European Central Bank President Mario Draghi delivered on his promise to “do whatever it takes” to defend the euro, unveiling a plan Thursday that will allow the ECB to purchase unlimited amounts of short-maturity European sovereign debt. The plan represented the bazooka investors were hoping for since the start of the crisis, and equity markets rallied in response, with the S&P 500 Index climbing to its highest level since 2008.
There is no doubt that the program, which goes by the catchy name Outright Monetary Transactions (OMTs), marks a significant evolution in the ECB’s thinking. With its unveiling, the ECB has helped to mitigate one of the biggest sources of systemic risk in the global economy. It also provided a necessary, but by no means sufficient, condition to fix Europe. While the program buys time, I see three main areas that still need to be addressed:
- a plan for further fiscal consolidation;
- structural and growth initiatives, and
- banking integration.
The latter is the biggest near-term worry. Until there is a functioning EU-wide banking system in Europe, complete with some version of euro-wide deposit insurance, a euro in a Greek bank will continue to be worth less than a euro in a German bank.
The ECB is the only institution in Europe with the financial firepower – by means of an unlimited printing press – to address the near-term threats facing the euro. By riding roughshod over the Bundesbank’s historical opposition to unlimited bond purchases, the ECB has at least temporarily capped European sovereign bond yields, mitigating the risk that a loss of confidence in Spanish or Italian debt will lead to dissolution of the euro.
The program does have limitations. The purchases will only be for sovereign debt of three years maturity and below, and the purchases will be sterilized, meaning that the ECB will soak up the extra liquidity to prevent a surge in the money supply. That said, investors got most of what they were looking for, including a pledge by the ECB that they will not have seniority to other bond investors, a necessity for the bond market.
The program should keep a lid on bond yields – Portuguese 10-year yields dropped nearly 70 bps on the day, and Spain’s were down by 35 bps. In order to avoid the fleeting euphoria of previous rallies, European politicians must use the time the ECB has provided to actually deliver on structural reforms.
To date, the political class can’t be faulted for making little progress on either fiscal consolidation or pro-growth initiatives. Italy still needs to reform its labor market and Spain has yet to fully clean up its banking system. Thanks to the ECB, European politicians now have the gift of time. Whether or not political realities allow them to meet these challenges is still an open question.