The European Central Bank offers unlimited aid to euro zone members — but only if they behave

September 5, 2012

Mario Draghi / Hannelore Foerster - BLOOMBERG

Bloomberg reports European Central Bank head Mario Draghi may finally take action to help struggling euro zone members. But there are plenty of strings attached.

For months, commentators have been urging the ECB to buy up bonds from Spain, Italy and other countries who have faced surging interest rates as the euro zone's crisis has intensified. The idea is that the bond buys would allow the countries to charge lower rates, lowering interest costs going forward and giving them some time to recover without worrying that the bond markets would spike rates up and force them to default. Brad described the doomsday scenario well: "If Spain and Italy have to pay too much to borrow money (say, because investors are losing confidence in the future of the euro), then those countries risk hitting an unsustainable cycle of doom. Their debts go up, which raises their borrowing costs further, which means their debts go up further… repeat until apocalypse."

Bond buys would prevent that from happening. Observers were disappointed a month ago when Draghi, despite promising to do all that's necessary to save the euro, declined to promise bond buys. But he suggested such action may be forthcoming in the future, a position in which only the German representative to the ECB, Jens Weidmann, dissented. That was to be expected, as Germany has thus far been least willing to support bank action to save Spain and Italy, but the fact that Weidmann didn't garner any support from other members of the bank was notable.

But good news! Draghi is announcing his next move tomorrow, and sources inside the ECB say he'll buy up unlimited amounts of Spanish and Italian debt. But there are catches. One is that Draghi won't set a "yield cap." That is, he won't commit to keeping Spanish and Italian interest rates below a certain level, say 7 percent (a level that is perhaps best described as the "Danger Zone") to ensure that the cycle of doom resulting from high rates doesn't occur. What's more, the bond buys are "sterilized". That means that instead of printing euros to buy the bonds, Draghi is going to sell other assets to pay for the purchases. That means the action won't have the stimulative effect that bond purchases usually have, or at least what effect there is will be much weaker.

The biggest catch of all, though, is that Draghi won't buy up debt from countries that don't abide by the euro zone's new budget rules, which limit deficits to 3 percent of GDP, and "structural" deficits (that is, those not caused by lackluster growth) to 0.5 percent, or 1 percent for countries with a small debt burden. If states don't meet those standards after he's bought their debt, he'll sell it. To be blunt: Spain is not going to meet those standards. This year, it's on track for a 6.3 percent of GDP deficit, almost double the target. It must either start growing much faster, or institute draconian austerity measures that will cripple growth, to meet the 3 percent figure. So it's unclear whether this new policy means Draghi will buy up Spanish bonds at all. By contrast, Italy is on target, but even then, its fiscal consolidation risks hurting growth which in turn grows future deficits, which could endanger its fiscal standing going forward. And with the ECB committed to not printing new money to finance its bond purchases, Spain and Italy won't be getting a growth boost from the bank.

So Draghi's latest plan gets closer to a policy that can avert disaster. But it probably doesn't get close enough.

Comments
Show Comments
Most Read Business
Next Story
Sarah Kliff · September 5, 2012