Part of Foreign Affairs Report: The Future of the Eurozone

The Challenge for Mario Draghi at the European Central Bank

How a Lender of Last Resort Could Reassure Global Markets

The anxiety surrounding the G-20 meeting in Cannes this week only deepened when Greek Prime Minister George Papandreou called for a popular referendum on the debt agreement reached between his country and its foreign lenders, placing the deal in jeopardy. Although Papandreou soon called off the vote, fears of a Greek default highlighted a critical transition at the top of Europe’s banking system. The accession of Mario Draghi, the former governor of the Bank of Italy, to the presidency of the European Central Bank will help decide how the Europeans will address the fundamental problems at the root of the current debt predicament.

Draghi is replacing Jean-Claude Trichet, who is stepping down after eight years on the job. Trichet made the ECB a respected and powerful institution. Only the U.S. Federal Reserve currently surpasses the ECB in steering global market expectations, and Trichet himself became a central figure in EU policymaking and an indispensable partner to European governments. Yet he is retiring in the midst of an emergency. Draghi immediately asserted himself as he took the helm, lowering interest rates by a quarter of a point, to 1.25 percent. But he may need to expand the ECB’s role even further to prevent a catastrophe in the eurozone.

Under Trichet, the ECB undeniably helped to alleviate Europe’s economic troubles. In 2007, when European banks stopped lending to each other out of concern that the toxic subprime loans from the United States on their balance sheets would force some of them into bankruptcy, the ECB quickly injected massive liquidities into the market. This prevented a breakdown of financial transactions, and other central banks soon followed the ECB’s lead. To stop Greece’s debt troubles from spreading, the ECB established a program to buy government bonds issued by struggling European economies, which has absorbed over $240 billion in debt since May 2010. In doing so, the ECB has operated at the legal edge of the Treaty on European Union, which contains a no-bailout clause that explicitly prohibits the bank from rescuing governments in fiscal trouble. Given the severity of the situation, however, Trichet argued that the ECB has a responsibility to safeguard the financial stability of the eurozone.

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