After days and days of objections from the Bundesbank, threats to resign from its chairman, secret meetings, press leaks and shady deals, Draghi has got his way. The ECB will make "unlimited purchases" of certain Eurozone nations' government bonds with maturities of up to three years. It will use newly-issued euros to make these purchases. To address concerns about debt monetization, the ECB will sterilise these purchases (withdraw the newly-issued money from circulation) by some means yet to be defined.
Firstly, let's be completely clear about the justification for this. It is absolutely not to relieve the problems of debt-laden sovereigns. It is to protect the Euro. As I pointed out recently, the stability of the Euro is under threat because of a growing belief among investors that some countries will abandon the Euro and issue their own currencies. According to Draghi, interest rate policy is now ineffective in those countries that investors think might leave the Euro, because yields are instead driven by the risk of redenomination. This is serious. Redenomination risk makes it impossible for the ECB to control inflation (or, in the periphery, deflation) and increases the likelihood of speculative attack on the Euro. Therefore - in Draghi's view - the ECB must act to eliminate redenomination risk.
The ECB's weapon of choice is selective QE focused on rapidly-deflating parts of the periphery. I have previously argued for QE in the periphery - and reverse QE in Germany - as a means of managing the huge variation in the money supply across the Eurozone that is evident from the Target2 imbalance. Draghi has proposed QE in order to limit interest rate variation across the Eurozone. It amounts to the same thing. Despite the concerns of the Bundesbank and others, this is MONETARY policy. Bailing out distressed sovereigns is a side effect, but it is not the aim of the purchases.
The problem is that, side effect or not, sovereigns will receive relief, and that is likely to act as a disincentive for them to follow through with the fiscal reforms they have agreed to both as conditions for their debt relief programmes and in the Fiscal Compact. Draghi threatens to end purchases for sovereigns that fail to follow through with reforms: but as James Mackintosh at the FT points out, this threat is empty. If a sovereign failed to implement agreed reforms and the ECB pulled the plug on bond purchases, it would be likely to default - in which case the ECB would suffer huge losses on its holdings of that sovereign's debt, and the Euro would probably collapse. So how could fiscal discipline and structural reform possibly be enforced?
Leaving aside the headache for Merkel that such moral hazard will create, there is also the problem that QE amounts to direct funding of governments by the ECB, which is explicitly forbidden by EU treaty. Draghi originally argued that if QE is used as a monetary policy tool, the fact that it is also monetisation of government debt is merely a side effect and therefore not a treaty breach, but Jens Weidmann of the Bundesbank was not impressed. Today, to calm the fears of Weidmann (and others) about inflation arising from debt monetisation, Draghi agreed to "sterilise" the bond purchases. This means that the newly created money used to buy the distressed government bonds would be withdrawn from circulation after the purchase, returning the money supply to exactly as it was before the purchases were made.
Draghi has - perhaps wisely - not explained exactly how he plans to do this. He could offer banks term deposits at a slightly higher rate of interest than they currently get in the regular deposit facility - that wouldn't be difficult, since ECB deposit rates are currently zero. Or he could sell some of the junk on the ECB balance sheet in open market operations, assuming he can find buyers willing to pay him something near the amount he paid for the junk - we can't have the ECB making losses on its investments, now can we? Alternatively, the ECB could issue a short-dated debt instrument for the amount of money created: this would probably mop up what is possibly rather a lot of new money more effectively than term deposits, since it would be offered to a wider range of investors.
An ECB debt instrument might also go some way towards addressing the shortage of collateral that Cardiff Garcia notes. Mind you, the way that would work is simply priceless. Spanish bank sells Spanish government bonds to ECB for new Euros: ECB sells ECB bonds (bills?) to Spanish bank, thus "buying back" the new Euros: Spanish bank repos ECB bonds at the Spanish national bank or the ECB for new Euros......Complete circularity. You really couldn't make it up, could you?
But entertaining though that is, there is a much better variety of Euro fudge, or rather Vampire Squid ink, lurking at the heart of this proposal. From the very start of the Euro crisis, Germany has adamantly refused to countenance the prospect of Eurozone common debt issuance. Merkel has made it clear time and again that Euro bonds are not an option while peripheral government debt and deficits remain well above the Maastricht limits. But if the ECB buys peripheral government bonds, then sterilises the purchases by issuing an equivalent amount of its own debt, it has effectively replaced the national debt of distressed Eurozone countries with common Eurozone debt, guaranteed (via ECB capitalisation) by the Eurozone member states and in particular by Germany. Admittedly it would be short-term debt, but the precedent would be set.
This is Draghi's debt trap. He set it up for the Bundesbank and, like the idiots they have so often shown themselves to be, they walked straight into it. In blindly pursuing their aim to prevent monetisation, with its attendant risk of inflation, they have unwittingly enabled Draghi to force their Chancellor into a position where she no longer has any power to prevent the issuance of common Eurozone debt.
You see, the ECB's sole mandate is to ensure price stability, which it can only do if the Euro is stable and monetary policy is effectively transmitted. So within its mandate it can do whatever it considers necessary to stabilise the Euro and maintain effective interest rate policy. Just as monetising peripheral government debt, if done solely for this purpose, would be MONETARY policy and therefore not illegal even though EU treaty specifically outlaws it, so converting peripheral government debt to common Eurozone debt would also be MONETARY policy. And the conduct of MONETARY policy by the ECB cannot, under EU treaty, be subject to political control. Unless Merkel can prove that in some way the ECB would be in breach of treaty by issuing its debt instrument, there is nothing whatsoever she can do to prevent it. From now on, Magical Mario is running this show and all the other players are his puppets.
There are two morals to this story. The first is the one that Bob Diamond learned to his cost: never, ever pick a fight with a central banker. They have much bigger guns than you.
And the second is this: never, ever pick a fight with a central banker who learned his trade at Goldman Sachs. You will end up lovingly entangled in his tentacles while he bleeds you dry.