Can Super Mario save the euro?

By Hugo Dixon
July 30, 2012

Can Super Mario save the euro? Mario Draghi said last Thursday that the European Central Bank’s job is to stop sovereign bond yields rising if these increases are caused by fears of a euro break-up. While this represents a sea-change in the ECB president’s thinking, it risks sowing dissension within his ranks. He will struggle to come up with the right tools to achieve his goals.

Draghi seemingly stared into the abyss and had a fright. Spanish 10-year bond yields shot up to 7.6 percent on July 24 while Italian ones rose to 6.6 percent. The high borrowing costs are not simply a reflection of the two countries’ high debts and struggling economies. Investors also fear “convertibility risk” – or the possibility that the euro will break up and they will get repaid in devalued pesetas and liras.

The central banker’s statement that dealing with convertibility risk is part of the ECB’s mandate is therefore highly significant. He rammed home his message, saying: “Within our mandate, the ECB is ready to do whatever it takes to preserve the euro. And believe me, it will be enough.”

Markets responded swiftly. Spain’s borrowing costs fell to 6.8 percent, while Italy’s dropped just below six percent. But these yields have to drop below five percent – and stay there – before confidence in the euro project will return. What’s more, it’s unclear what Draghi will actually do.

One possibility, immediately latched onto by investors, is that the ECB will relaunch its programme of buying government bonds in the market. But such an operation would be tough to calibrate. If the ECB was prepared to do whatever it took to drive yields below a certain level, the pressure would certainly be off Spain and Italy. But politicians might then stop reforming their economies. When the ECB bought Italian bonds last summer, that’s precisely what happened.

That’s why Germany’s Bundesbank, which has a powerful voice within the ECB but no veto over its actions, is opposed to bond-buying – potentially setting the stage for a stormy meeting when the ECB governing council meets to discuss what to do on Aug. 2. It’s not yet clear how big a spoke the German central bank will be able to put into Draghi’s plans.

On the other hand, if the ECB made its support conditional on good behaviour, investors might not be reassured. Their anxiety would be heightened if central bank bond-buying pushed private creditors down the pecking order. That’s what happened when Greece’s debt was restructured earlier this year: private bondholders suffered big losses while the ECB theoretically stands to make a profit. A half-hearted bond-buying programme might therefore simply encourage investors to dump their holdings on the ECB while having no lasting effect on Spain’s and Italy’s borrowing costs.

Draghi may think that the two countries’ current leaders – Spain’s Mariano Rajoy and Italy’s Mario Monti – are more serious about reform than their predecessors Jose Luis Rodriguez Zapatero and Silvio Berlusconi. But even the new leaders have shown signs of losing momentum. Rajoy’s latest spurt of action – further budget-tightening and a plan to recapitalise the country’s struggling banks – only occurred because his back was to the wall. In Italy, meanwhile, Monti says he will stop being prime minister next spring. It’s not clear whether his successor will be committed to reform.

For these reasons, Draghi seems reluctant for the ECB just to buy bonds on its own. Rather, he seems to want to do so in combination with the euro zone’s bailout funds, which have the ability to buy bonds directly from governments – something the ECB is banned from doing. One advantage is that Madrid and Rome would have to sign memorandums of understanding setting out their reform plans in order to access the bailout funds. It would then be easier to hold them to their commitments.

A further idea, reported by Reuters, could help deal with private creditors being pushed down the pecking order. Policymakers are working on a “last chance” option to cut Athens’ debt – involving the ECB taking a haircut on its Greek bond holdings. If that happened, investors would worry less about being unfairly treated if Spain or Italy ever needed to restructure their debts. They might then not view bond-buying as the perfect chance to offload their holdings onto the public sector.

The two-pronged approach is preferable to the ECB buying bonds solo. But it would still put the central bank in the front line of rescuing governments. A better approach would be to scale up the euro zone’s bailout funds and get them to do the entire job of lending to Spain and Italy, if they need help. This could be achieved by letting the soon-to-be-created European Stability Mechanism (ESM) borrow money from the ECB.

Draghi should prefer lending to the ESM than buying Spanish or Italian bonds because, if either country got into trouble, the bailout fund not the ECB would take the first losses. Unfortunately, the ECB said last year that extending loans to the ESM would contravene the Maastricht Treaty – a position Draghi himself repeated after he took over as president, even though there are plenty of lawyers who think the opposite.

Super Mario is now warming to the idea of lending to the ESM, according to Bloomberg, even though that’s not part of his immediate plan. If Draghi does this, he’ll have to find a way to eat his words without losing credibility. If not, he will have to rely on second-best options with all their drawbacks. Mind you, it’s the job of super heroes to get out of tight spots.

9 comments

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Saving the Euro – PLEASE! All the undercapitalised, overleveraged financial sector is really worried about is saving their own skins and using any opportunity their sugardaddy Mr Draghi offers them to dump their Spanish and Italian bonds onto his lap (while once again socialising their potential losses/costs onto society and protecting themselves from their own “priveleged” failure).

Mr Draghi – Please don’t confuse saving the Euro with saving irresponsible bankers from the stupidity of their own actions (e.g. lending to banks at 30+ times leverage and to peripheral governments at the same rates as Germany). Banks can and should be allowed to fail and governments should be allowed to default. The ECB would be much better off letting these failures/defaults happen and only then using taxpayers money to recapitalise the system (this would come at much lower long term costs and risk to taxpayers in the Eurozone)

Posted by Maunsell | Report as abusive

This article restates the fact that all the ECB can do is buy time by keeping the system liquid. Buying time in order to finance governments while their economic systems adjust to budget cuts and market reforms is a good idea.

These countries are not reforming their economies. Labor markets are still rigid, and it is very difficult to open new businesses considering all of the red tape. Basically, the current European strategy is to keep the whole dysfunctional system intact while hoping for a miracle to save everything before time runs out. Now, how many Spanish and Italian bonds do you wish to buy for your portfolio?

http://dareconomics.wordpress.com/

Posted by dareconomics | Report as abusive

kicking the can…

Posted by robb1 | Report as abusive

Europe is a terminal basket case until the elite and the electorates (as in the UK) come to the conclusion that the current and past (Delors) logic is the road to ruin.
To achieve this the Euro has to fail – action to support it just continues the agony and increases the terminal pain.
National currencies, sound money, budgets balanced over the cycle, less state,free trade, lower taxes, deregulation,confronted vested interest, progressive lowering of national debt and floating exchange rates are the route to prosperity.
Perchance to dream.

Posted by Northwesterner | Report as abusive

some bloated eurozone governments need to downsize and stop corrupt dependencies on their debt-fuelled spending (greece and sicily come to mind, as well as spain and italy)

those co-dependencies also include the us and uk
- geithner was pleading with scheuble to allow draghi and the ECB to use its tricks to solve their trans-atlantic banking problems (carrot and stick diplomacy in the form of continued IMF support for failing euro states)

@ Maunsell – agree

@ robb1 – the BoE is kicking the uk can down the road into a depression

Posted by scythe | Report as abusive

Mario Draghi is an unelected banker whose allegiance to the financial cartel, which includes the ECB, appears greater than it should for a national leader. To refer to him as Super Mario seems contemptible. I am assured though that Mr Draghi will ensure an extremely profitable environment for his shareholders.

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