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New European Central Bank (ECB) President Mario Draghi leaves the "World Savings Day" meeting in Rome October 26, 2011. The reform proposal outlined by the Italian government in a letter to its European Union partners contains ideas which must now be acted on rapidly, Draghi said on Wednesday. REUTERS/Remo Casilli (ITALY - Tags: BUSINESS POLITICS) (REUTERS/REUTERS)
New European Central Bank (ECB) President Mario Draghi leaves the "World Savings Day" meeting in Rome October 26, 2011. The reform proposal outlined by the Italian government in a letter to its European Union partners contains ideas which must now be acted on rapidly, Draghi said on Wednesday. REUTERS/Remo Casilli (ITALY - Tags: BUSINESS POLITICS) (REUTERS/REUTERS)

Debt crisis will test mettle of new ECB head Draghi Add to ...

The latest economic forecasts, employment numbers and inflation data coming out of the euro zone will not make life any easier for Mario Draghi, the MIT-trained economist who takes the helm of the European Central Bank on Tuesday.

The ECB is already under increasing pressure to play a more activist role as the 17-country euro zone grapples with a stalling economy and a crippling debt crisis that threatens to tear apart the currency union. Now, the Organization for Economic Co-operation and Development has underscored those concerns, warning of “patches of mild negative growth” in the region and slashing its GDP forecast to 1.5 per cent this year and a mere 0.3 per cent in 2012.

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The warning comes as unemployment continues to rise, hitting 10.2 per cent in September. Analysts had forecast a slight improvement to 10 per cent.

As recently as June, the OECD predicted the euro-zone economy would expand by 2 per cent both this year and next.

The OECD has urged the central bank to cut interest rates in response to deteriorating conditions and has called for greater deployment of the ECB’s balance sheet to combat the debt crisis and stabilize the battered financial system. Analysts also see the ECB as the only institution with enough firepower to put a lid on the crisis.

The central bank has kept the money taps open to banks needing operating capital and has continued buying the bonds of such troubled countries as Italy and Spain in the secondary market to keep already high spreads in check. But some key bank policy makers have argued against further expansion of the its role, fearing it will lose credibility as primary defender of the euro and leader in the battle against inflation.

Two Germans on the ECB’s policy-making board, Axel Weber and Juergen Stark, quit this year over their opposition to the bank’s role in buying up troubled government bonds.

Mr. Draghi has played his cards close to the vest. The ECB will hold its first policy meeting under his direction on Thursday.

Up to now, Mr. Draghi has kept a low profile, and was “hard to place on the ECB’s ‘hawk-o-meter’ ranking,” said Carsten Brzeski, an economist with ING Group in Brussels. “Those looking for the big coming out on Thursday will probably be disappointed. In our view, [Mr.]Draghi will do all he can to ensure continuity of the ECB’s monetary policy and also its communication.”

But others say Italy’s former central banker will be able to rely on his formidable background and considerable experience dealing with Italy’s myriad financial and economic problems to exert more influence over ECB policies.

Mr. Draghi certainly brings more impressive economic and monetary policy credentials to the job than his French predecessor, Jean-Claude Trichet. While Mr. Trichet had no formal training in these broad policy issues, Mr. Draghi studied under Nobel laureates Francesco Modigliani and Robert Solow.

“He understands what real inflation is and what it isn’t and he understands how to read a money supply chart and he understands the linkages between money supply and inflation, particularly under circumstances of an economy with a lot of slack in it,” said Carl Weinberg, chief economist with High Frequency Economics.

Inflation in the euro zone held steady at 3 per cent in October, slightly above what most economy watchers had predicted and above the ECB target level of just under 2 per cent. As a result, the bank is not expected to react to worsening economic conditions by cutting cut rates at its first meeting under Mr. Draghi.

Still, Mr. Weinberg suspects “we will see inflation risks de-emphasized, starting as soon as this Thursday’s statement, and a bigger focus on systemic risks, which are a much bigger issue for euro land than inflation right now.”

The Germans, who prefer a less activist central bank focused on inflation, still have a loud voice at the bank. “But they’re not the only voice,” Mr. Weinberg said. “The Italians and the French and Spanish also have their influence.”

But Mr. Draghi will not be able to lead the bank into such dangerous waters as “unsterilized” purchases of troubled country bonds, which would mean printing money to pay for the debt.

So far, the bank has made only sterilized, or covered purchases, selling, say, German bonds to offset the cost of newly acquired Spanish, Italian or Greek debt.

“He may argue for unsterilized bond purchases, given his background,” Mr. Weinberg said. “His studies at MIT would have taught him that there’s nothing wrong with uncovered bond purchases in circumstances like today’s.

“But I don’t think he’ll be able to get the traction to do them. The Germans will go nuts altogether, if the ECB starts printing money.”

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