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Is ECB's Draghi Trying to 'Out Bluff' the Markets?

Friday, 21 Sep 2012 | 10:15 AM ET

Praise all around for Mario Draghi and his European Central Bank's bold strategy of "conditional" bond buying across the euro zone, if and when deemed necessary.

Fredrik Von Erichsen | AFP | Getty Images

"This is the big game changer", insists Polish finance minister Jacev Rostowski, echoing what virtually all of his colleagues both inside and out of the EU have voiced over these past weeks.

And for a change, markets all around are in rare agreement with politicians on this one. That the markets are happy is obvious.

The announcement of the ECB has given them the welcome present of something they seemed to have lost ever since we tumbled headlong into the subprime crisis: a safe investment.

Well, as safe as it gets.

I am, of course, talking about high-yielding 1- to 3-year sovereign bills/bonds of hitherto endangered "peripheral" euro zone countries.

If the yield goes through the roof and they are on the brink of becoming really "endangered", the ECB — or so they hope — will step in and sweep them up.

So far, so good (or not).

Of course, the concentration on the short end of the maturity spectrum might well lead to an unwelcome front loading of the market with 1-3 year paper.

Which in turn would not only dry up the longer end, but also cause an even more unwelcome dislocation of the yield curve.

Tricky, but ultimately these are naught but pragmatic considerations.

The real problem with the ECB's OTM program is and remains a fundamental one: has the ECB left the path of monetary policy and is it now marching down the bumpy road of monetary politics?

Let me explain: the ECB's line of arguing is flawed and contradicts itself.

If the OMT program is a "strictly monetary measure" — which they insist it is — then it cannot and must not be linked in any shape or form to political conditions.

The ECB is charged with keeping money flows, financial markets, the banking system functioning.

If the transmission processes in the now extremely fragmented eurobond market no longer work, then the central bank should and must step in — even with bond purchases to help stabilize the market.

That is a monetary measure well within its mandate.

The ECB is the euro zone's monetary fire brigade. There is a fire. Put it out.

But then comes the word "conditionality" (which both the ECB and politicos praise as the safety valve against blind state financing which, of course would be "verboten").

Let's stick with the image of fire.

Now the ECB — the fire brigade — says: We only put out the "fire", if you agree to a "program" (exact form of that yet to be defined) first.

Can you imagine your friendly real fire brigade informing you in case of your house of fire that they will only turn on the water, if you first embark on a roof-improvement scheme? Absurd.

But that's what the ECB announced at its last policy meeting. The big "game changer".

It is that indeed. In more ways than one. Once again, the ECB has bought euro zone politicians time. Now that, as we all know, is always a double-edged sword.

Taking the pressure off has its perils.

Already one hears "let's not rush to beat the self-imposed January deadline for banking supervision". And "let's give Greece more time to adjust".

That doesn't have to be bad news. Doing things right is more important than doing them fast.

But if the history of (missed opportunities) for euro zone economic reforms is anything to go by, "more time to adjust" could only too easily turn into "let's postpone reforms until the economy picks up".

If the markets also take the pressure off now, because they love the idea of ECB free candy in the shape of a promised OMT program, then the ECB's much-praised rescue plan might well turn into what Mario Draghi could not have intended: long-term financing of government debt that actually prevents both budget reforms and economic recovery.

Simply because it's much less risky and more profitable for banks to buy higher-yielding sovereign debt than to lend to the private economy.

That would be the kind of "game changer" that Bundesbank "renegade" Jens Weidmann called "Teufelswerk" (devils work) in commemorating Goethe's "Faust".

But maybe, just maybe Draghi and the ECB will "out bluff" both the markets and politicians.

If they only have to talk about OMT and never have to deliver it, "Super Mario's" move will go down in ECB history as - well - super.

If, however, the other Mario (Monti) calls the ECB's bluff by not accepting any bailout program and yet forcing the ECB's hand on activating OMT for Italy, well ...

Then the "big game changer" might have pushed the ECB down the road of monetary politics to a destination yet unknown.

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