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The ECB after Draghi: ‘You need an actor who can act fast’

In the eyes of some, Mario Draghi has a rock-star quality about him. How else to explain the clamour for selfies from MEPs when the European Central Bank president turned up for his last appearance at the European Parliament in January.

Best known for declaring in July 2012 that he would do “whatever it takes” to protect Europe’s single currency, the central banker was in Strasbourg to accept a plaque bearing the words, “To President Mario Draghi for saving the euro”. It represented the start of a farewell tour for the 71-year-old Italian who steps down in October after eight turbulent years in charge, a period during which he changed the DNA of the institution.

The achievement of Europe’s current economic leaders, which include not only Mr Draghi and those in his inner circle but also Germany’s chancellor, Angela Merkel, is to have kept the eurozone together during the most serious crisis in its 20-year history. To do that meant carrying out root-and-branch reform of how the central bank operates, changing it from an institution built in the mould of Germany’s Bundesbank and obsessed with keeping inflation in check to one more willing to buy insurance against a vicious cycle of market panic and collapsing growth.

“Under his leadership the ECB has broadened its toolbox,” says Roberto Gualtieri, chair of the European Parliament’s economic and monetary affairs committee. A reference to the bond purchases worth trillions of euros, negative interest rates and using the central bank’s credibility to signal that euro borrowing will remain cheap for years to come. “The ECB now has a toolbox comparable to the Federal Reserve’s.”

Chart Bond holdings grow in size at the ECB

Yet Mr Draghi is handing over the ECB reins at a time when the European economy is again looking vulnerable. Growth is slowing across the eurozone and the chances of a recession are on the rise. With inflation only around 1.5 per cent at a time when interest rates are at zero, even the risk of a Japan-style stagnation, which haunted the region during the euro crisis, has not completely disappeared.

These worries forced Mr Draghi to make an about-turn last week on plans to slowly remove crisis-era stimulus and offer fresh loans to eurozone banks, having spent the past two years trying gradually to wean them off the ECB’s easy money policies.

And amid the backslapping celebrations of Mr Draghi’s legacy there is growing concern over whether his successor — yet to be selected — will have sufficient ammunition to deal with a long-term slowdown. With rates at record lows and the bank running up against limits on the amount of government bonds it can buy, the new ECB chief will need to be inventive if the region is hit by fresh shocks.

“Trade tensions will prevail, as will some of the political uncertainty,” says Laurence Boone, chief economist at the OECD, which last week slashed its projection for eurozone growth from 1.8 per cent to 1 per cent. “Our main message is that the ECB cannot do everything — there should be some help from the fiscal and structural side.

In the frame
Jens Weidmann: the critic

© Bloomberg

The Bundesbank president has been a thorn in Mario Draghi’s side, pushing for the bank to ditch the crisis-era stimulus far earlier than desired by most others on the governing council. His chances of securing the top job looked to be lost after it emerged that Berlin would push for the presidency of the European Commission. However, some in Berlin think that he could make a comeback and would soften his stance if he moved to the ECB.

“[But] what we have observed in the past is that when there is a sudden shock — and political risks tend to produce these shocks — you need an actor who can act fast,” she adds.

It seems odd to say it now but Mr Draghi won the position only by accident. The job was expected to go to Axel Weber, then the Bundesbank president. But in 2011, with the gulf between Germany’s top central banker and the rest of the region’s monetary policymakers widening over the crisis in Greece, Mr Weber decided he could no longer succeed Jean-Claude Trichet as ECB chief and left his Bundesbank post that year.

It left the way open for Mr Draghi. Although he joined the ECB direct from the Bank of Italy, he was no career central banker. His time at Goldman Sachs and the Italian Treasury had given him an excellent understanding of how markets — and politics — worked.

By the end of 2011 both Mr Weber and Jürgen Stark, the other German on the ECB’s governing council, had quit, exposing the scale of the task facing Mr Draghi in persuading Germany’s conservative political and economic establishment to buy into the bank’s response to the eurozone financial crisis.

The early signs were positive. Bild handed a Prussian helmet to Mr Draghi following an interview in which he convinced journalists at Germany’s most widely read newspaper that his ECB, like the Bundesbank, would protect the currency against inflation — an ever-present fear in the German mindset following the hyperinflation of the 1920s.

