PARIS: Buying unlimited quantities of bonds is sometimes described as a central bank’s nuclear option, deploying an overwhelming force that threatens speculators with annihilation.
Like atomic weapons, the bank’s powers to print money and buy securities are best held in reserve as a deterrent, even if their use would not wreak destruction on a comparable scale.
Having to use them to defend a country or a policy objective could cause unintended damage and expose fatal weaknesses in the political will to sustain the action.
European Central Bank President Mario Draghi seemed to borrow from the Cold War lexicon of deterrence in July when he told financial markets that the ECB would do “whatever it takes to preserve the euro. And believe me, it will be enough.”
The Draghi Doctrine sounded a bit like the macho boast on unofficial Israeli air force T-shirts on sale in occupied Jerusalem: “Mince with us and you’ll end up as chopped liver.”
But his fighting talk was soon questioned by skeptics in the financial markets and the commentariat.
Did he really have the weapons? Would he use them? Could he secure support from key stakeholders, most importantly European economic powerhouse Germany, for his strategy? Could he act without that? And could he keep going after a first strike?
The ECB chief sought to answer the doubters when he outlined a strategy for buying unlimited quantities of short-dated bonds of any eurozone state that requested a European assistance program and stuck to its strict conditions.
The word “unlimited” was meant to serve as a warning and signal resolve. It shouted “don’t even think of betting against the Central Bank because we can overwhelm you.”
Market players used to the adage “never bet against the Fed” were supposed to hold the ECB in similar awe.
A senior central banker, asked whether the new policy was the equivalent of a nuclear weapon, said the ECB stood ready to fight anyone speculating on a break-up of Europe’s single currency “if necessary with massive retaliation.”
But Draghi’s big bazooka was undermined from the outset by the declared opposition of Germany’s central bank. Even though Bundesbank President Jens Weidmann was alone in voting against the decision, he has used his position to sap German public trust in the policy and by extension in the ECB.
“The key element in deterrence is credibility – making those you are trying to deter believe that you actually would do what you say you would do, that you have not just the military means but the political will,” said Simon Lunn, a former NATO defense planner and expert on nuclear strategy.
“Does the ECB have the will, given that it depends on a range of diverse stakeholders, just as NATO does? And can that will be sustained when the going gets tough?” asked Lunn, who served at NATO headquarters during the 1980s Euromissile crisis.
In that phase of the East-West conflict, NATO had agreed to deploy U.S. medium-range missiles in five European countries to counter Soviet SS-20 rockets threatening western Europe.
The strategic aim was to demonstrate that the United States was “coupled” with its European allies and had the political resolve to launch a nuclear war if they were attacked, whether with conventional or atomic weapons.
The victors’ version of history is that the Soviet Union blinked, just as it had during the 1962 Cuban missile crisis, and the West went on to win the Cold War without firing a shot.
That account omits many of the difficulties along the road, which hold lessons for the ECB today.
The U.S. missiles scared the Europeans they were meant to protect at least as much as they frightened the Russians, spawning a large anti-nuclear movement and raising doubts about the resolve of allied governments to see through the deployment.
The willingness of the U.S., if push came to shove, to put its own homeland at risk for the sake of Germans or Italians unwilling to spend enough on their own conventional defense was always a matter of some doubt.
Possessing a massive nuclear arsenal didn’t save the Soviet Union from collapse or the loss of its hold on Eastern Europe due to a combination of economic weakness and political dissent.
The U.S. deterrent was credible partly because Washington had dropped an atom bomb on Japan in 1945. No one could be sure it would not resort to nuclear warfare again, however suicidal.
The ECB’s “nuclear” credibility is harder to establish.
The Bank’s previous half-hearted intervention steadied borrowing costs only temporarily for weak eurozone countries and did not prevent Greece, Ireland and Portugal from being shut out of capital markets and forced into full state bailouts.
The disclosure that ECB policymakers had set a weekly limit on bond-buying made it easy for speculators to game the system.
Banks and hedge funds used the Securities Markets Program as a chance to dump dodgy debt on the Central Bank and run – not exactly the ECB’s desired outcome.
There was also no mechanism to ensure governments helped by the purchases stuck to promised economic and fiscal reforms, and the policy withered due partly to German opposition.
Within weeks of the ECB intervening in August 2011 to buy Italian bonds, then-Prime Minister Silvio Berlusconi laughed off the reform pledges he had made to obtain Central Bank support.
Draghi was determined to avoid another such fiasco when he designed the new Outright Monetary Transactions policy.
The Bank would buy bonds only if a country accepted strict conditionality and international supervision, and would stop the support if a government veered off course, he declared.
But EU-IMF monitoring of austerity measures and reforms imposed from abroad is so humiliating that the target states, Spain and Italy, are desperate to avoid requesting assistance.
Yet many market players will only believe the ECB if they see it buying bonds on a massive scale.
There are also doubts about the credibility of the ECB’s threat to stop supporting a country that goes off track, if the result would be to tip Spain or Italy into default. The eurozone has not dared to risk that even with smaller Greece.
Richard Portes, professor of economics at the London Business School, said the ECB had undermined its own deterrence by making itself dependent on other players.
“To defend the euro, they should have made the intervention unconditional, set a specific cap on bond spreads and stated explicitly that if a country is insolvent in the ECB’s judgment, they will let it go,” he told Reuters.
As an example of successful deterrence, he cited the Swiss central bank’s capping of the Swiss franc’s exchange rate against the euro.
“I don’t think the SNB had to intervene in any significant volume. Once they had said they would do whatever it took to defend that parity, nobody was going to test it,” Portes said.