Thursday, 6 November 2014

Why Mario Draghi's ECB colleagues just kneecapped his credibility: the politics of market tripwires

Something is afoot at the European Central Bank.  People at the very top of the institution--leaders of the central banks of the member nations, and members of the small Governing Council responsible for key decisions--have apparently co-ordinated to anonymously tell Reuters just how very much they dislike Draghi's leadership style.  He even looks at his mobile phones--all three of them--when they're trying to say important things to him! 

I think it likely that these public complaints had a very specific goal--and it wasn't to get Mario to put his screens away.  Instead, they are intended to weaken Draghi's influence over ECB policy and strengthen the influence of other members of the ECB Governing Council. To do this, it was necessary to weaken the credence markets give to Draghi's statements, and that the ECB insiders shaped their remarks accordingly--or so I argue in this post.

The politics of market tripwires

To understand the conflict between Draghi and his colleagues, one needs to bear in mind that it is playing out on the backdrop of the intense attention financial markets pay to the pronouncements of central bankers.  

Financial markets, as is well-known (read Keynes on this) are characterised by self-fulfilling prophecies. If market participants believe an asset will fall in value, they will convert prediction into fact by selling it and driving down the price. Market participants thus have an understandable terror of being the last to sense a shift in the collective prophecy (more prosaically known as "market expectations"), unable to sell before the price has fallen or buy before it has risen. 

Thus, investors are especially sensitive to what I'll call "market tripwires" -- events expected to cause a general shift in market expectations. When one of these tripwires is triggered, investors rush to react as quickly as possible, in some circumstances creating a panic. An example of a market tripwire familiar from the financial pages is the earnings forecasts of stock market firms--whether these are met, exceeded, or undershot can set off large shifts in prices. 

Sometimes, political actors create market tripwires in order to impose costs or constraints as a tool of influence. For example, the IMF's Michael Mussa accused Argentina's Finance Minister Domingo Cavallo of doing just this to pressure the IMF into extending more help as Argentina fought to stave off devaluation of the peso in the summer of 2001 (I assume the story is true, but don't know for certain; for present purposes it's enough that it could be true):
Through leaks to the local press, the Argentine government circulated the story that the Fund … would augment [a planned] disbursement with an addition of about $8 billion. Financial market reacted positively to this news, and the bank runs slowed. ...The suggested augmentation of Fund support was announced without consultations with the rest of the Argentine government. ... There were no prior consultations with the Fund, nor any prior indication of support from the Fund for a substantial augmentation of its lending. Indeed, Cavallo's tactic was to force the Fund to augment its lending by creating a fait accompli. Financial markets and Argentine citizens reacted favorably to the announcement of augmented Fund support. If they were disappointed that this support was not forthcoming, the Fund (and the international community more broadly) would be responsible for the consequences. [Mussa, Michael. 2002. Argentina and the Fund: From Triumph to Tragedy. Washington, DC: Institute for International Economics, p. 41-42]
In our terms, Cavallo tried to create a market tripwire.  He hoped to turn the IMF's failure to provide additional support into a signal for market panic, betting that the prospect of the panic would cause the IMF to agree to his demands.  

Draghi's tripwires

More than once, Draghi has used his status as the ECB's main spokesperson to do something very similar--make public announcements about policy, shifting market expectations, and implicitly (or explicitly, for all I know) inviting his ECB colleagues to contemplate the consequences of failing to carry out the policy.

A highly consequential example was Draghi's famous "whatever it takes" statement in July 2012, inserted into a prepared speech at the last minute.
Just as shocked were the ECB boss's aides and his colleagues on the bank's policymaking Governing Council, none of whom knew Draghi would make such a sweeping promise. "Nobody knew this was going to happen. Nobody," one senior ECB official said of the speech.
The tactic worked. Draghi's statement had a huge immediate impact in alleviating panic on sovereign bond markets, creating a market tripwire: failure to agree on an official lender-of-last-resort programme would reignite the panic, almost certainly in worse form.  The well-reported narratives of the ensuing hard bargaining that concluded with the announcement of OMT demonstrate that Draghi's statement was made well before he could be sure that he could get support for the sort of programme he wanted. 

