We reported last week on the probable endgame for the European sovereign debt crisis.It begins with the European Central Bank explicitly commit ing to hold borrowing costs for peripheral European countries (at least, those countries not on a bailout) within a specific range.
Economists have argued that much of Northern Europe’s resistance to taking more activist measures in the European crisis stems from their super-cheap cost to borrow, which keeps their domestic economies going strong even as peripheral Europe collapses.
Targeting spreads between borrowing costs, however, would likely increase yields on German and French bonds while diminishing those on Spanish and Italian bonds. This would expose states like Germany and France to more of the crisis and eliminate some disincentives for things like eurobonds.
It looks like a similar proposal is finally reaching European leadership, and it could be something leaders are already discussing behind the scenes.
Former ECB governing council member Lorenzo Bini-Smaghi advocates this proposal in a column published in the Financial Times today. He writes:
A request for assistance from the eurozone’s rescue funds could be further de-politicised by setting a threshold, in terms of bond spreads (for instance 200 bp, as in the Maastricht convergence criteria), beyond which the procedure would be triggered in a semi-automatic way. This would be analogous to the excessive deficit procedure, which also implies strict conditionality and monitoring and is launched as soon as deficits rise above 3 per cent.
It’s clear this is more than just an ECB-led measure; Bini-Smaghi is advocating common bond purchases by the European bailout funds as well as the ECB once spreads (the difference between a country’s cost and Germany’s borrowing costs) rise above a certain level. Such actions would require deeper financial commitments from creditor countries like Germany, essentially dragging them forcefully into the fray whenever the spread becomes too high.
Bini-Smaghi qualifies that EU leaders must still work out some problems before this policy can be pursued. When official institutions like the ECB, EU bailout funds, and the IMF purchase sovereign bonds, they become a country’s de facto senior creditors since it’s generally known that they won’t accept losses should a country have to restructure.
ECB President Mario Draghi demanded that EU leaders resolve this problem in his last press conference, and Bini-Smaghi seconds such requests.
We still think that spread targeting is a long way away, since Draghi is using the threat of high borrowing costs for Italy and Spain as a tool to force EU leaders to act. Nonetheless, the game plan for Europe is slowly becoming clear, and this is an important piece of that puzzle.