Mario Draghi, President of the European Central Bank
Over the summer, Mario Draghi, the governor of the European Central Bank, told the world that he would do “whatever it takes” to save the euro. On Thursday, what that actually means in practice finally became clear: The ECB’s governing council agreed on a plan to buy the sovereign bonds of troubled eurozone nations that are under attack in financial markets.
The new policy, agreed to after intensive behind-the-scenes negotiations by Draghi with European policymakers and central bankers, comes with some significant caveats. The biggest is that any national government that wants the ECB’s active help to fight off financial speculators must first agree to embark on a program of tough macroeconomic policy measures, and then must follow through. The International Monetary Fund will be brought in, alongside European authorities, to tailor the “conditionality” that is best suited to the nation in difficulty. Those terms may be difficult politically for governments to accept, especially Spain, whose bonds have been a major focus of market attacks over the past few months. (The ECB, which calls its new bond-purchase plan, “Outright Monetary Transactions”, outlined the details here.)
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The decision nonetheless amounts to a significant shift in tactics, and marks a political triumph for Draghi, who overrode strong German objections to such a plan. The head of Germany’s central bank, Jens Weidmann, has been outspoken in his opposition to the ECB essentially bailing out national governments; he has argued that such a move would go far beyond the mandate of the central bank, and may make heavily indebted countries less likely to take the tough measures they need to bring their economies back to health.
The ECB decision was not unanimous. Draghi said one member of the council had voted against it, but didn’t specify who it was. The German press has been filled with speculation this week that Weidmann has considered resigning in protest.
The logic of the new policy from the bank’s viewpoint is that the speculative attacks on the sovereign debt of countries like Spain and Italy create a destructive spiral: By pushing up borrowing costs, the markets can make it impossible for nations to refinance their debt, thereby raising the risk of default, which in turn threatens the euro’s existence. The new plan “will enable us to address severe distortions in government bond markets which originate from, in particular, unfounded fears on the part of investors of the reversibility of the euro,” Draghi said. “Hence, under appropriate conditions, we will have a fully effective backstop to avoid destructive scenarios with potentially severe challenges for price stability in the euro area.”
The ECB isn’t saying at what level it might start to buy sovereign bonds. For a period in July, the yields on Spain’s sovereign bonds were trading above 7%, an unsustainable level at a time when interest rates in Germany and the U.S. are close to zero.
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To head off potential inflationary implications of the new policy, the council agreed that any sovereign bond purchases should be “sterilized” – in other words that purchases of bonds would be offset by sales of other holdings, in order to avoid any increase in the money supply. There would also be an important element of transparency involved: The ECB plans to publish a monthly breakdown by country of the amount of sovereign bonds it has purchased.
Will all this be enough to save the euro? Financial markets have been rising this week in anticipation of such a decision. European stock markets jumped further on the news, and the euro rose. Most significantly, pressure on the borrowing costs of the most troubled European nations has eased. That comes as welcome news for the entire continent: The latest forecasts by both the ECB and the Organisation of Economic Cooperation and Development suggest that European economies — including Germany’s — will contract in the second half of this year.
But as the crisis in the 17-nation monetary area has spread and grown over the past two years, there have been plenty of other decisions that initially brought relief but didn’t end the troubles. In fact, one of Draghi’s first moves on taking office last year was a huge injection of liquidity into European banks, which provided respite that turned out to be temporary.
What’s different about this decision is that the ECB has a gigantic arsenal it can employ against market players. That’s likely to serve as a big deterrent. But it will only be able to begin using that arsenal if governments are willing to sign up for the tough measures. And the markets are likely to test the new policy to the full, to check whether it’s credible.