Thursday, November 10, 2011

Italy and the ECB

Two weeks into the job and what will most likely prove to the defining moment of the tenure of new ECB President Mario Draghi is already upon him.

The ECB has been receiving a bit of flak lately – for not being sufficiently decisive or bold in its actions. It was under some duress that the Bank moved to purchase Italian and Spanish bonds in August.

We’ve been prepared to cut them a bit of slack. On one level, the Bank has been reluctant to solve the problems of political intransigence. The European debt crisis is essentially of a political making, and it has taken a sense of crisis from time-to-time to keep moving the politicians forward.

On another level the Bank has been reluctant to move into what it deems to be the realm of fiscal policy. There also appears to be a number of folk at the ECB who were students of post- World War I German hyperinflation that was the genesis of the anti-inflationary zeal of the Bundesbank. Hence the reluctance to expand the monetary base (the earlier purchases of Italian and Spanish bonds were sterilised).

However, with Italian bond yields surging higher it’s time for the ECB to step up and act decisively by significantly expanding its purchases of Italian sovereign bonds. Only the ECB has the ability to take this step. The expanded EFSF will not be ready in time – we still don’t know how it is going to be scaled-up let alone then going through the process of getting broad political agreement. The various Euro zone parliaments have only just finished ratifying the July 21 proposal for the EFSF to lend up to its full face-value of €440 billion, which will prove to be woefully inadequate for the job ahead.

The ECB will be concerned that given the scale of the job needed, they will have no option other than to monetize their bond purchases. They will fret about the likely inflationary consequences, but no one will doubt their zeal in dealing with that problem when the time comes.