Buying Time by Buying Bonds

On Thursday, European Central Bank President Mario Draghi outlined a framework for a bond buying program to stabilize financial markets as policymakers tackle the underlying national and eurozone structural reforms that are necessary to overcome the crisis.

The ECB’s bond buying program will be focused on short-term bonds with maturities up to three years, more powerful than if only one-year bills were purchased. The pari passu treatment of private creditors squashes fears that their bond holdings will be subordinate to the ECB’s. Another major feature is the absence of any a priori limits on the size of bond purchases by the ECB, reminiscent of Draghi’s announcement in early August that he is ready to do “whatever it takes”. To mitigate inflationary risks, the liquidity created by ECB bond purchases will be fully sterilized. Purchases of sovereign bonds will only take place under the condition that the country is involved in a European Financial Stability Facility/European Stability Mechanism agreed adjustment program.

If one asks whether these “guns of early September”, (rather than August, see “Mario Draghi’s Guns of August”), will be powerful enough, the answer would be that the ECB’s move will most likely reduce immediate stress in financial markets, although a likely bond purchasing program was at least partially already priced into late August/early September asset prices. Longer-term success will have to have two further dimensions. There has to be the right mix of structural reforms and macroeconomic policies. Too rapid and too draconian fiscal consolidation and short-term demand reduction will likely cause these programs to fail, as recognized by the International Monetary Fund in its Article IV Consultation report on eurozone policies. Moreover, structural reforms must be supportive of sustainable long-term growth. The ECB’s bond buying program provides the opportunity for policymakers to implement serious reforms without facing market panics and capital flight. If the steps toward national policies able to achieve long-term fiscal health but also re-launch growth are not implemented quite quickly, the opportunity created by the ECB will be missed.

Success will also depend on eurozone-wide institutional reforms that have been promised but have yet to come alive. Progress toward greater sharing of sovereignty, a banking union and a common fiscal framework are crucial, as are more expansionary policies in Germany, which is now running the largest current account surplus in the world.