Why Draghi likes London

By Hugo Dixon
May 27, 2013

When Mario Draghi was appointed President of the European Central Bank, the German tabloid Bild gave him a Prussian helmet because it admired his Teutonic anti-inflation credentials. The Sun, Bild’s British equivalent, should give him keys to the City of London because of his pro-market credentials.

Draghi likes London. The Italian still has a flat in the city, kept from his time as a Goldman Sachs banker. He is a man with a natural affinity for the markets.

Last week Draghi was in London, the scene of his July 2012 promise to “do whatever it takes to preserve the euro”. The ECB President’s message this time was that Europe needs a more European UK as much as the United Kingdom needs a more British Europe.

He was careful not to wade directly into the British political swamp and say, for example, that the United Kingdom would be crazy to quit the European Union. He confined himself to listing the ways in which Britain’s economy, and the City in particular, are entwined with the euro zone. But it seems clear that he would prefer the United Kingdom to get stuck into Europe rather than stay on the sidelines (where it has been since Britain decided not to join the euro) – let alone quit entirely.

Draghi didn’t say what he meant by a more British Europe. But it is interesting to speculate what the euro zone would be like if the United Kingdom had decided to join the single currency. For a start, the zone’s monetary policy would probably have been less German-dominated – and, hence, less obsessed with fighting inflation to the exclusion of other economic objectives.

The ECB has, of course, still managed to innovate – in particular, with its bond-buying plan which has taken some of the sting out of the crisis. But it always has to watch its back, given criticism from Germany’s Bundesbank and challenges in the country’s constitutional court.

A more British Europe might also now find it easier to adopt a sensible “macroprudential” policy for managing the flow of credit around the financial system. One of the zone’s little noticed potential design flaws is a Germanic insistence on Chinese walls between bank supervision and the conduct of monetary policy, even though both will come under the ECB’s aegis.

While such separation makes sense insofar as the supervision of individual banks is concerned, it could be problematic for macroprudential supervision. Take the current situation. With inflation low, the ECB should be pushing interest rates into negative territory or buying government bonds. The snag is that, while such a monetary policy would be right for the euro zone on average, it would be too loose for Germany.

The sensible approach would be to counterbalance such one-size-fits-all monetary policy with tight credit policy focussed on Germany, implemented via extra high bank capital requirements there. Maybe the ECB will eventually get round to such a rational policy mix. But it would be easier if it could operate like the Bank of England, which doesn’t have Chinese walls.

The zone’s banking system would also, arguably, be in a better shape if it was more British. This is not to deny the United Kingdom’s massive banking crisis. The point rather is that Britain has done a fairly good job of cleaning up the mess, while the zone has tended to sweep problems under the carpet – which has debilitated parts of the economy.

The ECB does have a chance to remedy this error. It has already insisted on a rigorous review of bank loan books and a stress test of their solvency before it takes responsibility for supervising them next year. It now needs to get governments to agree to wind down or recapitalise any banks that fail the test.

Another area where a more British Europe might have been beneficial would have been in shooting down the planned Financial Transactions Tax – which will gum up the markets, in the process disrupting the ECB’s monetary policy. Maybe the FTT will prove still-born anyway given lukewarm support from Germany. But this is not guaranteed.

The same goes for the management of the Cyprus crisis, where the somewhat anti-market European Commission insisted on imposing capital controls against the ECB’s advice. Again, it may not be too late to mitigate the damage. The controls could, and should, be lifted when the resolution of the country’s two big banks is finished. But it would have been better not to have imposed them in the first place.

To some extent, such speculations are academic. Britain hasn’t joined the euro and won’t for a long time, if ever. But there are still two main ways in which a more engaged Britain could advance not only its economic interests in Europe, but Europe’s too.

First, David Cameron’s push for more competitive markets – principally by extending the single market to services and by signing free trade agreements with the United States and Japan – could play a role in solving the euro crisis.

Second, the United Kingdom could campaign for an enhanced role for London’s capital markets in Europe. The EU’s “bankcentricity” – under which finance is mostly routed through a semi-broken banking system rather than the markets – will be a drag on growth.

Cameron and Draghi should make common cause on such an agenda. That’s a practical way to make the United Kingdom more European and Europe more British.

 

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