The Guest Blog

Guest blog post by Luis Pablo de la Horra

Mario Draghi is a man of few words. The President of the ECB is not the kind of public figure that enjoys being in the spotlight all the time. Yet every time he speaks, he makes the headlines.

Last May 11, Draghi gave a speech at the European University Institute (EUI) where he looked back at the financial crisis in the Eurozone and made some proposals to reform the European Monetary Union (EMU). Some of the ideas he put forward have been echoed by the media, especially those concerning the creation of a fiscal instrument that acts as a complement to monetary policy in times of crisis.

That was undoubtedly the most controversial part of Draghi’s address to the EUI audience. Yet he dealt with many other interesting issues during his speech that are worth a careful analysis. He began with a short though accurate overview of the Euro crisis, pointing out that the Eurozone lacked at the time the necessary mechanisms to face the most severe economic shock the world had experience since the Great Depression.

If the Eurozone aims to cope with future economic and financial crises with certain guarantees, Draghi argues, two objectives must be achieved. First, the EMU needs to improve the stability of the financial sector. In this sense, the Bank Recovery and Resolution Directive goes in the right direction: it establishes a resolution mechanism whereby creditors are compelled to bear part of the losses in case of bank restructuring or bankruptcy.

This directive is aimed at discouraging banks from irresponsible risk-taking by providing creditors with an incentive to monitor the quality of banks assets, reducing at the same time the moral hazard of financial institutions. In addition, the Single Resolution Fund creates an insurance scheme funded by financial institutions themselves to make sure banks with problems do not cause systemic risk to the entire economy.

Draghi proposes to go beyond and involve fiscal authorities by making them lenders of last resort in case the Resolution Fund runs out of capital. However, the President of the ECB seems to overlook the contradiction of implementing such a measure. Those policies intended to remove moral hazard and prevent taxpayers from paying the bill would be turned into hot air if financial institutions are certain that fiscal authorities will inject capital into failed banks when needed. In other words, we would go back to the onset of the financial crisis when excessive risk-taking by the financial sector was awarded with bailout funds instead of being penalized for mismanagement by the market.

A second objective Draghi deems necessary to accomplish is full economic integration. In order to attain this goal, Draghi advocates structural reforms, especially for those countries that struggled the most during the crisis because of their lack of economic dynamism. In effect, structural reforms are growth-boosting and make economies more flexible and resilient to face future economic turndowns. Spain is an example of this. The labor market reform that the conservative government undertook in 2012 has resulted in a drastic decrease in unemployment: from a peak of 27% in the 2013Q1 to 17% in 2018Q1. In addition, it has provided the labor market with certain flexibility, which will reduce the job destruction rate in the event of a new crisis.

Yet Draghi argues that structural reforms are not enough. When financial and economic crises hit the European economy, other mechanisms must be deployed. He mentions the sovereign bond-buying program the ECB created in the aftermath of Draghi’s famous “whatever-it-takes” speech to support countries under the threat of default, or the European Stability Mechanism (ESM), which provided the Spanish government with funds to recapitalize its banks. But again, Draghi considers both mechanisms insufficient and calls for the creation of an “additional fiscal instrument (…) to provide an extra layer of stabilization”.

There are several problems with this idea. First, Draghi himself acknowledges that the idea is extremely vague. What would it be employed for? Would it provide funds to financially-distressed countries? However, this is exactly what the ESM does. Should we design another mechanism that further encourages fiscal indiscipline and exacerbates moral hazard?
On the other hand, if the aim is to provide the Eurozone with a “fully-fletched fiscal capacity”, he would be assuming that fiscal policy in the form of increased public spending (funded by fiscally-disciplined countries for the benefit of fiscally-irresponsible countries) is effective to tackle economic shocks. Yet this is highly questionable as shown by the concept of monetary offset: to compensate for the inflationary effects of fiscal stimulus, central banks see themselves compelled to pursue contractionary policies, making public-spending countercyclical measures useless. Therefore, increasing the fiscal capacity of the Eurozone to assist countries in problems would likely result in a waste of resources, encouraging fiscal indiscipline during economic booms along the way.

Fiscal mechanisms aimed at supporting financially-distressed banks or countries create perverse incentives and reinforce the vicious circle “mismanagement-bailout-mismanagement” in which many European economies have been immersed since the last financial crisis. Socializing losses generates economic instability in the long term, weakening the foundations upon which the Eurozone is based; precisely the opposite Mario Draghi says he aims to achieve with his reform proposals.

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