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Draghi's next move

Zhang Danhong / sgbSeptember 3, 2014

The eurozone is not in good shape: The economy is stagnant, unemployment remains at record levels, and the specter of deflation is about. Many politicians are looking to Mario Draghi to solve their fiscal problems.

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ECB's Mario Draghi

Two years ago Mario Draghi, head of the European Central Bank, saved the common European currency with a single sentence.

"Within our mandate, the ECB is ready to do whatever it takes to preserve the euro", he told the Global Investment Conference in London.

But while Draghi put to rest speculation about a breakup of the monetary union, he also took the pressure off ailing euro countries to carry out tough structural reforms.

Problem children France and Italy

As a result, French President Francois Hollande took this as a license to vacillate - and is now exactly where he was two years ago. And Italy's third prime minister within two years tried to placate his euro partners by implementing only mini-reforms. With two of its heavyweights ailing, the economy of the entire eurozone stagnated.

These problems are compounded by the continuing fall in inflation, most recently to 0.3 percent, an even further slide from the target value of just under 2 percent. Fears are now growing of deflation - a vicious circle of falling prices, vanishing investment and a decline in the economy.

Against this background, speculation is running wild as to what "Super Mario" will announce on Thursday (04.09.2014) following the ECB's monthly board meeting.

Reduce interest rates or buy bonds?

The ECB chief can barely do anything more with interest rates. In early June he lowered the key interest rate for the eurozone to a record low of 0.15 percent. That's about as far as monetary policy can go.

The central bank could, for example, create money through the simple expedient of buying government bonds. The United States already led the way, giving this the inocuous name of quantitative easing (QE). With the newly printed money, companies can invest and create growth.

This is not as easy in the eurozone, where 18 sovereign states have bonds on the market. Which ones should the ECB buy? If it bought proportionally, the biggest share would come from Germany. But this would make no sense, because the German economy is in robust form and is in no need of support from the central bank.

If the ECB but only bonds from weak euro countries, as it has already done, it would reek too much of monetary financing, which is forbidden by the ECB Statute and would encounter stiff resistance, especially from Germany.

Time for a kick-start?

It's a similar situation with corporate bonds. There are enough buyers for debt securities issued by solid German companies. In contrast, there is only a small market for bonds from medium-sized Italian companies. If the ECB stepped in here, the papers would soon disappear completely. That would constitute a fairly drastic market distortion.

That's why the central bank isn't looking at individual corporate bonds, but bundles of them - the infamous credit securitization or asset-backed securities (ABS). These were discredited because they obscured risks - and triggered the global financial crisis in 2008. In Europe, the market for ABS dried up soon afterward.

Now Draghi wants to revive this market. A few days ago, he brought in US asset manager BlackRock to help design and implement an ABS program for the ECB. Since the preparations will take some time, few observers expect Draghi to reveal details of the program on Thursday, but they do expect him to reaffirm his intentions to begin buying bonds later.

What has already been decided is that banks in the eurozone need to be generous with money again. In September they will receive the first of two installments totaling around 400 billion euros. The banks are expected to pass on this money to companies as loans. In late 2011 and early 2012, the ECB tried to provide banks with liquidity using long-term refinancing operations like these, because their trust for one another had broken down.

Who's afraid of a weak euro?

While experts quarrel about the effects of these monetary-policy regimens, some euro countries are already delighted with one side effect: For four months, the value of the euro against the dollar has gone in only one direction - down. This makes goods from the eurozone cheaper and strengthens the competitiveness of the euro countries. A weak euro also increases the cost of imports and could help fuel inflation.

The ECB is apparently only worrying about how it can pump even more money into the markets at the same time the Fed has begun to tighten its leash over monetary policy. That means the downward trend of the euro is likely to continue for a while. And certain politicians will likely be thanking Mario Draghi once again for taking the pressure off them to implement harsh reforms.