This week's anonymous attacks were motivated by an effort to prevent Draghi from doing it again. This time, the issue on the table is not bond market panic, but the threat of deflation, brought on by weak growth prospects and the contraction of ECB lending as banks pay back earlier ECB loans without taking on new ones. To deal with this contraction would necessarily involve the buying Eurozone sovereign bonds (imprecisely known as Quantitative Easing, or QE), which German members of the ECB leadership oppose.

In recent months, Draghi has clearly been trying to encourage the market to believe that this sovereign bond buying will happen, creating a market tripwire that he can use as leverage to make the program happen. Examples are:

  • Draghi's warning in his Jackson Hole speech--like "whatever it takes," inserted at the last minute beyond the control of the rest of the ECB leadership--that deflationary expectations were spreading and a promise that the ECB would "use all the available instruments" to try to fight them.
  • statement in early September that the ECB would try to expand its balance sheet to the levels of early 2012 (ie, reverse the contraction of its lending) 
Members of the ECB Council are perfectly aware of what this manipulation of market expectations is intended to accomplish.  According to one of Reuters' interviewees, the balance sheet statement,
"...created exactly the expectations we wanted to avoid," an ECB insider said. "Now everything we do is measured against the aim of increasing the balance sheet by a trillion (euros)... He created a rod for our own backs." 
You say that like it's a bad thing. Draghi wanted precisely that rod as a tool of policy influence. 

No, don't believe him

Of course, market tripwires only work as a tool of policy influence if markets believe the statements intended to set them. Cavallo would have gained no leverage over the IMF if the announcement of an impending expansion of support had not slowed bank runs. "Whatever it takes" would not have helped the passage of OMT without its calming effects on the markets.

So to disable the tripwire tactic, the German members of the ECB leadership Reuters' anonymous insiders set out to tell markets that Draghi is not to believed.  
"We specifically agreed at the meeting... not to put any numbers on the table," [said] one central banker. "Draghi's reference to the balance sheet of 2012 irritated a lot of colleagues. So he has had to backtrack a bit ... to compensate."
In other words, just because Draghi promises something, it's not necessarily going to happen. It is precisely Draghi's ECB opponents need to make this point, I believe, that explains why these complaints were made in public rather than in private. In July 2012, Draghi said:
Within our mandate, the ECB is ready to do whatever it takes to preserve the euro. And believe me, it will be enough.
What his ECB colleagues are saying is: no, don't believe him. Wait to hear from us.

In particular, as becomes clear in the final paragraphs of the Reuters piece, don't believe Draghi if he hints that QE is coming. You can believe in QE if and when it is announced as an official policy. The insiders claim that without a consensus for QE in the ECB--and it's currently opposed by "at least seven and possibly as many as 10 of the 24 council members"--it can't happen because it's too politically divisive. (On this matter, one can only hope that the ECB majority will listen to Paul de Grauwe. A long as the ECB has unaccountable power, it should be used for good and not only for evil.) 

Kneecapping Draghi's credibility will make it harder for him to use his public announcements as a tool of unilateral policy-making, but it has costs, too. If the anonymous insiders succeed in turning Draghi into "the boy who cried QE," he will be unable to reassure the markets at moments when they need it most. For them that may be a feature rather than a bug of their strategy, but the rest of us should fear the dismantling of whatever capacity there is to contain the dangerous fickleness intrinsic to financial markets, and the destruction of whatever limited hope there is that deflation can be avoided without reversing austerity.

1 comment:

  1. Highly interesting and spot-on (in my humble opinion). One wonders to what extent the ECB's brave new world of CB transparency can shed some more light on the internal fault lines you mention at the end of your post (with the publication of governing council voting records and minutes, or 'public accounts', up from 2015 likely to be decided in next week's GC meeting).