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On Wednesday, Mario Draghi, head of the European Central Bank, appeared before the German Bundestag to explain himself. In September the ECB announced a program of “Outright Monetary Transactions.” The bank will buy three-year member-state bonds in the secondary market, subject to what it delicately calls a “macroeconomic adjustment”—writing austerity into the member state’s budget. The program, the bank hopes, will lower the yields on these bonds, in turn lowering the state’s financing costs. Jens Weidmann, head of Germany’s Bundesbank, has said the action will just print money and even went so far as to compare it with an inflationary plan from the devil in Goethe’s Faust. This leaves Draghi with both an economic and a political problem. He has to save Europe from its sins. And still, even though the German Bundestag and high court have already nodded their approval of the ECB’s European Stability Mechanism, Draghi has to convince the Germans that he is not compounding Europe’s sins with more of his own.
The market, he explained in his prepared opening statement, is wrong. A central bank can’t just set market lending rates. It sets the few it can directly control, then hopes those rates seep into the market through what is called “monetary policy transmission.” In normal times, this transmission works, unseen; in interesting times, it can become blocked. Banks in Europe, Draghi said, aren’t passing on low interest rates equally to all businesses and households in the euro area. Here’s where a market purist would answer that investors perceive risk in Spain and are pricing it in. Not completely so, says Draghi. Investors, he told the Bundestag, are “charging interest rates to countries they perceived to be the most vulnerable that [go] beyond levels warranted by economic fundamentals and justifiable risk premia.” This fear, he said, is “unfounded.” The market is wrong.
He would say that. He’s trying to get the market to relax. But there’s reason to believe him. When the financial crisis started, central banks had only a theoretical understanding of what might happen if they did anything other than move interest rates up or down. But five years have now passed since the first bank run in the U.K., and central banks are beginning to look at the empiric data of what’s actually been happening. Several recent papers support what Draghi is saying. Last year economists from the Peterson Institute for International Economics and the Federal Reserve Bank of New York found that, in the U.S., the Federal Reserve’s large-scale asset purchases “led to economically meaningful and long-lasting reductions in longer-term interest rates on a range of securities, including securities that that were not included in the purchase programs.”
This has been true in Europe, too. In July, Germany’s own Bundesbank looked at the effectiveness (pdf) of the ECB’s actions early in the crisis. It found that, after October 2008, the bank had a harder time moving Euribor rates—what banks in Europe estimate they will be charged to borrow money from other banks—through traditional monetary policy. As Draghi explained to the Bundestag, monetary policy transmission stopped working. Moreover, the paper found that, by loading up its balance sheet late that year, the bank was able to exert a “significant influence” on Euribor rates, lowering them by at least 80 basis points. Germans and their parliamentarians, as they consider what Mario Draghi said Wednesday, should listen to the economists at their own bank. Central bankers can’t always just set interest rates and hope for the best. Draghi isn’t succumbing to an inflationary whim. He’s relying on what has become a best practice.