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Wednesday, 30 July 2014

Draghi and his magic bee

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Beware central bankers selling euros employing false analogies. European Central Bank President Mario Draghi invited us last week to believe a string of unlikely things when he compared the euro’s travails to the supposedly impossible flight of the bumblebee.

James Saft, Reuters Columnist

The news that drove markets upward last week, however, was Draghi’s pledge to “do whatever it takes” to preserve the euro, wording that investors interpreted as flagging another round of bond purchases of weak eurozone nations in the secondary market.

Perhaps more striking was the following flight of entomology: “The euro is like a bumblebee. This is a mystery of nature because it shouldn’t fly but instead it does,” Draghi told a conference in London on Friday.

They did it because he pledged to do something well within his power, if not necessarily entirely in his gift.

“So the euro was a bumblebee that flew very well for several years. And now – and I think people ask “how come?” – probably there was something in the atmosphere, in the air, that made the bumblebee fly. Now something must have changed in the air, and we know what after the financial crisis. The bumblebee would have to graduate to a real bee. And that’s what it’s doing.”

It’s hard to think of a single line of argument that better exemplifies the disorganised magical thinking of euro zone policy makers, and ironically given that markets jumped on the speech, one that gives you better reason to be short the euro and the euro zone.

This reasoning is wrong and confused in a number of ways. First, scientists now do understand how bumblebees fly. They are notably inefficient, which might also be said of the ECB, but the idea that bumblebee flight is scientifically impossible appears to be a myth.

Second, the life cycle of a bumblebee does not include metamorphosis into a “real” bee or honey bee, so asking us to bet on the bumblebee/euro graduating into a honey bee/sound currency is a stretch.

Finally, if we gloss over the internal contradictions and simply take Draghi’s analogy at face value, we are left being asked to believe the euro can be strong because it used to do something no one understood, stopped, but will soon do it again because it will change. It is possible that it will change, but the journey to joined-up currency, banking and fiscal union is a difficult one. Perhaps not quite as difficult as a bumblebee becoming a honey bee, but not to be counted upon.

ECB’s gift

Now hard-bitten investors didn’t buy the euro, stocks and eurozone bonds because they believe Draghi and the ECB can wave a wand over an insect and turn it into another sort of being. They did it because he pledged to do something well within his power, if not necessarily entirely in his gift.

Draghi argued, correctly, that divergent interest rates within the euro zone were breaking the transmission mechanism of monetary policy. If interest rates in Greece are 25 percent for two-year money, despite rock-bottom ECB reference rates, then indeed the ECB isn’t in control and is justified in intervening in financial markets.

This only points out the structural weakness in current arrangements. The ECB isn’t a proper central bank, one that has recourse to the ultimate tactic - financing the government directly by creating new money to buy new debt. That leaves all ECB actions more prone to be tested, as indeed we can expect this latest sally to be.

Bonds did rally sharply on Draghi’s pledge, but if it is not followed by a fleshed-out plan, with evidence of backing from Berlin and, ideally, the Bundesbank, we could see a near-term test to the ECB’s resolve. Thursday, when the ECB announces interest rate policy and Draghi speaks to the press, is a key date. Already the famously contrary Bundesbank has re-voiced its objections to more bond buying, maintaining, rightly, that they set up false incentives.

A key idea, but one that the ECB may not be comfortable with, is granting the European Stability Mechanism bailout fund a banking license, which would allow for a back-door monetisation of sovereign debt, as the ESM could then borrow through the ECB. That idea was rejected explicitly by Draghi in May and would be political poison in Germany, which faces elections in 2013.

It is no wonder Draghi is asking us to believe the impossible; he is being asked to perform the (nearly) impossible and with tools that are far less well suited to his task than a bumblebee’s wings are to its.

The alternatives are dire. Here’s hoping he succeeds, but it is essential to plan for the very real possibility that this bee won’t get off the ground.

(At the time of publication James Saft did not own any direct investments in securities mentioned in this article. He may be an owner indirectly as an investor in a fund. You can email him at jamessaft@jamessaft.com)

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