By Sebastian Dullien, Special to CNN
Editor’s note: Sebastian Dullien is senior policy fellow at the European Council on Foreign Relations and professor for International Economics at HTW Berlin – University of Applied Science. The views expressed are his own.
Throughout the euro crisis, it has been remarkable how often the financial markets have gotten things wrong when analyzing policy decisions. After almost every major summit of the past couple of years the markets have reacted with immediate enthusiasm, sending share prices and bonds soaring and bringing spreads down. However, the relief never seemed to last long, and within a few days markets soberly realized that the steps announced after each EU summit were less far-reaching than originally thought, and insufficient to put an end to the euro crisis.
Last week, the financial markets were disappointed by the words of European Central Bank President Mario Draghi. Instead of at once beginning to print money and buying periphery bonds (as some market participants had hoped), or at least cutting the main refinancing rate further from its already low 0.75 percent, the ECB simply announced that its council “may consider undertaking further non-standard monetary policy measures according to what is required to repair monetary policy transmission” (ie bring down excessively high spreads between the yields of periphery bonds and those of Germany) and would work on modalities over the coming weeks. Mario Draghi even made it clear that the ECB would only buy periphery bonds if the country in question had agreed on a program with the EFSF/ESM bailout funds. Markets didn’t like the news, and reacted with rising spreads on periphery bonds and falling share prices. The euro also weakened.
In my opinion, financial markets got it wrong once again. In fact, the ECB’s announcements are almost a revolution relative to its approach to the euro crisis so far. When the ESM becomes operational (hopefully after a positive ruling by the German constitutional court in September), for the first time since the onset of the euro crisis, we’ll finally have the instruments in place to solve the circular problem of market panic driving up interest rates to a point at which these elevated interest rates by themselves threaten a country’s solvency.
To understand this, you need to go back and look why the EFSF/ESM framework so far hasn’t been able to stem the confidence crisis in the euro: While the volume of these two funds looks large (with publicly reported volumes of up to $1 trillion), the effective lending capacity is much smaller and it has always been clear that these funds wouldn’t be sufficient should Italy need a full-blown EFSF/ESM program. It wasn’t even obvious that the funds would be sufficient to cover Spain by itself, given that the problems in its banking system might not yet be fully disclosed. Yet, with significant risks of a continuing crisis in the euro area and the potential for an ultimate and globally disastrous break-up, investors remained reluctant to buy periphery government bonds. As a result, the crippling crisis in confidence hasn’t been solved. Investor skepticism has then translated into high interest rates, which in turn further threaten the solvency of the Eurozone’s fragile periphery nations.
This, however, is exactly the problem that has now been addressed through Mario Draghi’s statement. He said that the ECB will do “everything that is required to reach the objectives” including protecting the euro and repairing monetary policy transmission. Clearly, “everything required” includes bond purchases. Together with his statement that a country needs an ESM program first, this basically amounts to saying that if the ESM has agreed upon a reform path for a country, the ECB can leverage the ESM’s firepower. While this isn’t done by giving the ESM a banking license, but at the ECB’s discretion, it does not change the fact that this potentially increases the ESM’s effective intervention capacity several times.
Specifically, such co-operation could look like this: A country such as Spain applies to the ESM for loans to help financing its budget deficit and agrees on a certain consolidation path and specific reforms. Once the memorandum of understanding is signed, the ECB starts intervening in the secondary bond market to bring down yields and allow Spain to continue to tap private capital markets. The ESM thus needs much less funds than without ECB support and fears of insufficient rescue funds can thus be dispersed. Ideally, this brings down interest rates in the markets and helps bringing the fiscal position of crisis countries back towards sustainability.
So far, so good, but this doesn’t mean that the crisis will be over soon. It’s far from certain that the ESM and ECB will really work as smoothly together as has been pictured above. It is also not certain that the Bundesbank and its president, Jens Weidmann, will refrain from torpedoing this constructive set-up with public criticism, destroying confidence in the market again. The crisis countries’ austerity programs in their current form are much too harsh and will do very little to improve the sustainability of public finances, as they will first lead to deep recessions and therefore a shrinking tax base. Also, issues of macroeconomic imbalances and lack of competitiveness in the periphery vis-à-vis Germany are far from solved.
All that said, with Draghi’s statements from last week, we have for the first time at least a real perspective on solving the problem of elevated risk premiums in the bond markets and the stubborn danger of a self-fulfilling confidence crisis destroying the Eurozone and sending more shockwaves through the world economy. If the euro crisis is to be solved at all, Draghi’s press conference from last week might well in hindsight be viewed as the crucial turning point.