Mario faces a Frankfurt bunfight

Fury over Mario Draghi's failure to consult the ECB board on his eurozone rescue plan is dividing the central bank and giving extra ammunition to a savage backlash from Germany.

Market confidence was sorely tested overnight as investors became increasingly aware that 'Super Mario' faced a fierce fight in Frankfurt before he could get around to his mission of saving Spain.

Mario Draghi’s pledge to do "whatever it takes to preserve the euro” prompted a savage German backlash overnight, with a junior member of German Chancellor Angela Merkel’s coalition government arguing that Berlin should take the "unusual step” of launching legal action against the European Central Bank if it steps up its purchases of Spanish and Italian bonds. Joerg-Uwe Hahn, from the pro-business Free Democrats, fumed to the German daily Die Welt that it was now time to examine what measures could be employed to "ensure that the ECB is brought into line to focus on its original task: monetary stability”.

Draghi’s comments also further stoked boardroom tensions for the Frankfurt-based central bank. German, Dutch and Finnish members of the board are furious that Draghi failed to consult the ECB board about his battle plan for saving the eurozone, which they believe will only deepen the crisis.

Draghi’s plan is to for the eurozone’s bailout fund to buy the bonds issued by Italy and Spain, which will ensure that the two countries will be able to continue to borrow at reasonable rates. Meanwhile, the ECB, which is not allowed to buy bonds directly, will hoover up Italian and Spanish bonds in the secondary market in a coordinated effort to drive the borrowing costs of the two countries lower.

But his plans risk creating a serious rift in the ECB board. As the German publication der Spiegel notes, German, Dutch and Finnish representatives "fear that the ECB, out of consideration for the crisis-ridden south, is willing to sacrifice even the most sacrosanct principles to monetary policy.” Meanwhile, representatives from the Mediterranean countries "suspect that the Bundesbank, in particular, doesn't even want to defend the euro anymore and is secretly contemplating a return to the Deutsche mark.”

According to der Spiegel, a deep-seated feeling of mistrust now pervades the ECB headquarters in Frankfurt. Draghi has become "thin-skinned and easily irritated by criticism, especially when it comes from Germany.”

But this has not prevented the powerful Bundesbank boss, Jens Weidmann, (backed by central bankers from the Netherlands, Belgium and Finland) from voicing his criticism of the ECB’s bond buying program, which he believes is expensive, risky and ultimately counter-productive.

Weidmann and his northern allies are aware that Spanish bond yields tumbled after the ECB bought large quantities of Spanish bonds last August. But as soon as the ECB stopped buying, yields quickly climbed higher than they were before the purchases began.

The ECB’s purchases of Greek bonds have proved even more disastrous. In Athens at present, the Greek government is locked in bitter negotiations with the "troika” – officials from the European Union, the ECB and the International Monetary Fund – over its failure to meet the conditions of its latest €130 billion ($US 160 billion) bailout plan.

Athens has asked for an extra two years to meet its targets, but this will require at least €20 billion in extra funding – something that the IMF has already ruled out, and which Germany and Finland are deeply reluctant to provide. As a result, the ECB is coming under intense pressure to help the debt-ridden country by writing down the value of the €52 billion Greek bonds it picked up from its previous doomed effort to drive down Greek interest rates.

The northern rebels on the ECB board are deeply concerned that Draghi’s policies are turning the bank into a pawnshop. They know that Draghi’s earlier plan to flood European banks with €1 trillion in low cost loans has resulted in the central bank’s balance sheet swelling to €3 trillion – even larger than that of the US central bank – and that the bank accepted low grade securities in exchange for the loans. The quality of the ECB’s balance sheet has already been weakened because of the bank’s "sterilisation” policy, which sees it selling the bonds countries such as Germany whenever it buys the bonds of distressed countries, so that the overall money supply does not increase.

They fear that if the ECB now buys more Italian and Spanish government debt, it will never be able to offload the debt, because this would require private investors who are willing to buy at a time when the two countries will be even deeper in recession, and when Spanish and Italian debt to GDP ratios are likely to be even higher than they are now. They fear that there’s a risk that the deepening European recession will mean the quantity of distressed debt will ultimately balloon to a point where it’s simply beyond the ECB’s capacity to absorb it all.

The northern rebels argue that by buying yet more bonds, the ECB is merely helping to temporarily disguise the symptoms of the European debt disease, rather than finding a lasting solution. Financial markets, they stress, will only regain confidence in Italian and Spanish debt if those countries clean up their finances and implement sweeping reforms to boost productivity.

But this will take time, and ‘Super Mario’ knows that markets are becoming increasingly restive. That’s why he’s preparing to do battle with his Frankfurt foes as a prelude to his larger battle to save the eurozone.