time you have insurance, you have moral hazard. But remember two things: First, the risk of a eurozone exit is a fundamental and immediate threat to the ECB, so it’s much more crucial than the moral hazard. Second, the stabilisation of budgets in the euro area is not a responsibility of the ECB, it’s a responsibility of governments. The ECB may be accused of encouraging governments to ignore the debt problem, but it’s a byproduct of their central mandate.
You once mentioned that long periods of low interest rates are the surest path to disaster because it causes misallocation of capital. Is that risk still existent?
I still believe that very low interest rates for a very long time are not good. The misallocation of resources is happening for example in the housing market. But again, it’s a side effect of the medicine. Medicines often have side effects. When you suffer a lot or your life is in danger, you take the medicine and watch the side effects. Central banks are eager to normalise interest rates. That’s true for the ECB, the SNB (SNBN 4900 0.2%), the Fed. At the same time, their first order of business is to bring inflation back to the target level, and that’s the overriding importance.
To what extent would a severe correction threaten the goal to keep the economy growing and to increase inflation?
The purpose of raising interest rates and reversing QE is to slow down inflation. In order to do so, you have to slow down growth. Monetary policy works through different channels such as asset prices and exchange rates. Therefore, when central banks are raising interest rates, the intention is to have the stock market stop going up and maybe decline because that’s the way they will control inflation. That’s classic policy making, so there’s nothing really new here – except the magnitude which is very large and that the situation is atypical because central banks don’t know what will happen.
Will central banks ever be able to normalise interest rates?
If I were Mario Draghi, my main concern would be that I may not have enough time to raise interest rates before the next slowdown. If rates just go up to 1 or 2% and there is a new slowdown, immediately the central banks would be back on the zero lower bound and will be stuck with the need for a new QE which they don’t want to. There is a race between the time window to raise interest rates and the end of the current growth period. There is nothing central banks can do about it but pray to god that the current expansion period lasts long enough for them to have the time to reach normal interest rate levels.
Will QE ever be reversed?
Central banks and commercial banks have learned to live with very large balance sheets. Banks are uncomfortable with low or negative interest rates they get on their deposits, so they have to be normalised. When that happens banks are happy to hold excess reserves. That’s good, because when there is financial or banking turmoil excess reserves help banks to face temporary difficulties without forcing central banks to intervene immediately. Put differently, large excess reserves of commercial banks are part of the new architecture of improving their resilience to financial shocks. For that reason, central banks will not fully reverse QE.
What about the risk of accelerating inflation when money starts to circulate again?
While central bank money is not inflationary, credit is. Banks could multiply their lending by 10 because they have so many excess reserves. So we could have an explosion of credit which would be inflationary. However, I’m not worried at all because central banks monitor credit growth very carefully. If credit growth were to accelerate sharply they would increase rates to slow down demand for credit. They can also raise the minimum reserve requirement to transform excess reserves into required reserves, or they can ask the regulator to toughen credit conditions by requiring more collateral. So I don’t think we will see fast inflation. In some places, inflation can go above 2%, probably to 3% or a bit higher before slowing down to 2%, but I don’t think you will see an explosion of credit. That’s not the issue of today, that’s the issue of tomorrow.
The Swiss National Bank has very large reserves, and uniquely they are in foreign currencies. How do you assess this situation?
The Swiss National Bank is in a very uncomfortable position. It never really had much monetary policy autonomy, in contrast to what they like to say. The reason is the exchange rate: The SNB cannot tolerate the franc to appreciate because of the risk to competitiveness if the exchange rate becomes too strong. And if things were to reverse, they would not want a quick depreciation either because that would increase import prices and therefore be inflationary. So the risks for the SNB are the same as for all central banks, except that they don’t really have much control of the situation since everything works through the exchange rate.
How should the SNB proceed?
The only thing they can do is to follow what’s happening elsewhere. When the ECB starts normalising, the SNB will start normalizing.
