European Central Bank to the Rescue

Frankfurt moves to purchase Italian and Spanish sovereign bonds in an attempt to defuse the European debt crisis.

European Central Bank president Jean-Claude Trichet testifies before the European Parliament in Brussels, March 22, 2010
European Central Bank president Jean-Claude Trichet testifies before the European Parliament in Brussels, March 22, 2010 (European Parliament/Pietro Naj-Oleari)

Once more unto the breach, Trichet! While central bankers from the north of Europe, including Germany, were reportedly against the ECB propping up Italy and Spain with a massive bond purchase operation, the Frenchmen acted to stem Europe’s unfolding debt crisis this weekend and prevent the contagion that nearly bankrupted Greece, Ireland and Portugal from bringing down the third- and fourth largest economies of the eurozone.

The European Central Bank announced late Sunday that it would “actively implement” its bond purchase program which had been put on hold before officials resumed purchasing Irish and Portuguese debt last week. These countries received billions in bailout funds from the European Union and the International Monetary Fund when they were no longer able to borrow against an affordable rate on the market.

Rome and Madrid have also seen their borrowing costs soar in recent weeks to above 6 percent, a rate that neither is likely to be able to sustain for long given the amount of new bonds they need to issue.

Although the ECB didn’t specifically mention Italian nor Spanish bonds in its statement, it did praise these countries for implementing “new measures and reforms in the areas of fiscal and structural policies.” Both have announced tens of billions worth of austerity measures but details are vague, causing investors to worry about the long-term solvency of what are two heavily indebted economies.

Italy’s debt equaled nearly 120 percent of gross domestic product last year when Spain faced a $130 billion shortfall on its budget. Spain’s predicament is exacerbated by extremely high unemployment and a lame-duck socialist government that is likely to be ousted this November.

Frankfurt always maintained that national governments, not the central bank, were primarily responsible for tightening fiscal policy and preventing the European debt crisis from spreading. “Monetary policy responsibility cannot substitute for government irresponsibility,” Jean-Claude Trichet warned in January of this year. His bank was also critical of its American counterpart which pursued an expansionary policy whereas the ECB championed austerity.

The recent bond purchase is not a total trend break but does signal a heavier involvement for the bank. It is tantamount, according to The Wall Street Journal, “to conceding that the euro’s member states are unable or unwilling to respond effectively, turning the ECB into the lead firefighter — and the eurozone’s lender of last resort.” That, the paper predicts, could herald a much closer monetary union, one that resembles a “European Monetary Fund” as French president Nicolas Sarkozy likes to call it, or “economic government” within the single currency zone. It also undermines the ECB’s reputation as an inflation fighter.

If the bank’s bond purchases fail to calm markets and bring down the interest rates on Italian and Spanish debt — it can only provide temporary relief in any event — the last line of defense against the specter of default is the European Financial Stability Facility which eurozone leaders recently empowered to react with short-term lines of credit whenever a financial crisis occurs.

Germany and its allies in the austerity camp, including Austria, Finland and the Netherlands, were previously skeptical of expanding the EFSF, fearing permanent bailouts. Their national parliaments will have to approve the changes before they can come into effect. Slovakia has already warned that its legislature might not vote in favor of a more flexible rescue fund.

Even if the EFSF were able to help countries finance their deficits without political approval from the rest of the eurozone, it has still only €440 billion to spend. The IMF estimates that Italy needs between €340 and €380 billion over the next five years to cover its shortfalls. Part of the €440 billion is already committed to Greece, Ireland and Portugal. If Spain is also to tap into the facility, Italy could be left in the cold.