Following Mario Draghi’s remarks last week in London, wherein he promised that the ECB stood ready to do ‘whatever it takes’ to save the Euro, as long as it was ‘within its mandate’, the markets were flooded with a wave of optimism. This optimism took on frenzied proportions as the head of the Austrian central bank, one of 23 members of the ECB’s governing council, evidenced support for the idea of the ESM getting a banking license. Much of this optimism has vanished in the face of the reality that confronted markets at the ECB’s press conference today. That is not to say that there has been no progress, only that what has been announced is not a game-changer.
We were sceptical at that time and said so. It turns out we were justified in our scepticism. The ECB did not intend to, nor was capable at this point of delivering a 'bazooka'. It has outright rejected the idea of the ESM getting a banking licence, once again. It has however held out a promise to reactivate the defunct Securities Markets Program (SMP) albeit with some important modifications. This note discusses what this means and what impact this may have on the progression of the Eurocrisis.
Spiking skywards? Tackling rising yields in the Eurozone
The Eurocrisis is once again dominating the headlines. Renewed talk of a Greek exit, record yields for Spanish bonds and rising Italian borrowing costs have been splashed all over newspaper headlines. This week Spanish bond yields reached new record highs breaching the 7% level for maturities of two years and above. Italian yields too were trying new highs.
Then the president of the ECB spoke saying that the ECB would do "whatever it takes" to save the Euro. The markets reacted positively and yields fell. There is an expectation in the markets that policy makers may come up with some new measures to address the spiking yields soon. We are much more sceptical both of their immediate intentions to enact more measures and their ability to bring the yields down sustainably. One could hardly expect the president of the ECB to not say that he would do whatever it takes to save the Euro. This Policy Brief addresses two questions 1) why are spiking yields a problem? and 2) what are the near-term options for bringing these down.
The Spanish Donkey, a feared torture device from the middle ages, consisted of a wedge on which the victim was seated with weights tied to his or her legs so that with enough weight, the wedge could even slice though the victim’s entire body. Arguably, the Spanish economy now sits atop such a wedge weighed down by deep austerity measures and unprecedented unemployment on the one side and by large unknown losses in the banking system brought about by a real-estate bubble that has burst on the other.
What is worse is that these two aspects weighing the economy down reinforce each other in a manner that is clearly not understood that well by EU policy makers. The Spanish economy today is at a point where every bit of austerity, measured in percentage points of GDP, leads to a reduction in demand that is even larger. So a 1% cut in government spending is likely to lead to a fall in GDP that is larger than 1%. This is because the uncertainty over the future of Spain and the fact that tomorrow, at this point, looks worse than today mean that neither consumers nor businesses are spending so a reduction in government spending translates directly into lost demand in the economy. What’s worse is that the expectation of falling GDP that accompanies such austerity means that both consumers and firms will make further cutbacks to their consumption and investment plans.
The short but important conclusions from the all night summit of Euro area leaders can be found here.
First the good news, four very important decisions were taken 1) A decision to eventually hand the European Central Bank direct supervision of Eurozone banks 2) A decision to allow, in principle, the European Crisis funds the EFSF/ESM to directly inject equity into troubled banks 3) A decision to waive seniority or preferred creditor status that Member States had claimed for the ESM, for Spain’s rescue 4) An agreement to activate crisis support for Spain and Italy through the EFSF/ESM buying bonds in order to bring borrowing spreads down.
At the eve of what is now being unofficially billed as the summit to save the Euro, things are not looking good at all.
To put it mildly, no one is expecting miracles from this summit. It would be enough if they can avoid this being a disaster.
The political space is now much smaller and the size of the economic problem now much bigger than at the last such comprehensive summit in March 2011. Despite this, the summit will devote far too much time on a highly ambitious political integration agenda, much of which is unachievable in the near future and devote far too little time to tackling the growing economic problems, where action is urgently needed now.