What can they do about their foreign currency reserves?
The large foreign currency reserves are the extra risk for the SNB. Depending on what’s happening with the exchange rate they can incur losses on these reserves. These are in fact book losses, but still losses. That’s not an economic problem and it’s not a financial problem, it is a political problem. Any time the SNB makes a loss, the Cantons start getting agitated because they want to have their income from the central bank. The SNB of course is completely aware of all these issues.
Back to the currency union: Is the Euro crisis over?
The acute phase of the crisis is gone. But there are lots of things that are left over from the crisis which are not dealt with yet. My biggest concern is that public debt in a number of countries is very large. Italy is the archetypal example, but many other countries came out of the crisis very weak, Portugal in particular. The average debt level in the Eurozone is 90% of GDP. That is much too high. This is a weakness which can lead to a crisis.
What is needed to overcome the debt problem?
I don’t believe that the crisis will be completely finished until we have found a way of reducing these debts through some sorts of interventions. There are many proposals floating around. All of them are being vetoed by Germany. So it’s a non-issue because Germany just says no to everything that leads to debt reduction. But I believe that something will have to be done if we want to close this chapter of the crisis.
If Germany opposes all proposals, will debt increase ever higher?
Let’s take the case of Italy because that is a good example. The Italian debt is very high. It means that the government is in a fragile position. When interest rates rise Italy will face serious difficulties. The debt creates limits to how the government can do countercyclical fiscal policy. If there is an insulated recession in Italy the ECB will not move. But the Italian government will not have enough space to slow down or shorten the recession which in turn can lead to market anguish about Italy’s membership in the Eurozone. All these stories that we have seen before remain a very serious concern.
What is the German point of view?
The German view is moral hazard: «We can’t do anything for the Italians, they have to do it themselves. And if they can’t, too bad. Let them just leave the monetary union.» At least that’s what I think finance minister Wolfgang Schäuble would say if he was speaking frankly. But of course if Italy leaves the Eurozone, the monetary union will soon be dead. And I think that Angela Merkel understands that very well. So the Germans are against debt reduction solutions because they focus on moral hazard. But moral hazard, as always, is only one side of the picture.
Why isn’t this problem addressed during the current economic upswing?
As we know, governments all over the world don’t like to deal with future threats. They deal with threats when they have their back against the wall.
Isn’t moral hazard a real concern, if some countries never tackle their issues because others pay the bill?
While moral hazard is bad, there are solutions to it, namely good institutions – which we don’t have. My hope is that Germany will be reasonable and understand that. Unfortunately, we will have to wait for the next crisis to make progress on the public debt reduction.
What else needs to be done to overcome the crisis once and for all?
The second thing which is not yet been addressed properly is the banking union and the situation of banks. In Italy, the banking system has not been cleaned up. And I suspect it has not been cleaned up either in other countries. I’m not sure that French or German banks are all in perfect shape, in contrast to what is being said by the officials. But if you were talking to Italian officials a year ago, they would tell you: «No, no, our banking system has been cleaned, it’s perfect.» So when officials say that, I tend to believe that they are lying to me. There must be a number of banks, big or small, which are still very fragile and have not been cleaned up adequately. There are still a lot of non-performing loans left over from the crisis years. So this chapter is not completed either.
How can the bad loans of banks be reduced?
What needs to be done is a cleanup. But in order to have a cleanup you need resources. We saw in the Italian case that the government didn’t have much resources and new regulations prevented the authorities from recapitalising banks. After months and months of negotiations, the government found a loophole so that they could negotiate with the European Commission and that went through. These are consequences of the fact that the banking union has not been completed.
What is needed for a full banking union?
There is a lot of work to be done. In particular, all banks have to be brought under European level supervision. Currently it’s only 124, and a large number of banks is not. Some of them may be in trouble. We don’t know, because the information is not freely available, it’s carefully hidden. And there again the problem comes with Germany, which for political reasons doesn’t want to put the Landesbanken and the Sparkassen under European supervision. That’s ridiculous. This has to be done, all banks must be centrally supervised.
