Santa Claus operated out of Frankfurt last year – and gave the Eurozone the fiscal equivalent of several billion stocking-fillers. But the European Central Bank’s largesse may not extend to those who don’t believe in it, writes Alan Shipman.
A single act of generosity by Mario Draghi, the European Central Bank (ECB) governor, has restored lasting calm to the previously turbulent Eurozone, neatly deflecting the winter blizzards across the Atlantic.
Draghi’s most dramatic achievement is to have radically reduced the cost of borrowing for Italy, Spain and other Eurozone countries that have large budget deficits to finance. This cost (the ‘bond yield’) fell to less than 5% in Spain’s early-January auction, from a crisis peak of more than 7.5%. It is a similar story in Draghi’s native Italy, where the public finances have been so effectively shored-up that voters can even contemplate a Silvio Berlusconi comeback. By promising ‘outright monetary transactions’ (OMT), the ECB has asserted the market-stabilising power long enjoyed by its American equivalent, the Federal Reserve. As a result, investors searching for higher yields have now moved back into corporate bonds and shares, lifting Eurozone stock markets to their highest level for two years.
From regarding the Euro area as a sinking ship that would either have to ditch its weakest members or be dragged underwater by them, some investors now view it as a better sovereign borrower than the previously mighty US. Both are currency zones with wide fiscal deficits. At present the US has a more impressive growth rate, while there is still a risk of weaker Eurozone members being cut adrift and forced into default. But in the longer term – if it can now hold together – the Eurozone has a better external balance (exporting more than it imports, thanks to Germany), greater power to impose fiscal discipline on its members, and stronger safeguards against unleashing inflation (sovereign borrowers’ traditional way of short-changing their creditors after securing the cash).
Debt guarantee
Perhaps most remarkably, Draghi has achieved this monetary escapology without having to part with a single euro of ECB funds. All he has done is announced that his bank will, in future, buy up the debt of any Eurozone country that is forced to default. This guarantees the debt of Italy, Spain and other struggling member-states, making it safe for ordinary investors (and investment funds) to buy. Their governments can now continue to finance the public investment needed to restore growth so that banks and households can bring down their own debt, and the costs of welfare support until new jobs emerge.
The announcement was well timed, coming at a moment when banks and bond-buyers are globally desperate for high-yielding issues, and prefer those which have a government behind them, regardless of quality. After all, Ukraine with an economy stalled by sliding steel sales and politics sliding back into industrial oligarchy and Latvia bailed-out by the IMF in 2008 and dragged through Europe’s deepest ever recession have recently made successful bond issues, despite having higher currency risks and lower credit ratings than any Eurozone member.
Neither Spain nor Italy, the most dangerous of the Eurozone’s weak links, has asked for a bailout so far. Both know that, if they do so, they will be subject to a German-driven, EU-administered ‘adjustment programme’ – worsening their already perilous economic and social situation, and probably discrediting whichever government has to enforce the emergency measures. Their additional borrowing is raising the scale of any future rescue effort. The ECB’s calculation is that, by making it clear that all Euro debt will be honoured in the event of a bailout, this becomes less likely to happen. That’s because member countries now have the fiscal strength required to drive a recovery, and because speculators will stop short-selling the debt in order to fulfil their own expectations of its collapse. The ECB’s promise buys time for governments to act so that the promise won’t need to be fulfilled.
Cross-Channel fallout
If this gamble works, it should be good for other European governments – notably the UK, which will blame its imminent return to recession on the weakness of demand and investor confidence in the single currency area. But in one important respect, the Eurozone’s improbable gain is its non-members’ loss. The UK had retained its top AAA credit rating, allowing it to finance its overrunning budget deficit at negligible cost, partly because it was regarded as a ‘safe haven’ for investment funds that felt at risk from Eurozone exposure. Now that Euro debt has been turned into a positive one-way bet, that of the UK doesn't look so enticing.
A credit-rating downgrade need not (as the US has demonstrated) cause any rise in UK interest rates, or loss of confidence in its turnaround strategy. But it makes it harder to maintain the present low rates long enough to complete the banks’ recapitalisation and float Britain’s mortgage borrowers off the rocks.
Mario Draghi is unlikely to be on George Osborne’s Christmas Card list at the end of 2013. But if his gamble succeeds, it’s a small price to pay.
Alan Shipman 24 February 2012
Alan Shipman is a lecturer in Economics at the Open University. He is responsible for the modules You and your money:personal finance in context and Personal investment in an uncertain world, part of the foundation degree in Financial Services.
The views expressed in this post, as in all posts on Society Matters, are the views of the author, not The Open University.
Cartoon by Catherine Pain