Draghi's timely actions provide strong platform for currency to bounce back

I have been reviewing an article I wrote in May about Europe titled "An end, with horror, is better than no end". The title refers to a German joke about the European situation, and in May a nasty crunch, with plenty of horror, seemed the likeliest outcome for the euro. I forecast that Greece would be the first country to leave the euro, probably as early as August this year, because the Greek financial and economic situation could not continue as it was, and others would follow.

In May, when I concluded that Europe had failed the survival test, and the euro would cease to exist in its current form, I drew five lessons for euro survival from the many financial crises that have occurred around the world in the past 30 years.

These were: the forgiveness of debts that would never be repaid; recognition of bad bank debt, followed by bank restructuring and recapitalization; cuts in wasteful or unnecessary government spending to eliminate national budget deficits; restructuring within economies to increase competitiveness; and carefully designed programs of public investment in infrastructure that could provide growth and employment to offset economic restructuring, at the same time providing a stronger foundation for sustainable economic growth and social development.

The outlook for the euro looks much more positive now than it did in May. So what has changed, and why should I adopt a more positive attitude to the euro?

The reason is Mario Draghi. Since Draghi, an Italian with a doctorate in economics from the University of Chicago, succeeded the Frenchman Jean-Claude Trichet as head of the European Central Bank last November, the bank has led the euro's fight-back against financial speculators, dubious economists and European politicians unable to take hard, vote-losing decisions.

Draghi has used his experience and first-class training in economics to clearly identify the nature of the economic and political problem in Europe. He has applied his imagination and exceptional intellect to find ways in which the bank can stabilize the euro, at the same time bringing enormous pressure to bear on national European governments to reform their economies and form the closer economic and political union on which the euro's future depends.

The powerful weapon at Draghi's hand is the bank. It is a money-machine that can create as many euros as it wants to, and can outspend any investor or financial speculator. It is mandated by the European Parliament to maintain price stability within the euro system. Draghi has interpreted the bank's price stability mandate in a way that permits the institution to buy debt issued by any European government, in unlimited amounts.

However, this promise is conditional on the country in question asking for such intervention, and then agreeing irrevocably with the bank to carry out the economic and financial reforms that will allow the country to reverse its decline, reduce its debt, restart growth and reduce unemployment. So that national European politicians understand their situation, Draghi has emphasized that the bank will only intervene if the country in question has placed itself, through reform, on a path of reduced budget deficits and increased economic competitiveness. If the bank feels it has to review a country's reform measures, its financial intervention to buy the country's debt will be suspended until the review is complete.

Draghi has made the bank into a force that can hold the financial markets at bay, because it has the power to print unlimited quantities of euros that it can use to buy any country's debt. Speculators will not take positions against a possible intervention by the bank on the other side, because they know that it always has more money than they do. But like a pack of hyenas on an African plain watching a female elephant defending her baby, Draghi's defiance only works if the markets believe that the bank is credible, and can maintain its position, and that the economic situation within the euro system and in weak countries will start to improve. As soon as the hyenas sense that the mother elephant is weakening, they will emerge from the bushes to start looking for a weakness.

This story has only one end.

Similarly, for Draghi's defiance of the markets to succeed, he has to ensure that European politicians take the hard decisions to cut, restructure and reform that so far they have avoided. In this way, everyone can see that the situation within the weaker European countries and the euro itself will improve. On the one hand, Draghi is threatening market speculators with huge losses. On the other, he is threatening to throw countries with unsustainable deficits and rising unemployment to the financial wolves. As he says, "some countries with unsustainable deficits do not yet realize that they have already lost their independence because, if nothing changes, the markets will destroy them".

Because the euro crisis has been going on for several years, it has taken months for Draghi to be listened to, understood and believed by the rest of Europe. His first bold step immediately after taking office a year ago was to announce two programs of euro bank financing in unlimited quantities. These were conducted in November and again in January. Draghi hoped that some of this new bank money would find its way to financing small and medium-sized European enterprises to boost growth.

But this has hardly happened as banks have ploughed the money into buying debt issued by their national governments in order to strengthen their own balance sheets, demonstrating in the process that much of Europe's banking system urgently needs to be restructured and recapitalized. However, the boldness and size, about $1 trillion (775 billion euros), of the bank's intervention did start to persuade markets that under new management the bank was imaginative and serious.

More recently, the European Parliament has approved additional measures for the bank, which Draghi has called outright monetary transactions, alluded to above. So far, none of these have been carried out, but it seems only a question of time before Spain becomes the first euro country to apply to the bank for intervention in order to relieve acute financial pressure.

Although Draghi's credibility has risen, not all Europeans have greeted the bank's money-creating measures with enthusiasm. The deep-rooted German fear of inflation and money debasement, following the experience under the Weimar Republic in the 1920s, which prepared the way for Adolf Hitler's dictatorship and eventual national humiliation, has led them to be slow in acknowledging and approving the correctness of Draghi's approach.

The head of the German central bank, Jens Weidmann, has been the sole negative vote in the European Central Bank board against approving Draghi's measures. But German support is vital to European success, and in September Draghi addressed the German Parliament in Berlin to explain his measures and their necessity. One journalist talked of his "charming the Lederhosen off German politicians".

Intelligence, integrity, forcefulness, knowledge and charm: these are significant weapons, and Draghi has them all. It is due entirely to his vision and leadership that the euro, and Europe, now have a glimpse of a better future, without horror. But as Draghi constantly emphasizes, it is up to Europe's politicians, not the European Central Bank, to force through the national spending cuts, economic reforms, bank restructuring and steps toward further European unification that will ensure the euro's future success.

Ultimately, all the bank can do is buy time and provide a platform, with a signpost for progress. But now at least the euro has a chance of survival. With Draghi's carrot-and-stick approach, the chance is a good one.

The author is a visiting professor at Guanghua School of Management, Peking University. The views do not necessarily reflect those of China Daily. Contact the writer at gileschance@yahoo.com

(China Daily 11/09/2012 page10)