Back in May it seemed that the risk of a broad based break-up of the eurozone was high. Greece looked like electing a radical left wing anti-bailout party into government driving fears it was heading to a messy exit from the euro, which would then further intensify fears that other countries would follow, ultimately taking out Spain and Italy.
The fear of a euro exit was seeing Spanish and Italian bond yields surge anew and their citizens withdrawing their euro denominated deposits from their banks. And it was well known that the eurozone bailout funds were not big enough to bailout both Spain and Italy and the ECB was back on the sidelines. Since then the risk of a break up triggering a financial crisis and global recession has receded significantly.
On the path to irreversibility
To be sure, the euro was flawed from the start. Having a monetary union without a fiscal union (i.e. common budgetary policy) is not sustainable and differences in competitiveness, work ethics and savings are immense across Europe.
But at every flare up of the crisis since 2010, Europe has been faced with a choice: either settle for “less Europe” and an inevitable break-up or push down the path of “more Europe”. And eurozone leaders have consistently chosen the latter. This is evidenced by the advent of various bailout funds, the fiscal convergence starting to occur via the fiscal compact (the ultimate end game of which may be the issuance of common Euro bonds several years ahead), the spreading of rational economic reforms into peripheral countries, moves towards centralised bank supervision, an extraordinary degree of patience shown towards Greece, and the recognition by the European Central Bank that preserving the euro is within its mandate.
At its heart, the euro is the culmination of a grand political vision of a more united Europe that’s been underway for more than 60 years, which European politicians do not want to give up on. So, given all the political capital tied up in the euro, they will continue to find a way to make the economics work. Even if progress looks less urgent than those outside Europe would like to see and seems to trace out a “three steps forward, two steps back” pattern.
Several things have happened to pull Europe back from the brink since May. First, the Greeks supported parties (namely New Democracy and Pasok) that were able to form a coalition government willing to work with the rest of Europe.
Second, eurozone leaders followed their commitment to the June G20 leaders’ summit to “take all necessary measures” to safeguard the eurozone with a leaders’ summit at which they agreed to move to the centralised supervision of banks and more flexible use of bailout funds, enabling them to recapitalise banks directly. Again, “more Europe”, not less.
Third and most importantly, in late July European Central Bank president Mario Draghi put the ECB and Europe on the brink of a major game-changer. Draghi said: “The ECB is ready to do whatever it takes to preserve the euro. And, believe me, it will be enough.”
He specifically tied this to high yields on some European bonds, which reflected fears of a eurozone break-up and indicated that they were hampering the transmission of easy monetary policy across Europe. What’s more, he quickly backed this up with plans to intervene in bond markets in troubled countries in concert with the eurozone bailout funds. So at last the institution with the power to settle the eurozone debt crisis has indicated that it will aggressively swing into action. What’s more, the plan has the support of the German government, and while the Bundesbank is opposed, it looks to be isolated.
The key aspects of the ECB’s bond buying plan (known as Outright Monetary Transactions) are as follows:
- First, troubled countries like Spain and/or Italy will have to apply for assistance to the eurozone bailout funds (most likely the soon to start European Stability Mechanism, or ESM) and sign up to key economic reforms. This gives the ECB comfort that it is not providing money for nothing.
- Second, once this occurs the bailout fund will provide assistance in the country’s primary bond market, i.e. when bonds are first issued, the ECB will then act in concert to buy the country’s bonds in the secondary market in order to reduce borrowing costs to more sustainable levels.
- Third, the ECB’s bond buying will be unlimited, which has the effect of leveraging up the limited firepower of the ESM (with around €400bn left), removing concerns that the bailout funds lack sufficient resources and removing the need for them to become a bank.
- Fourth, while the ECB will focus on buying short-term bonds (out to three-year maturities) as it’s consistent with the realm of monetary policy and provide added incentives for countries to reform, portfolio effects will see the impact transmitted out to longer dated bonds.
- Finally, the ECB has indicated it will not rank senior to other investors, encouraging them to stay invested.
While the ECB is often viewed sceptically by non-Europeans, it would be wrong to underestimate the ECB’s commitment to preserving the euro, with Draghi saying “it’s pointless to bet against the euro…because it will stay and it’s going to be irreversible”.
Draghi has already proven he is very different to Trichet, his predecessor at the ECB. In particular, he has a track record of delivering despite initial scepticism, as was seen last year with the provision of cheap funding for banks.
The important point is that Europe finally seems to have a credible and well-articulated plan to bring bond yields back under control in troubled countries. The ECB’s actions, once they commence, should have the effect of repairing the transmission of easy money across Europe, which should take pressure off the Spanish and Italian economies.