Euro Area Saved – For a Short Moment

Today, markets rallied.  Financial markets around the world let loose a big sigh of relief as the President of European Central Bank (ECB), Mario Draghi, said today at a conference in London that he is ready to do “whatever it takes” to support the euro.  People have been wondering whether or not the ECB would do ‘whatever it takes’ for some time now, and fears were growing that they in fact would not.

Reading inbetwen the lines, “whatever it takes” means that the ECB is prepared and willing to buy sovereign bonds/debt of the troubled euro area countries.  This would take the bonds off the hands of worried banks and investors that already own those bonds, alleviating a lot of fear, and would lower the perceived riskiness of those sovereign bonds since the ECB would step in.  This would put a lot of the financing pressure off the distressed governments that have been caught in the vicious cycle.

The details of what the ECB will actually do should be announced next week.  The ECB may step in to buy newly issued debt directly from the governments (primary market), will buy existing debt and take it off the hands of private investors and banks (secondary market), or both.  What markets are really hoping for and encouraged by is the prospect that the ECB will intervene in the secondary market.

Buying government bonds in the secondary market as a very large market participant will allow the ECB to bring down yields on the sovereign bonds that it buys (bring down the perceived riskiness and required rates of return to hold onto those risky bonds).  This will likely help calm down the markets, restore confidence in the banks, and take a lot of pressure off the governments in the periphery that have been struggling to raise funds to close their budget gaps and help their ailing economies.

But it will not provide the necessary reforms that are crucial to restoring growth and setting the euro on a path out of crisis.  The euro crisis is a vicious cycle of high debt, low income growth (or poor competitiveness), and fear.  The move by the ECB is intended to tackle the fear, but tackling high debt and low income growth will also require the periphery governments to make serious reforms and policy decisions that will help their economies grow and turn the vicious cycle into a virtuous cycle of high economic growth and employment.  The markets realize this.

Although today’s announcement by Mr. Draghi and the expected market intervention by the ECB is very encouraging, the long term problems of growth and competitiveness are still very real, and the future of the euro is still very much in question.

Leaders right now need to quickly exploit this temporary confidence by deciding on promising reforms and adjustments to their current budgets and policies.  They need to help make that temporary confidence more robust, which would in turn lead the euro out of the woods, sparing all of us an even more massive headache.

(Photograph by Mario Vedder/AP Photo)

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