Last week Mr. Draghi the ECB governor gave two interviews. One to Frankfurter Allgemeine Zeitung (FAZ)and the other to the Wall Street Journal (WSJ). Both are very interesting and worth reading. I found a part in each interview that stood above the rest.
In the FAZ Mr. Draghi explains why and when a central bank should intervene. Of course as always the interventions is needed when markets do not work properly. This I do not get. If all the agents in the market are wrong what is the extra piece of information that the central bank has that gives it the authority to intervene? There is another facet to the story. It could be that the central bank intervention gets in the way of the “market” solving a problem, pushing out some bad apples, some bad investments. If that is the case then the central bank intervention will only postpone the inevitable.
And there is another effect for the short term as the central bank intervention does the market a big disfavor by pooling the “good” guys together with “bad” guys. Thus, investors will not be able to choose between the two and all the research in the world will not save them from a bad investment.
“How can you tell whether a market price is right or wrong?
One indication is extremely high volatility. Strong fluctuations can shake confidence so badly that nobody dares to lend out money any more. Interbank lending then becomes virtually impossible and the banks can no longer issue any bonds either, even when these – like covered bonds – are well secured. In such a situation one knows that something is wrong.
And then the central bank must intervene?
If the operation of monetary policy is no longer certain because of the distrust, if monetary policy is no longer reaching the economy which negatively affects credit, overall demand and ultimately price stability. Yes, then the central bank must act and work out a strategy for dealing with the disruptions. Of course it depends on the reason for the risk aversion. If it is because of a lack of liquidity, or even just the assumption that the counterparty might be short of funds, then the central bank could help. But if banks have a capital shortfall, then it is not the task of the central bank. ”
On the WSJ interview Mr. Draghi surprises on the positive side. Although the comment that I find important is not about monetary policy but about fiscal policy. Mr. Draghi’s view of future Europe is something I have been advocating for Romania for some time. Hopefully someone will listen now.
“WSJ: Austerity means different things, what’s good and what’s bad austerity?
Draghi: In the European context tax rates are high and government expenditure is focused on current expenditure. A “good” consolidation is one where taxes are lower and the lower government expenditure is on infrastructures and other investments
WSJ: Which do you think are the most important structural reforms?
Draghi: In Europe first is the product and services markets reform. And the second is the labour market reform which takes different shapes in different countries. In some of them one has to make labour markets more flexible and also fairer than they are today. In these countries there is a dual labour market: highly flexible for the young part of the population where labour contracts are three-month, six-month contracts that may be renewed for years. The same labour market is highly inflexible for the protected part of the population where salaries follow seniority rather than productivity. In a sense labour markets at the present time are unfair in such a setting because they put all the weight of flexibility on the young part of the population.
WSJ: Do you think Europe will become less of the social model that has defined it?
Draghi: The European social model has already gone when we see the youth unemployment rates prevailing in some countries. These reforms are necessary to increase employment, especially youth employment, and therefore expenditure and consumption.
WSJ: Job for life…
Draghi: You know there was a time when (economist) Rudi Dornbusch used to say that the Europeans are so rich they can afford to pay everybody for not working. That’s gone.”