Markets wrong about ECB moves
August 9th, 2012
11:49 AM ET

Markets wrong about ECB moves

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.

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Topics: Economy • Europe • Germany

soundoff (8 Responses)
  1. Kailash

    BORING .. LOL 🙂

    August 9, 2012 at 12:17 pm | Reply
  2. kc

    Dullien has it right in this story.It has become apparent that goverments need to be on guard from banks and other corprates.We have entered an era of corprate hand out welfare. Banks get excited when there is any sighn of goverment bailout through loans,or bond purchases,etc.These practices raid tax payer coffers,but are lucative to short sellers.Investment houses seem to think tax payers are a bottomless well of liquid capital,but thier not. If firms wynde up bankrupting a goverment by taking taxpayer funds what do they care as long as they made a profit along the way.The ECB wants to make a situatiion were bond purchases dont leave taxpayers holding a bag of toxic junk.Thats good fiscal goverment response, but bad investment house welfare,so of course there will be complaints.

    August 11, 2012 at 11:24 am | Reply
  3. Odum Bilhirami

    There are no solutions to the economic problems we are facing today. Time will either solve them or events in the world will solve it for us. Remember how Hitler came into power?????

    August 11, 2012 at 8:21 pm | Reply
  4. j. von hettlingen

    All bonds bought by the bail-out funds, or by the ECB would be treated equally to those held by private investors.

    August 12, 2012 at 2:50 am | Reply
    • j. von hettlingen

      But they aren't amused. Being given the "seniority", they should – in theory – be better off in case of a default.

      August 12, 2012 at 2:51 am | Reply
  5. kc

    Saying bonds bought by bailout ,or theECB will be treated equaly is like saying the sky is often blue .Duellien's point is that the ECB would like to see investment banks take steps towards stability rather than just automaticaly buy periphery bonds. Automatic buying of periphery bondsjust entices markets to do whatever and then expect tax payers to float thier losses,while executives get bonuses for failure.

    August 12, 2012 at 1:02 pm | Reply
  6. kc

    Saying bonds bought by private investors or by the ECB will be treated equaly is like saying the sky is often blue.Duellien's point is that the ECB wouldlike to see investment bank stake steps towards stability rather than just buy thier periphery bonds.Automaticaly buying periphery bonds (without consessions)encourages markets to do whatever and then expect taxpayers to float thier losses,while executives get bonuses for failure to produce real market equity.

    August 12, 2012 at 1:21 pm | Reply
  7. deniz boro

    Reading the bold wording gives the message. Almost cross reading but understandable still. For the Regeneration of Global Public Squash

    August 14, 2012 at 2:37 pm | Reply

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