The morning after the night before

September 7, 2012

After some perplexingly negative initial market reaction to the Draghi gambit everything turned around. European stocks leapt nearly 2.5 percent yesterday and Asian shares are set to bank their biggest daily gain in six weeks. Italian and Spanish borrowing costs have fallen markedly.

The fact that the ECB has set no limit on how many bonds it might buy marks this scheme out as very different to its predecessor but we’ve seen many false dawns before so it behoves us to keep an eye on what might prevent ECB President Mario Draghi drawing a line under nearly three years of debt crisis.

       1. Could Bundesbank chief Jens Weidmann, who remains strongly opposed, quit as his predecessor did last year? Very unlikely for now though there could be a later confrontation, on which more below. It was notable how many of Angela Merkel’s political lieutenants were deployed in public to back Draghi yesterday, although the German press have taken an altogether more negative view which could inflame German public opinion.

       2. The biggest risk is that Spain cannot stomach the sort of conditionality and outside intrusion that could be imposed if its seeks help from the euro zone rescue fund, after which the ECB can pile in. Prime Minister Mariano Rajoy declared in advance that he didn’t expect to have to jump through any extra hoops in order to get help. And of course if more austerity is demanded and adhered to, recession will deepen leading to  a Greek-style downward spiral.

        3. The German constitutional court could rule next Wednesday that the new ESM rescue fund should not come into being. That seems extremely unlikely but conditions could be imposed by the court giving the Bundestag more oversight and a growing number of German lawmakers are against doling out more help to euro zone weaklings.

        4. The other big problem could come further out. If Spain reneges on its austerity pledges because they get too painful or Italy elected an anti-austerity government in the spring and also refused to meet its reform commitments, could the ECB really withdraw support, pushing them into default and watch calamity unfold in the euro zone?  It’s very hard to see how it could so the spectre of moral hazard looms large. At that point it is easy to see the Bundesbank and broader German opinion going truly ballistic.

         Despite all the risks, Draghi has potentially bought the euro zone a considerable period of time. If the LTRO money printing exercise delivered three months of calm at the beginning of the year, this unlimited programme could presumably buy a lot more. Governments now have to use it. As key ECB man Joerg Asmussen says this morning, the central bank could not substitute for government reforms.

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