How Speculators Could Break The New Eurozone Rescue Plan

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Photo: U.S. Army via Flickr

At first glance, Friday’s Eurozone agreement was a big positive, markets are up and Spanish bond yields are down. Though details of the agreement are still very fuzzy, however, there might be one big problem with the effort to support bonds.

A post at VoxEU by Paolo Manasse explains that because the size of the European Stability Mechanism (ESM) is capped at €700 billion ($884 billion), a speculative attack could cause it to fail.

Here’s how it could happen: 

  • The ESM will buy bonds in an attempt to reduce Italian and Spanish yields.
  • Underlying problems and debt in the countries are not resolved, keeping up pressure on borrowing costs and worrying bondholders.   
  • Investors sell bonds to the ESM at greater rates, anticipating a price drop once the fund’s resources are exhausted.  
  • Having already used most of its funds supporting yields, the ESM will be unable buy any more bonds, causing spreads to rise precipitously.

On the other hand, having made the big step in allowing the ESM to buy bonds on the open market, it seems likely that Eurozone policy makers will want to make sure it works. 

Manasse asserts that it will take unlimited funding from the ECB for the plan to work. 

Read the full post at VoxEU

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