However, the moment that has defined Mr Draghi’s tenure, and initially strained relations with Berlin, came in the summer of 2012, when he declared that he would “do whatever it takes” to protect the single currency against speculative bets on its demise as the eurozone crisis worsened.

With markets beginning to panic that the currency area would split, the cost of borrowing for highly indebted member states — including Italy and Spain — had soared, threatening to push Rome or Madrid into default. The impact of Mr Draghi’s pledge to buy government bonds in potentially unlimited quantities was remarkable. In the months after, borrowing costs across the region’s periphery fell closer to those of core countries such as Germany.

In the frame
Erkki Liikanen: the safe bet

© Bloomberg

A veteran of European politics and finance, Finland’s former central bank governor and EU commissioner has played an important role not only in shaping ECB policy but in helping build the region’s banking union. He appeals to Berlin and other northern European capitals for his hawkish credentials. His main disadvantage is his age — Mr Liikanen would be 77 at the end of an ECB president’s eight-year term.

In the eurozone’s economic powerhouse, the declaration ignited suspicions that the region’s new monetary guardian was shifting away from the Bundesbank’s hard-money doctrine.

Bild even asked for its helmet back.

Yet Mr Draghi’s bold response, it later emerged, had the implicit backing of Ms Merkel. “When Mr Draghi said he would do whatever it takes, it was clearly not thought through; he did not have that text prepared,” says David Marsh, a historian of the euro area and the Bundesbank. “But the crucial thing was that Ms Merkel backed him. [She] has an instinctive reaction of saving herself and knew a good thing when she saw it. The next ECB president, in a similar situation, may not be so fortunate.”

Ms Merkel is set to step down as German chancellor at some stage and the political make-up across Europe, with the rise of populist anti-EU parties, could look very different after European elections in May.

Mr Draghi also managed to isolate the Bundesbank president, Jens Weidmann, within the governing council by winning implicit support from the ECB’s German executive board member, Jörg Asmussen — a move that in effect split the German economic elite.

“If we compare the [bond-buying programme] of Trichet with the OMT [outright monetary transactions] in 2012, the success of the latter versus the failure of the former is due to a change in political context,” says Lucrezia Reichlin, professor of economics at London Business School. “Draghi showed a high level of political sensitivity. His main virtue has been high political skills and effective communication.”

Chart ECB asset purchases slow

Economic growth and inflation remained stagnant after the intervention, forcing the ECB to become the first main central bank to enter the topsy-turvy world of negative interest rates. In 2015 it followed the Federal Reserve and the Bank of England by beginning a €2.6tn bond-buying quantitative easing programme.

But it faced immediate resistance from ECB hawks, worsening relations with two of the candidates tipped to replace Mr Draghi — Mr Weidmann and Klaas Knot, his counterpart at the Dutch central bank. However, the entire council including the hawks declared that QE was legal, even if it was not desired, to provide some cover against criticism of the bond purchases in northern member states. Three years on most now think the actions helped boost growth.

“If you look at the massive fall in unemployment in the eurozone over the past few years, then you can see there has clearly been a massive stimulus,” says Richard Barwell, head of macro research at BNP Paribas Asset Management. “It was either down to Draghi deploying negative rates and QE, or Santa Claus. My money is on Draghi.”

Draghi’s tenure

Rates, QE and a lot of bond-buying

© AFP

November 1 2011

Mario Draghi succeeds Jean-Claude Trichet as ECB president, making the switch from the Bank of Italy.

November 9 2011

Uses his first meeting as ECB president to reverse Trichet’s decision to raise rates. By the end of the year, interest rates are 50 basis points lower than they were before Draghi took charge.

July 26 2012

With the eurozone at risk of a messy break-up, Draghi declares that the ECB will do “whatever it takes within our mandate” to keep the single currency together.

September 6 2012

Draghi unveils his plan to stem market panic: the outright monetary transactions programme, under which the bank will buy bonds in potentially unlimited quantities. Only one member of the governing council opposes the programme: Bundesbank president Jens Weidmann.

June 11 2014

The ECB turns its deposit rate negative, in effect imposing a levy on a portion of lenders’ deposits parked at the central bank.

January 22 2015

The bank unveils its quantitative easing programme to stamp out the threat of deflation and begins buying bonds in the spring of that year.

