Analysis: ECB's "nuclear option" better as deterrent than weapon

PARIS Mon Oct 1, 2012 1:54am EDT

The partially built new headquarters of the European Central Bank (ECB) is seen behind a fence with razor wire at its construction site in Frankfurt, September 19, 2012. REUTERS/Kai Pfaffenbach

The partially built new headquarters of the European Central Bank (ECB) is seen behind a fence with razor wire at its construction site in Frankfurt, September 19, 2012.

Credit: Reuters/Kai Pfaffenbach

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PARIS (Reuters) - Buying unlimited quantities of bonds is sometimes described as a central bank's nuclear option, deploying an overwhelming force that threatens speculators with annihilation.

Like atomic weapons, the bank's powers to print money and buy securities are best held in reserve as a deterrent, even if their use would not wreak destruction on a comparable scale.

Having to use them to defend a country or a policy objective could cause unintended damage and expose fatal weaknesses in the political will to sustain the action.

European Central Bank President Mario Draghi seemed to borrow from the Cold War lexicon of deterrence in July when he told financial markets that the ECB would do "whatever it takes to preserve the euro. And believe me, it will be enough."

The Draghi Doctrine sounded a bit like the macho boast on unofficial Israeli Air Force T-shirts on sale in Jerusalem: "Mince with us and you'll end up as chopped liver."

But his fighting talk was soon questioned by skeptics in the financial markets and the commentariat.

Did he really have the weapons? Would he use them? Could he secure support from key stakeholders, most importantly European economic powerhouse Germany, for his strategy? Could he act without that? And could he keep going after a first strike?

The ECB chief sought to answer the doubters when he outlined a strategy for buying unlimited quantities of short-dated bonds of any euro zone country that requested a European assistance program and stuck to its strict conditions.

The word "unlimited" was meant to serve as a warning and signal resolve. It shouted "don't even think of betting against the central bank because we can overwhelm you."

Market players used to the adage "never bet against the Fed" were supposed to hold the ECB in similar awe.

A senior central banker, asked if the new policy was the equivalent of a nuclear weapon, said the ECB stood ready to fight anyone speculating on a break-up of Europe's single currency "if necessary with massive retaliation."

UNDERMINED

But Draghi's big bazooka was undermined from the outset by the declared opposition of Germany's central bank. Even though Bundesbank President Jens Weidmann was alone in voting against the decision, he has used his position to sap German public trust in the policy and by extension in the ECB.

"The key element in deterrence is credibility - making those you are trying to deter believe that you actually would do what you say you would do, that you have not just the military means but the political will," said Simon Lunn, a former NATO defense planner and expert on nuclear strategy.

"Does the ECB have the will, given that it depends on a range of diverse stakeholders, just as NATO does? And can that will be sustained when the going gets tough?" asked Lunn, who served at NATO headquarters during the 1980s Euromissile crisis.

In that phase of the East-West conflict, NATO had agreed to deploy U.S. medium-range missiles in five European countries to counter Soviet SS-20 rockets threatening western Europe.

The strategic aim was to demonstrate that the United States was "coupled" with its European allies and had the political resolve to launch a nuclear war if they were attacked, whether with conventional or atomic weapons.

The victors' version of history is that the Soviet Union blinked, just as it had during the 1962 Cuban missile crisis, and the West went on to win the Cold War without firing a shot.

That account omits many of the difficulties along the road, which hold lessons for the ECB today.

The U.S. missiles scared the Europeans they were meant to protect at least as much as they frightened the Russians, spawning a large anti-nuclear movement and raising doubts about the resolve of allied governments to see through the deployment.

The willingness of the United States, if push came to shove, to put its own homeland at risk for the sake of Germans or Italians unwilling to spend enough on their own conventional defense was always a matter of some doubt.

Possessing a massive nuclear arsenal didn't save the Soviet Union from collapse or the loss of its hold on Eastern Europe due to a combination of economic weakness and political dissent.

The U.S. deterrent was credible partly because Washington had dropped an atom bomb on Japan in 1945. No one could be sure it would not resort to nuclear warfare again, however suicidal.

