Photo: World Economic Forum, Flickr
It’s been a wild two weeks in Europe.A couple weeks ago, borrowing costs in Spain and Italy were soaring, and Mario Draghi was forced to make a crucial statement, that surging borrowing costs were impeding monetary policy, and thus it was the prerogative of the ECB to forcefully lower them.
Peripheral borrowing yields instantly fell on expectations that the ECB was about to turn on the printing press to buy sovereign bonds.
Then on Thursday, stocks plummeted and yields soared, as Mario Draghi didn’t explicitly activate any bond purchase schemes.
But Friday, sentiment did a 180-degree turn. Stocks soared! Sovereign borrowing yields collapsed.
Simone Foxman explained here that Mario Draghi had essentially made European leaders a promise. If they get their act together on activating their various bailout funds and moving more towards fiscal union, then the ECB as a matter of policy will work to depress short-term borrowing costs in Italy and Spain.
This is actually much more powerful than mere bond buying. After all, last year the ECB engaged in sovereign bond buying, via a program called the SMP, but the program wasn’t that affective since it didn’t seem unlimited. It seemed temporary and only marginally helpful.
What’s key is that Mario Draghi has been hinting at this kind of deal for several months now.
In a speech in December, Draghi said two paragraphs in a speech which at the time got people excited (though the excitement didn’t last long):
What I believe our economic and monetary union needs is a new fiscal compact – a fundamental restatement of the fiscal rules together with the mutual fiscal commitments that euro area governments have made.
Other elements might follow, but the sequencing matters. And it is first and foremost important to get a commonly shared fiscal compact right. Confidence works backwards: if there is an anchor in the long term, it is easier to maintain trust in the short term. After all, investors are themselves often taking decisions with a long time horizon, especially with regard to government bonds.
This word “sequencing” is everything. If European leaders agree to budget controls, then the ECB will do stuff. Now Mario Draghi, by talking about short-term bond buying is spelling out what those “other elements” that “might follow” are.
If the Euro is going to survive, everyone knows it needs at least two elements: Some kind of ceding of budget control, and a willingness by the ECB, with its printing press, to be the backstop for the other thing. Maybe we’re getting closer.