Contents
Sometimes a single sentence is enough to turn a crisis around. But only if everyone believes that the sentence is backed by a power that can and will make it come true. Mario Draghi’s pledge of July 2012 is regarded as one of the most impressive examples of Credible Commitment: a pledge that changes other people’s behavior without the threat having to be carried out.
A market betting on the end
Situation
In the summer of 2012, the euro crisis is at its peak. Investors fear that countries such as Spain or Italy could leave the monetary union. They demand ever higher interest rates on their government bonds. In July, the yield on 10-year Spanish bonds rises above 7%. High interest rates make the debt even harder to bear, and that reinforces investors’ fears.
Link to the principle
A self-fulfilling expectation is at work here. Because many expect the end, interest rates rise, and because interest rates rise, the end becomes more likely. No argument helps against such a spiral; only a commitment that turns expectations around does.
One sentence in London
Situation
On July 26, 2012, Mario Draghi speaks at an investor conference in London. “Within our mandate, the ECB is ready to do whatever it takes to preserve the euro,” he declares. And he adds: “And believe me, it will be enough.” The phrase “whatever it takes” goes around the world. That same day, the yields on Spanish and Italian bonds fall.
Link to the principle
Draghi commits himself publicly, without limit. A central bank can create its own currency in any amount. A speculator cannot win against it if it is determined. So what matters is not the money but the belief in its determination. That is exactly what Draghi creates.
From sentence to program
Situation
On August 2, 2012, the ECB Governing Council announces bond purchases, and on September 6 the details follow under the name Outright Monetary Transactions. The ECB can buy unlimited amounts of short-term bonds from countries that submit to an aid program with conditions from the European rescue fund. The decision is almost unanimous; only Jens Weidmann, president of the Bundesbank, Germany’s central bank, votes against it.
Link to the principle
A sentence alone would not be enough in the long run. The program makes the commitment binding. It shows that the pledge was not just a turn of phrase but has a tool behind it. At the same time, the conditions ensure that countries cannot abandon their reforms.
The weapon that was never fired
Situation
In the years that follow, the program is not activated a single time. Nevertheless, risk premiums fall significantly. A study by ECB economists (Carlo Altavilla, Domenico Giannone and Michele Lenza, 2014) estimates that the announcements alone lowered the yields on two-year Italian and Spanish bonds by about two percentage points.
Link to the principle
This is the core of credible commitment. If the commitment is believed, it does not have to be carried out. The other players change their behavior beforehand. The strongest threat is the one that never has to be carried out.
Limits and controversy
Situation
The program is controversial. Critics in Germany bring a case before the Federal Constitutional Court because they see it as prohibited monetary financing of governments. The court refers the case to the European Court of Justice. In June 2015, the Court of Justice rules that the program is compatible with European law.
Link to the principle
A commitment is only as strong as its legal and political foundation. Had courts or governments stopped the program, its credibility would have collapsed. If you commit yourself, you have to be sure that no one can pull the ground out from under you.
Key takeaways
Key lessons
- Against a spiral of fear, a clear commitment helps more than an argument.
- Commit yourself only if you have the means to make it come true.
- Turn your pledge into a tool, not just a sentence.
- The best threat is the one you never have to carry out.
- Secure the foundation on which your pledge rests.
Summary
In July 2012, the markets were betting on the end of the euro. Mario Draghi publicly committed the European Central Bank to doing whatever it took, and with the OMT program he created the right tool. Interest rates fell, even though the program was never used. The case shows that a credible commitment changes other people’s behavior before a single euro flows.
Sources
- Thomas C. Schelling: The Strategy of Conflict. Cambridge (Mass.): Harvard University Press 1960.
