In October 2008, with the eurozone already in recession and Spain at the gates of it, the then president of the European Central Bank (ECB), Jean-Claude Trichetbowed to the voices that had been demanding a drop in interest rates and announced a reduction of half a point for the price of money, from 4.25% to 3.75%.
It did not do it alone, but within a joint action of the most important central banks in the world to face the tsunami that had triggered the bankruptcy of Lehman Brothers a few weeks earlier.
With that decision, Frankfurt rectified and began to respond to a crisis of financial origin that had been damaging European economies for some time. Just a few months earlier, in July 2008, the ECB had raised rates, to 4.25%, despite the weakness of the economic context. He did so determined to fulfill his mandate: to combat inflation in the euro zone, which was at 4% year-on-year.
That decision adopted at a time when the United States Federal Reserve had already begun to lower interest rates to stimulate the economy in the face of the collapse of mortgages subprime, will accompany Trichet’s reputation forever. There is consensus in qualifying that rise as the biggest mistake in the history of the ECB.
Already in February of that year, the French economist, on a visit to Spain, had heard the voices from southern Europe calling for a rate cuts to deal with incipient turbulence economic. However, he considered that his independence and the ECB’s credibility in the face of inflation should prevail and he chose not to succumb to the pressures that also came from other euro countries.
Thus, when Trichet finally agreed to lower rates in October 2008, voices such as French President Nicolas Sarkozy came out to publicly express their satisfaction with Frankfurt’s change of course.
Much has happened since then in a monetary policy that could be said to have reached 2022 exhausted after two financial crises very closely followed.
From 2008 to Greece
Already in 2007 and 2008, the ECB began to inject liquidity into the markets to support the European financial system, always with the shadow that the Federal Reserve was ahead on schedule and ambition.
However, with the highly stressed interbank market, the ECB chose to resort to ‘unconventional’ tools that in those years were colloquially baptized as liquidity hoses to the bank. Auction programs were also opened to support the European financial sector.
In 2009, with the outbreak of the Greek debt crisis, Europe opened the era of austerity. The pulse that is now illustrated as a battle between hawks Y pigeons began to mark began to mark the future of an institution, hardly recognizable 14 years later. By then, inflation was no longer a concern. On the contrary, the risk was deflation and rates reached 1% in the summer. At that time, intervening in the sovereign debt market was one of the Red lines from the northern countries.
However, Trichet ended up crossing that threshold by starting to buy public and private debt in the markets to help the three countries rescued by Brussels: Greece, Portugal and Ireland.
Trichet and Zapatero
Soon, the contagion to Italy and Spain. As a witness of those times of tension, the letters exchanged between José Luis Rodríguez Zapatero and Trichet in the summer of 2011. A few months in which before the attack of the markets, Spain asked the central bank for help to purchase sovereign debt in exchange for offering measures for fiscal consolidation (with a change in the Constitution to limit the public deficit) or for the labor market.
It was in that convulsive context in which an Italian economist, mario draghitook over from the orthodox Trichet at a time when the future of the euro as a common currency was faltering.
‘Whatever is needed’
Draghi’s first decision was only the foretaste of the new monetary era that was opened in the eurozone, with a reduction in interest rates to 1.25%.
If Trichet’s reputation was forever marked by his decision to raise rates in 2008, Draghi went down in history as the savior of the euro for a few words he spoke in July 2012.
The famous “whatever it takes” (whatever it takes) in defense of the common currency was a strong message launched against speculation in the financial markets.
The credibility of the institution made it certain that no speculative attack against Spain or against Italy would succeed against the ECB. Thus began the relaxation of risk premiums after months of high tension.
‘Hawks’ and inflation
Since then, the pulse between hawks (representatives of the northern countries) and pigeons (Southern countries) has been a constant in the decisions of the ECB. The reason was none other than to withdraw ammunition to prevent Europe from experiencing episodes like those that preceded Hitler’s arrival in power due to the increase in prices derived from inflation.
Not without difficulties, Draghi managed to approve its OMT program (Monetary Operations for Sale, for its acronym in English) in September 2012 to buy sovereign bonds in the secondary markets. Furthermore, rates continued to fall to 0.05% in 2014.
Until, in 2015, six and a half years after the Lehman bankruptcy, the ECB finally announced its first major stimulus program to inject 60,000 million euros per month into the economy with which to buy public and private debt issued in the Eurozone.
The now Italian Prime Minister ended his term at the ECB known as ‘SuperMario’. Despite his heterodoxy, his friction with European politics also remained in the newspaper library, something understandable given the independence that a central banker must always display.
A former politician at the ECB
The surprise was when the European Council decided to appoint a former politician and lawyer, Christine Lagard, as the new President of the ECB in October 2019.
A dove that he wanted to take off his nickname to call himself owl under pressure from the hawks for a rapid withdrawal of stimuli from the economy that would prevent a future burst of inflation in the euro zone and allow for ammunition in the event of a new economic crisis in the future.
Just a few months after Lagarde landed in Frankfurt, the pandemic arrived. And with Covid-19, his first slip, when he stated that “we are not here to reduce risk premiums”. The reaction of the markets was immediate and ended up forcing the ECB to launch a program of 750,000 million euros in stimuli.
What happened afterwards was summed up in his column in this newspaper by financial analyst Juan Ignacio Crespo, with the so-called ‘Graph of the century’.
The four major central banks (the United States, China, the Eurozone and Japan) have injected almost 12 billion euros into the economies in two years. Of that amount, around five trillion has been put into circulation by the ECB.
To gauge the impact of that figure in two years, it is enough to remember that, between 2006 and 2020, the money injected to combat the crisis by these central banks was 14.7 trillion.
With the inflation ghost out of the grave (in May it set a new record at 8.1%), Lagarde’s ECB now faces the challenge of draining that liquidity with a war being waged on European territory. To do this, he announced on Thursday the end of sovereign bond purchases, a rate hike in July and another in September.
Thus, what Lagarde described as a “long journey” will begin to return to price stability in a scenario in which a recession is not ruled out if tension with Russia intensifies.
When reviewing the newspaper archives, it can be seen how, since the times of Trichet and Draghi, countries like Spain had been asked to make an effort with labor reform, pension reform or fiscal consolidation so that the risk premium was more resilient to a withdrawal of stimuli that sooner or later would have to arrive.
There were many times that Draghi reminded European politicians from his lectern in Frankfurt that monetary policy could not replace fiscal policy and economic policy.
The pandemic diluted that message while allowing the euro states to issue unprecedented volumes of debt, protected by the liquidity of the system and the credibility of the ECB with investors. A reputation that Lagarde must now consolidate in the face of inflation.
Spain and the periphery
With the recently approved ‘labour counter-reform’ and the rest of the reforms as pending subjects, The Spanish risk premium reaches this moment at a manageable level of 112 points. It is a situation similar to that of Portugal (117) and more comfortable than that of Italy (213) or Greece (249). At the other extreme of the countries that suffered the most in 2012 is Ireland, with a risk premium of 57 points.
Interestingly, the Eurozone is currently facing the threat of an economic recession or, at best, economic stagnation for the war in Ukraine and the sanctions against Russia.
This has returned the ECB to the exit box of the monetary dilemma. It’s time to raise rates and withdraw stimulus to fight inflation without solid growth. The question is how far Lagarde will have to go so that the ECB can fulfill the mandate that obsessed Trichet: maintain price stability, that is, act until inflation returns to around 2%. Something that will not happen until 2024.
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