Eurozone: Are the building blocks falling into place? by Simon Tilford
On the face of it, September was a good month for the euro. For once, market expectations were met. The European Central Bank (ECB) belatedly opened the way for action to address the ruinous polarisation of government borrowing costs in the eurozone. Germany’s Constitutional Court removed the last obstacle to the deployment of the European Stability Mechanism. The Commission put forward proposals for a eurozone banking union. And Dutch voters resisted the clarion call of political populism. Will the market rally that greeted these developments be sustained, or will it prove as transient as previous ones? Cautious optimism is warranted, but more is needed to convince investors of the irreversibility of the euro. The ECB’s announcement prompted a steep fall in Spanish and Italian bond yields and a strengthening of the euro. For many, the ECB had demonstrated that it would do everything necessary to save the single currency. For others, it marked the end of central banking independence and presaged the monetisation of debt and a surge of inflation. The reality is more prosaic. The move certainly marked an unequivocal intellectual victory for Mario Draghi. The Italian won almost unanimous support for the move; Bundesbank chief Jens Weidmann was the only dissenter. But the announcement is less than it appears. And the political stalemate at the heart of the euro crisis remains unresolved. The ECB’s readiness to purchase potentially unlimited quantities of government debt marks
a victory for those who have long called for such action to counter the break-up risk responsible for the struggling eurozone economies’ inflated borrowing costs. Investors believe that there is a chance that Italy and Spain will ultimately be forced out of the currency union and are thus demanding a hefty premium to insure against this eventuality. This feeds convertibility risk by weakening countries’ fiscal positions and raising private sector borrowing costs (government bond yields set the cost of capital for the private sector). The ECB announcement represents an acknowledgement of the perversity of countries in deep recessions paying the highest borrowing costs and a repudiation of the idea that the high interest rates largely reflect governments’ credibility problems. Finally, it demonstrates a willingness to act in the