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European Central Bank President Mario Draghi arrives at a euro zone finance ministers meeting in Luxembourg June 20, 2013. (FRANCOIS LENOIR/REUTERS)
European Central Bank President Mario Draghi arrives at a euro zone finance ministers meeting in Luxembourg June 20, 2013. (FRANCOIS LENOIR/REUTERS)

economy

How economic firefighters stoked a new threat to the euro zone Add to ...

You could argue convincingly that the two Marios – Mario Draghi, president of the European Central Bank, and Mario Monti, former prime minister of Italy – saved the euro zone from destruction. You could equally argue that each of their firefighting campaigns were marred by two big miscalculations that may yet cause the euro zone severe pain, or worse.

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The two are related. Mr. Draghi’s miscalculation was to remove market discipline by promising to backstop the sovereign bonds of any country that had trouble financing itself. Reform complacency was the predictable result.

Mr. Monti’s miscalculation (after he did the world a big favour by replacing Silvio Berlusconi, Italy’s would-be agent of destruction) came when he avoided using that backstop while he was still in office. Instead, Mr. Monti, who had been a technocrat leader, decided he would become an elected politician. That meant he lost the guts to make unpopular decisions, even if he knew they would be the right course for Italy. The result is a country stuck in the recessionary bog, failing to pursue the deep reforms needed to make itself competitive.

Mr. Draghi’s firefighting skills have been impressive. “The ECB under Mario Draghi has become … much more pragmatic and pro-active than under of any of Draghi’s predecessors,” ING economist Carsten Brzeski said in a Friday note.

When Mr. Draghi, a former Goldman Sachs banker, went from the Bank of Italy to the ECB in 2011, investors, economists and probably more than a few finance ministers reached for the Valium. But Mr. Draghi swung into action, fearing that a wait-and-see approach would either revive the banking crisis or rip the euro zone apart, starting with the exodus of Greece.

His first big move, in late 2011, was to inundate the banks with ultra-cheap liquidity through a program called LTRO – long-term refinancing operation. It not only helped to stabilize the banks and prevent inter-bank lending market from seizing up (as it did after Lehman Bros. imploded in 2008), but it also propped up sovereign finances since the banks used the money to load up on bonds.

His nuclear move, revealed in September, 2012, was the bond backstop program, called outright monetary transactions, or OMT.

It would see the ECB buy unlimited quantities of short-term sovereign bonds to keep borrowing costs low, allowing even governments in crisis to finance themselves. The program lent credence to Mr. Draghi’s promise to do “whatever it takes” to keep the euro zone from breaking apart.

On Thursday, SuperMario was back fighting again, this time dropping interest rates to a record low to prevent rapid disinflation from turning into economy-busting deflation. Most economists didn’t see that move coming.

The OMT program is the one with potential to backfire. It may have backfired already, even though it has never been used: Its mere presence has been enough to drop bond yields sharply in Italy, Spain, Portugal and a few other struggling countries. Italy’s 10-year yields have fallen by almost three percentage points, to 4 per cent, allowing the government of Mr. Monti’s successor, Enrico Letta, to claim that the Italian debt crisis is over.

That’s a far-fetched claim because Italy’s so-called economic reform program constitutes fiddling while Rome burns. The country’s notoriously high labour taxes have gone down, but just a bit. Unit labour costs have barely budged. The budget is in eternal deficit and the national debt is above 130 per cent of gross domestic product. The country is in deep recession, is deindustrializing at an alarming rate, and youth unemployment has topped 40 per cent. Italy’s is in dire need of a political and economic revolution.

Mr. Draghi must be distraught that the Italian government did not hold up its end of the bargain, which was: We will come to the rescue if your bold reform efforts cause turmoil. The OMT was not an invitation to do nothing.

Which brings us to Mr. Monti. In the autumn of 2011, the sober-minded economist could have demanded that OMT be put into action (it cannot be forced onto a country). At the time, Italian bond yields were still at crisis levels, yet reform was barely started. OMT would have forced rapid reform on Italy in exchange for the bond buying.

As an unelected leader, Mr. Monti could have pulled it off. Instead, he went to the polls. It was a double loss. Italy missed its moment to clean up its act and Mr. Monti went nowhere in the election.

Italy is not the only country to embrace complacency as the ECB stands guard. On Friday, S&P downgraded France by one notch, to double-A, and heaped abuse on that country’s overhaul efforts. “The downgrade reflects our view that the French government’s current approach to budgetary and structural reforms … [is] unlikely to substantially raise France’s medium-term prospects,” S&P said.

Mr. Draghi is a good firefighter, perhaps too good. Because of him, the euro zone is not in imminent danger of collapse. At the same time, he in effect encouraged complacency in the hard-hit countries.

No good deed goes unpunished.

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