What about banks that get into serious trouble?
The second thing that has to be established to complete the banking union is a resolution fund. You need a place where you have a pot of money that can be used to clean up or close down banks. That was the problem in Italy with Banco Veneto and Monte dei Paschi. They had to find a way of resolving the banks smartly. Again, Germany is strongly resisting any such resolution fund because they see that as a mutualisation of risk and they don’t want to mutualise anything with anybody.
Couldn’t Germany also use a resolution fund if needed?
They believe their banks are safe and that all this money would only serve to protect lousy Italian banks. But I think this is just the wrong approach. The banking union needs a large resolution fund, so that the banks can be cleaned up and that chapter of the crisis can be closed. Maybe after the elections the German government will become more realistic, but at the current stage with the current finance minister the situation is hopeless. That’s why the banking union has not been completed. Everybody knows that, and all my colleagues keep singing the same song that the banking union has to be completed as quickly as possible.
All in all, where do we stand in overcoming the Euro crisis?
As the acute phase of the crisis is gone, we now face threats of the next crisis. And these threats could be dealt with if only there was political will.
Is Mario Draghi still the right person to exit from the current unconventional measures?
Mario Draghi is absolutely the right person to do the job. He is a first class economist, he understands the issues very clearly, he’s a very smooth diplomat and he can be decisive. He’s been a blessing, a great central banker. When the economic situation changes he will adapt. His recent speech in Sintra was already an indication that he is thinking far ahead.
What will happen after Draghis term ends in October 2019?
That’s my personal nightmare. The one thing I’m really worried about is what happens afterwards. It’s not just about Mario Draghi. The key part of the ECB is the executive committee with six members. For many years at the beginning of the monetary union, the executive committee didn’t have very good people on it. I knew all of them pretty well, and a number of them were just very weak in understanding and in analytical capabilities. That’s why the European debt problem became a European debt crisis. If they had had a better team back then they would have moved decisively and quickly and would have prevented the situation from becoming what it became.
Is the current ECB committee better?
There is a rotation, people were replaced. By pure luck, the quality of the executive committee was enormously improved. And it’s the new team that basically solved the acute phase of the crisis. So it’s not just about Draghi leaving. The competent people in the executive committee are all going to leave in the next three years.
Aren’t there any competent successors ready?
There is no lack of good people in Europe. But the appointment process is terribly bad. Early on, bad people were appointed, and there is no guarantee that this will not happen again. It’s basically about sharing the spoils among governments, it’s pure politics: You let my guy go to the ECB, I let your guy go to Nato or to Unesco or to wherever. The governments basically share jobs for their nationals. It’s all give and take, it’s about national pride and very often about friends of the leaders, or about enemies of the leaders that they want to send away. That’s the way they think when they make appointments. They don’t ask themselves at all who the six best people are to run the ECB. So we were unlucky at the beginning, we were lucky afterwards. And in the future round that will start with Draghi, by pure luck they could appoint qualified people again, but by bad luck there could be incompetent people. And that’s my personal nightmare.
Do you have a favourite candidate?
There are a large number of people who are very good and who might be interested and would do the job very well. At some point we should start to publicly discuss names to give Ideas to the top politicians – but I don’t think the politicians will really listen. That’s why I’m very hesitant to come up with names at this stage. And the names I haven in my mind may not be politically acceptable for hundreds of reasons that I don’t really understand.
Jens Weidmann has been talking a bit more softly recently to put himself in position. Would he be a good successor of Mario Draghi?
It is true that more recently, Jens Weidmann’s statements have been more measured than before, that‘s a good sign. There is a large number of excellent German economists that should be considered alongside Jens Weidmann because the job of running the ECB is extremely complicated. It is absolutely essential that we have highly competent people at the top.