HARD TO ESTABLISH

The ECB's "nuclear" credibility is harder to establish.

The bank's previous half-hearted intervention steadied borrowing costs only temporarily for weak euro zone countries and did not prevent Greece, Ireland and Portugal being shut out of capital markets and forced into full state bailouts.

The disclosure that ECB policymakers had set a weekly limit on bond-buying made it easy for speculators to game the system.

Banks and hedge funds used the Securities Markets Programme (SMP) as a chance to dump dodgy debt on the central bank and run - not exactly the ECB's desired outcome.

There was also no mechanism to ensure governments helped by the purchases stuck to promised economic and fiscal reforms, and the policy withered due partly to German opposition.

Within weeks of the ECB intervening in August 2011 to buy Italian bonds, then Prime Minister Silvio Berlusconi laughed off the reform pledges he had made to obtain central bank support.

Draghi was determined to avoid another such fiasco when he designed the new Outright Monetary Transactions (OMT) policy.

The bank would buy bonds only if a country accepted strict conditionality and international supervision, and would stop the support if a government veered off course, he declared.

But EU-IMF monitoring of austerity measures and reforms imposed from abroad is so humiliating that the target states, Spain and Italy, are desperate to avoid requesting assistance.

Yet many market players will only believe the ECB if they see it buying bonds on a massive scale.

There are also doubts about the credibility of the ECB's threat to stop supporting a country that goes off track, if the result would be to tip Spain or Italy into default. The euro zone has not dared to risk that even with smaller Greece.

Richard Portes, professor of economics at the London Business School, said the ECB has undermined its own deterrence by making itself dependent on other players.

"To defend the euro, they should have made the intervention unconditional, set a specific cap on bond spreads and stated explicitly that if a country is insolvent in the ECB's judgment, they will let it go," he told Reuters.

As an example of successful deterrence, he cited the Swiss central bank's capping of the Swiss franc's exchange rate against the euro.

"I don't think the SNB had to intervene in any significant volume. Once they had said they would do whatever it took to defend that parity, nobody was going to test it," Portes said.

(Editing by James Jukwey)

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Comments (4)
VonHell wrote:
lol nuclear weapon?…Draghi took the cold war analogy too seriously that he even learned how to bluff like a politician…
Isnt the central bank president just another public employee chosen by the head of state? Some may say the central bank is independent, but this is just talk…
In some public event he announces he has a magic superweapon to finish off the crisis… then in a series of dinners he gathers “support” from the PIIGS finance ministers, politicians, speculators and the dumb media to promote the idea…that he has the solution…
Then he turns to the germans and dutch and try to transfer the responsibility: Now all depends on you lol… must be a joke or the worst corruption attempt ever…
His magical idea: waste money in a bond buying program… unlimited… what is seen as a waste of money since the begining of whole thing together with bailing out banks without nationalizing the banks and transfering the losses to the management, shareholders and bubble investors…
When the media thinks Merkel has an ally in ECB… stabbed on the back by the italian…lol
If anyone intends that fiscal and banking union together with the regulatory body work out… they need get rid of this people… Draghi bows to the spanish and italian govs…
The problem with eurozone is that all are traped in the currency, with the broken links of the chain trying to transfer the burden to the good ones… If Spain was not in the euro, noone would help with the debt and banks and the actions of the politicians could be very different…
What euro needs within its members is a way to dump them out easy as it is to bring them in…

Oct 01, 2012 6:21am EDT  --  Report as abuse
reality-again wrote:
The head of the ECB has the power to detonate a monetary bomb, but it is similar to the power a suicide bomber has to detonate explosives wrapped around their body.
If Draghi carried out his threat in full or in part, the result for the euro currency and the eurozone members would be catastrophic.
It’s a no-brainer.

Oct 01, 2012 8:48am EDT  --  Report as abuse
drh wrote:
Mr Taylor, Good, insightful article. Perhaps some indepth analysis of the Federal Reserves policies regarding the “unlimited” purchase of mortgage backed (toxic) securities is also in order.

Oct 01, 2012 11:06am EDT  --  Report as abuse
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