Does the European crisis need to get worse to get better?

August 3, 2012

Europe will do what it takes to save the euro, after it tries everything else. That seems to be the conventional wisdom about the continent’s muddled handling of a financial crisis now well into its third year.

The latest whipsaw came this week when, having hinted at aggressive action on the part of the European Central Bank, its president, Mario Draghi, backtracked a bit by saying the ECB “may” take further non-standard measures such as purchases of government bonds of countries like Spain and Italy, which have come under extreme market pressure.

John Praveen, chief investment strategist at Prudential International Investments Advisers, notes Draghi appears to have attached a new condition to ECB bond buys. Those countries must first ask for a formal bailout from the European Union, which they are reluctant to do because of the tough austerity measures that would then be imposed on them.

The ECB tied its fresh measures to actions by national governments. Specifically, before the ECB reactivates the SMP and steps in to buy bonds on the secondary market (Spanish and Italian bonds), these national governments will first have to seek formal assistance from the ESM/EFSF (Eurozone’s government bail-out fund) to purchase their bonds. Following the request to the EFSF, the ECB will step in to buy bonds.

Unfortunately, at present, both Spain and Italy are very reluctant to seek EFSF support due to the onerous austerity and structural reform conditions that this would entail. Thus, it appears that the crisis (in Spain and Italy) has to worsen and borrowing costs rise further before these governments are forced to ask for EFSF help. Thus, the ECB is likely to standby until the crisis worsens.

 

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