August has been a dangerous month in European history, but this year it could be the turning point for the eurozone – and perhaps for the world economy. On July 26, Mario Draghi, President of the European Central Bank, declared that his institution would do “whatever it takes” to preserve the euro, and added: “Believe me, it will be enough.”
Draghi’s strong – indeed, unprecedented – statement was widely interpreted as signaling that the ECB would soon revive its bond-purchase program, focusing on Spanish debt in particular. Stock markets around the world soared. Jens Weidemann of the Bundesbank immediately expressed reservations, but the next day German Chancellor Angela Merkel and French President François Hollande issued a joint statement expressing their determination “to do everything in order to protect the eurozone.”
I recently argued that the ECB, working with the nascent European Stability Mechanism (ESM), was the only institution that could save the eurozone. It could do so by buying Italian and Spanish bonds in the secondary market with the pre-announced intention of keeping their sovereign interest rates below a certain threshold for a certain time.
It is likely that Draghi’s statement will indeed be followed by ECB purchases of Spanish (and Italian) sovereign bonds. A man like Draghi would not have issued such a statement without believing that he could follow through on it. But, if this is to become a decisive turning point in the eurozone crisis, three things must happen.
First, the ECB’s renewed bond purchases must express the clear intention of reducing sovereign interest rates to sustainable levels, which are at least 200 basis points below their July averages. A high-level German diplomat reportedly dismissed Spain’s 6.5-7% interest rates recently, on the grounds that Spain borrowed at nearly the same rates in the 1990’s. But that statement, amazingly, ignored Spain’s higher pre-euro inflation – thus confusing real and nominal rates – and more rapid GDP growth.
For countries that are following agreed reform programs, the ECB should commit itself to bringing down interest rates to levels compatible with projected inflation and growth rates, and announce how long (say, nine months) this will continue. A sporadic program without such announced objectives is unlikely to work, and could even be counterproductive, as private investors might well demand even higher returns because the growing ECB share of the debt would be considered senior, augmenting their risk.
That would not happen if the ECB announced – and demonstrated – its determination to bring down interest rates, whatever it takes, for a significant period of time. Doing so would allow the eurozone to establish the institutional and legal means to achieve greater cooperation and integration, as agreed at the European Council’s meeting in June.
The second thing that must happen is that eurozone leaders and parliaments, with the cooperation of the courts, must be seen to push ahead with institutional reforms to establish not only the ESM, but also a banking union and partial debt mutualization. But, while greater merging of economic sovereignty is the only long-term solution to the eurozone’s woes, such reforms cannot happen very quickly, which is why the ECB’s role is so crucial. The eurozone can no longer sustain continued uncertainty and high real interest rates in the peripheral countries, so the ECB must provide a solid and credible bridge to the future.
Finally, the adjustment programs themselves must be carefully re-calibrated. It should be clear by now that excessive, front-loaded austerity measures tend to be self-defeating, because they trigger a downward spiral of output, employment, and tax revenues. Indeed, the International Monetary Fund’s most recent report on the eurozone says as much (if cautiously).
The pace of deficit reduction must be slowed, particularly in Spain, because output is determined in the short run by demand, and private demand cannot replace public demand until a degree of faith in the future is restored. This move toward support of effective demand must be combined with the kind of structural reforms that will allow more rapid, supply-side growth in the longer term.
If these three steps – an ECB bond-buying program to hold down sovereign interest rates, concrete progress on establishing a real economic union, and realistic revision of current adjustment programs – could be achieved as a package, the resources that the ECB would need to use for its bond purchases would drop, because credibility would be restored. Even if there is further bad news for Europe – from Greece, for example, or from a sharper-than-expected slowdown in China – the eurozone could begin to move out of crisis mode this month.
But that is possible only if, this time, the “big bazooka” really is put in place. Otherwise, the eurozone’s position – financially, politically, and socially – will soon become undefendable.