08/03/2012 11:47 am ET Updated Oct 03, 2012

Did Draghi Say What Investors Heard?

At the global investment conference in London on 26 July 2012, Mario Draghi, the president of the European Central Bank (ECB) said "[W]ithin our mandate, the ECB is ready to do whatever it takes to preserve the euro. And believe me, it will be enough." Markets reacted jubilantly and commentators were ebullient about the remarks essentially calling them a "game changer" in the attempts to address the on-going crisis in the eurozone.

When we look closely at the text of Draghi's remarks and place them into context, a different interpretation appears much more likely. Just as Ben Bernanke, the head of the Federal Reserve in the United States, said in his testimony on 17 July 2012 before the US Congress, "communication" is one of the tools that a central bank has in the tool box to affect markets. The Financial Times noted that communication was one of two main instruments at the Fed's disposal. Draghi's remarks look more and more like a statement of the obvious, trying to affect markets without actually taking any action. Would the head of the ECB say anything different? Would the ECB ever say that they would not or could not act? That their actions would fall short of what is necessary? Would they ever say that any actions that they might contemplate would fall outside their mandate? Surely not.

But, of course, this is not the way markets took it for a very clear reason: regardless of whether the statements were a statement of the obvious, investors seized upon the words as a way to try to force the ECB to take action. Markets started speaking about massive purchases of Spanish and other eurozone government securities and about giving the European Stability Mechanism (ESM), the permanent bailout fund that will gradually take over from the European Financial Stability Facility (EFSF), a banking license so that it could lend directly to governments and banks.

Investors of course are not unknown to "talk their own book." Trying to push the ECB into action would positively affect their investment positions. Again investors look for government action to bail them out of investment risks they willingly undertook -- they take the upside by investing more risky investments like Spanish government, bank or regional government bonds, but then they look for government action to cushion or eliminate the downside.

Pushing markets up on the back of comments by Draghi would make it more difficult for the ECB not to take bold action as expected by the markets as disappointment would cause markets to fall, perhaps more than they rose in anticipation of ECB action. The ECB does not want to be seen as the cause of falling markets and falling confidence, so indeed the ECB may feel it is under some pressure to act.

Investors are at the moment looking at the short-term. They complain about the lack of policy response from European political leaders and complain that the remedies are clear and it is just lack of conviction or lack of understanding by the politicians. (It does not help when the criticism of eurozone leaders is motivated in the UK, the heart of the European financial sector, by euro-sceptic sentiments and a hidden joy that the euro project is in crisis.) What investors do not understand is that politicians are looking for the proper policies to address the euro crisis -- policies that will address not only the current issues but also longer term structural issues -- not simply actions that assuage markets. We have come so far in the globalisation of markets that in many circles, notably in the City of London and on Wall Street (and these do have a disproportionate influence on UK and US government policy thinking), that we think it is perfectly normal that politicians should look to markets as a measure of whether their policies are correct or that politicians should adopt policies that markets will cheer. In fact, no one elected markets as the arbiter of proper policies and the more we allow markets to lead government action, the more we will achieve the result of bailing out investment decisions not based on a financial risk/reward analysis, but on a game of chicken with governments.

The question that is not asked is what policies will serve the people. With the focus on market reaction and markets seeming to try to push governments and central banks into actions whose benefits will accrue to the few, it is no wonder that public perception of the financial sector is so low.

Unfortunately, investors hear what they want to hear. The business and investment media, whose main sources come from the financial sector, do not challenge these ideas.