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ECB: Building a Bridge to Nowhere?

EXCLUSIVE: Insight into the long-term pros and cons of the ECB's new bond-buying programme

Kathleen Brooks 14 September, 2012 | 9:00AM

This article is part of Morningstar's "Perspectives" series, which is a series of articles written by third-party contributors. In this exclusive article for Morningstar, Kathleen Brooks from FOREX.com provides insight into the long-term pros and cons of the ECB's new bond-buying programme.

Since the President of the European Central Bank Mario Draghi said that the eurozone is irreversible and the ECB would do “whatever it takes” to save the currency bloc, the markets have rejoiced. Bond markets in Europe’s troubled periphery have staged an impressive recovery, stock markets are higher and the euro is higher. The euphoria went into over drive at the September ECB meeting when the Bank announced an unlimited bond-buying programme to try and bring down borrowing costs even further for troubled members.

Looking on the Bright Side

But is this enough to finally bring an end to the sovereign debt crisis? Looking at the positives first there are two points of note that make the latest ECB plan admirable. Firstly, there is no denying this is bold action from the ECB. Let’s face it: every developed nation on earth relies on a well-functioning debt market. A country is a bit like a business, you need low borrowing costs to even out your cash flow and make the most efficient use of your capital. When those costs start to soar you have a major problem. The ECB is saying that it will stand behind the bond markets of Spain and Italy, which removes a lot of the dysfunction from these markets.

Secondly, the German approach to solving the sovereign debt crisis, which concentrates on austerity and fiscal discipline, has been blamed for exacerbating the problems facing Europe’s periphery. By implementing the bond-buying programme in the face of German disapproval this move is deeply symbolic. It says that the German way of solving this crisis is not the only way. The ECB hopes that by lowering borrowing costs it will generate consumer and business confidence and also help investment to flow into the currency bloc, thus boosting economic growth in the long-term. Only now has a solution to the crisis appeared to have future growth prospects in mind.  

The ECB Can Only Do So Much

In the aftermath of the ECB meeting some commentators voiced their concern over the conditions that will be imposed on a country if the ECB buys its bonds. The ECB will insist that a country first applies either for a full-blown sovereign bailout or a precautionary line of credit. Some have focused on these conditions and the threat they might pose to growth. But conditions or no conditions, the ECB’s latest actions have made the prospect of a Spanish bailout far less scary for the financial markets. In fact, a bailout could be the beginning of the end of Spain’s problems if the ECB’s bond purchases reduce its bond yields once and for all.

A bailout could be the beginning of the end of Spain’s problems if the ECB’s bond purchases reduce its bond yields once and for all

But the ECB can only do so much. It can only look after bank funding concerns and, after announcing its bond buying programme, it can now step into sovereign bond markets. This is a powerful position, but it essentially can’t get rid of any of the debt that caused the sovereign crisis in the first place. It can’t make Greece as competitive as Germany for instance, and it can’t make Germany and the other creditor nations decide to mutualise some of the eurozone’s debt. This is a problem for the politicians to solve. The ECB can solve some of the economic problems in the region, but it will take more than economic reform to ensure the survival of the currency bloc in the long-term.

A Time for Re-Balancing

Essentially the solution is one of re-balancing. Germany needs to spend more and save a bit less, while Spain, Greece, Italy, etc. need to save more and spend a lot less than they have been doing in recent years. One way to do this is to re-balance wage growth. If German workers were paid more they might spend more, but workers in Greece, Spain and Italy need to earn less to make their exports at least as competitive as Germany. That’s not all. Some argue that for the currency bloc to survive the rich countries need to face up to the fact that they must subsidise the poorer nations – a bit like what happens in the USA where richer states make transfers to poorer ones.

This is a huge challenge and progress towards economic and political re-balancing has been slow. There has been some movement towards political union and there are some plans to implement banking union, but most of these ideas are still with working groups. Whether a ‘United States of Europe’ ever sees the light of day is still open for debate. The ECB can’t create this magical world of fiscal union; it can only provide a bridge to it by stabilising the current sovereign situation. If politicians don’t pull their weight then the ECB could be building a bridge to nowhere. 

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About Author Kathleen Brooks

Kathleen Brooks  is research director at FOREX.com, which is a part of GAIN Capital.