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Draghi's plan is a bold one, but who will bite?
Spain may look at the European Central Bank's plans, look at Greece and say 'no thank you'
07 Sep 2012
Stephen King, Group Chief Economist
You have to feel sorry for Mario Draghi. The problems confronting the President of the European Central Bank are far greater than those sitting in the in-trays of his colleagues in Washington or London. Ben Bernanke doesn't have to worry about keeping California in the dollar bloc, even though Sacramento does not have a favourable credit rating. And while Alex Salmond might dream of Scottish independence, Mervyn King has not yet had to grapple – at least not in public – with the currency implications of border controls north of Berwick-upon-Tweed.
Mr Draghi, however, now has to use his monetary powers to save the euro. His actions yesterday were designed to do exactly that. By buying government bonds, he hopes that the ECB can reduce the cost of borrowing – both for governments and the private sector – in those nations most badly scarred by the crisis. By doing so, he hopes to end the capital flight that was threatening to engulf the euro.
Over the summer, the German Government could borrow money for two years at an interest rate of 0.4 per cent. Italy was being charged well over 3 per cent, while Spain had to pay more than 4 per cent. Mr Draghi's bond-buying programme, so-called Outright Monetary Transactions, is designed to create a semblance of order in what was fast becoming a chaotic situation.
The higher borrowing costs in the periphery reflect growing fears of default, departure and break-up. Weak growth led to bigger budget deficits. Bigger budget deficits led to more austerity. More austerity led to weak growth. And the longer the suffering went on, the more likely it was that something would snap.
Understandably, investors headed for the exit – more accurately, a route northwards across the Alps and the Pyrenees. Fearing both euro break-up and subsequent devaluation, they no longer felt confident keeping savings in Italy or Spain. Yet the sight of suitcases full of money heading to Germany and other "safe havens" only made things worse. There may have been a single currency but there was no longer a single interest rate. And it was those nations with the deepest recessions that, in the topsy-turvy world of the eurozone, ended up with the highest borrowing costs.
Not everyone is happy with the plan. The Bundesbank, home of German monetary conservatism, is aghast at the idea of the ECB buying government bonds: the folk memory of the Weimar Republic is too deeply etched into its psyche. Yet Mr Draghi is hardly a soft touch: any government that hopes to benefit from the ECB's scheme will be subject to strict conditions. For the likes of Spain, that probably means a "full macroeconomic adjustment programme", a euphemism for year after year of continued fiscal austerity, imposed by the European Commission and monitored by the IMF.
That creates a dilemma. Greece has been under just such a programme over the past couple of years. At first, the costs were considered to be modest. In May 2010, for example, the IMF projected a decline of 2.6 per cent in Greek national income in 2011, followed by a 1.1 per cent recovery in 2012. These numbers have proved hopelessly wide of the mark. Greek national income dropped a shocking 6.9 per cent in 2011. A decline of similar magnitude is on the cards for 2012.
True, Greece was unable to benefit from Mr Draghi's scheme. But it did benefit from a prototype version that did little to keep a lid on its borrowing costs. Given the Greek experience, other countries will surely be wary of getting hooked on the ECB's bait. The promise of lower interest rates is enticing, but nothing can really happen until the fiscal conditions are spelt out. That may mean that Spain, for example, will reject Mr Draghi's overtures.
While the scheme shows that the ECB will do all it can to ensure the euro's survival, it also highlights the limits of central bank power. Even if their interest rates fall, Spain and Italy still face enormous headwinds, not least austerity and a serious lack of competitiveness. The risk of break-up may have been reduced but, despite Mr Draghi's best efforts, the euro's internal contradictions have not yet gone away.
Stephen King originally wrote this article for The Times newspaper, published on 7 September 2012.