March 16 2016

Official interest rates in the eurozone hit an all-time low. The main refinancing rate is zero, the deposit rate is cut to minus 0.4 per cent.

December 13 2018

The ECB declares victory over the threat of deflation and calls time on the expansion of QE after buying a total of €2.6tn worth of government bonds.

March 7 2019

The ECB says it expects to keep interest rates on hold at record lows “at least” until the end of 2019 amid fears of a prolonged slowdown in growth.

Appointing Mr Weidmann would be seen, by Draghi supporters, as a threat to his legacy. The Bundesbank president was the only member of the council to reject Mr Draghi’s “whatever it takes” plan and is yet to change his mind.

An early favourite, Mr Weidmann’s chances appear to have dimmed, not least because of Berlin’s preference to snatch one of the other key European jobs — commission president or head of the European Council — that will be decided in Brussels horse-trading this summer.

Other candidates, such as the two Frenchmen — Benoît Cœuré, one of Mr Draghi’s most senior lieutenants, and François Villeroy de Galhau, current Banque de France governor — as well as Erkki Liikanen, the Finnish former central bank governor, are seen within the ECB as far safer bets. A decision is expected to be made by European heads of state at a summit on June 20 and 21.

One way of influencing the future direction of ECB policy, say those around Mr Draghi, is by controlling the appointment of the bank’s chief economist — a position Peter Praet, the current occupant, will vacate in June. Mr Draghi has pushed for Philip Lane, like him a US-educated economist, who is head of Ireland’s central bank, to take over.

The chief economist carries clout. They are responsible for presenting the bank’s economic forecasts and options during the opening part of each of the governing council’s policy meetings.

And depending on who replaces Mr Draghi — the holder of a doctorate in economics from the Massachusetts Institute of Technology — the position could become even more significant. Some of the names being touted for ECB president — such as Mr Villeroy de Galhau and Mr Liikanen — have no formal background in the “dismal science”.

That could leave the new chief economist as the primary driving force behind policy, responding to “complex monetary issues raised by potential new crises”, says Melvyn Krauss, a senior fellow at the Hoover Institution at Stanford University.

ECB downgrades forecast for 2019 eurozone growth

Whoever succeeds Mr Draghi will not be entirely free to reshape the central bank’s monetary policy from day one. Like the Federal Reserve and the Bank of England, the ECB deploys what central bankers dub “forward guidance” to influence monetary policy. This involves putting out a strong message to markets that borrowing costs in the eurozone will remain low and supplies of credit plentiful for some time yet.

As the result of last week’s U-turn, the ECB is now committed to keeping its record-low interest rates on hold “at least” until the end of 2019. It also expects to continue reinvesting the proceeds of the €2.6tn of bonds bought under QE as they mature “for an extended period of time” and has made a fresh offer of cheap longer-term loans — cementing Mr Draghi’s QE legacy for several years to come. In effect, the key decisions for the first year of the new president’s term have already been taken.

In the frame
François Villeroy de Galhau: the civil servant

© Leo Novel/FT

The Banque de France governor is seen as the favourite candidate from the eurozone’s second-largest economy. He has been the central bank governor in Paris since the end of 2015. A fluent German speaker who hails from the border region of Alsace-Lorraine, his chances may be dented by the fact that in Jean-Claude Trichet, France has already had an ECB president.

Mr Draghi’s legacy will be shaped in part by what happens to the global economy over the next few years. And here circumstances have not been kind to the ECB boss. While he might have hoped to mark the end of his term by raising interest rates, he faces a trade war and a slowdown in China, which is having a significant impact on Germany. And while most European governments are no longer imposing austerity, public spending is only mildly expansionary and Berlin, which has the fiscal space to move, looks unlikely to launch major stimulus to counter any slowdown.

Yet the fact that Mr Draghi will depart without having normalised borrowing costs could leave his successor short of ammunition to use during any downturn.

“Draghi and his inner circle . . . have performed monetary miracles but most of the policy space that they created has been used up,” says Mr Barwell. “The market is questioning whether their successors will have the conviction to do whatever it takes to achieve the ECB’s mandate, the ingenuity to conjure up the next stimulus package and the courage to sell it in the next downturn.”

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