New York Times
POSTED: 1:30 a.m. HST, Jan 21, 2012
BERLIN » Throughout the month, countries caught in the eye of the European financial storm, including Italy, Spain and France, have repeatedly defied expectations, selling big batches of bonds to the public at interest rates significantly lower than investors demanded at the height of the euro crisis late last year.
The surprisingly successful auctions owe little to improving economic data around the region. On the contrary, many of the countries that use the euro as their currency appear to be confronting a renewed recession, and pessimism about their growth prospects remains abundant. Just last week, Standard & Poor's stripped France of its coveted AAA rating for the first time in recent history and downgraded eight others.
Instead, most of the credit seems to go to the European Central Bank, which in late December under its new president, Mario Draghi, quietly began providing emergency loans to European banks -- hundreds of billions of dollars of almost interest-free capital that the banks have used to come to the rescue of their national governments.
Although the central bank, based in Frankfurt, used typically understated and technical language to describe its actions, it appears to have done what its leadership said repeatedly throughout 2011 that it would not do: namely, flood the financial markets with euros in a Hail Mary attempt to make sure that the region's sovereign debt crisis did not lead to a major financial shock.
Although on a smaller scale and in a subtler manner, it has in some ways taken a page from the U.S. Federal Reserve's playbook for the 2008 financial crisis, which has been roundly criticized in Europe as a reckless bailout that risks setting off uncontrolled inflation. And, at least for now, the effort has worked. Spain's 10-year bonds now carry interest rates that hover around 5.5 percent, compared with 7 percent and higher in November, and Italy's five-year bonds are approaching 5 percent, down from nearly 8 percent at their peak.
There have been moments before when European leaders declared the crisis contained, only to see it return. But the central bank's incentives, combined with a push from the private banks' home governments, seem to have convinced investors that this time may be different, and financial markets in Asia, Europe and the United States have responded with strong gains this year.
Fears of a bank collapse -- the so-called Lehman Brothers moment, when one financial institution's failure threatens the stability of the entire system -- have subsided. And Greece appears to be closer to a deal with its creditors to pare its debt obligations rather than engage in a messy, disorderly default that could plunge the financial system back into chaos.
That encouraging situation seemed highly unlikely as recently as early December, when panic over the European debt crisis was reaching a peak, just before a European Union summit meeting in Brussels. While national leaders postured and pursued their parochial interests, Draghi told reporters at the central bank's headquarters that he would conduct "two longer-term refinancing operations" (in plain English, emergency funding) for cash-starved banks for three years instead of one year.
The European economy was on the brink and threatening to take the rest of the world with it, and Europe's new top central banker did not seem to get it.
"Why is it so impossible for the ECB to act like the other central banks, like the Federal Reserve System or the Bank of England?" a reporter asked him. "Why do you not act more directly to help European countries by buying up the debt on a massive scale?"
Draghi said he was bound by the European treaty, which "embodies the best tradition of the Deutsche Bundesbank," the German central bank, code for strict inflation-fighting and the furthest thing from a wholesale emergency bailout.
European stocks fell. Financial experts declared that Draghi had disappointed. The world demanded a bazooka, but he had shown up with a water pistol, or so it seemed.
Less than two weeks later, on Dec. 21, the bank announced the results of its technical maneuver: The banks had taken $630 billion as part of the program. The banks appear to have used a sizable share in the weeks that followed to buy the European bonds so desperately in need of customers. It was as if the European Central Bank had injected lenders with steroids, then asked them to do the heavy lifting. The strategy appears to be paying off. Even in the face of recession warnings and the agency's downgrades, the European debt market keeps improving.
Financial experts say the central bank's intervention seems to have catalyzed a virtuous circle: As new governments come in and promise to deliver spending cuts, tax increases and balanced budgets, once gun-shy banks have an added incentive to tap new financing from the central bank and jump back into bond markets that they were running from just a few months ago.
The question now is whether the ECB's action merely delayed the inevitable reckoning for the eurozone's weakest members or whether falling interest rates and improved growth will become entrenched, bringing the critical phase of the Continent's debt crisis to a close.
"I think that they have mastered it to the extent that this isn't going to get a whole lot worse," said Jacob Funk Kirkegaard, a research fellow at the Peterson Institute for International Economics in Washington. "We do have in my opinion fairly credible signs of stabilization."
The central bank under its previous chairman, Jean-Claude Trichet, had long resisted more aggressive action, unwilling to flood the market with money the way the Fed did in 2008 until governments committed to reining in spending and deregulating their economies.
"By refusing to act decisively at an early stage, they in a sense perpetuated the crisis, creating a situation where in the end the euro-area politicians had no other choice than to do the right thing," Kirkegaard said.
The central bank is preparing another infusion in February, and many banking experts expect it to be even bigger. The unspoken quid pro quo -- that banks need to buy government debt in exchange for the central bank's largess -- seems to be working.
But the strategy is not without risks, warned Thomas Mayer, chief economist at Deutsche Bank in Frankfurt.
"It may please some of the purists as it looks purer, but the banks may become addicted," Mayer said.
There is a limit to how much of this debt the banks can buy, he said: "Near-term relief of government bond deals may come at the cost of making the banks' balance sheets more toxic."
Policymakers say they are aware that all the central bank has done is give them breathing room to set their houses in order; the bonds are due in just three years. So the summit meeting of European leaders scheduled for Jan. 30 is likely to focus on finding ways to spur growth as well as on reining in budget deficits.
"The fetishizing of austerity by European leaders, clamping down on growth so severely, may create political backlash that will not be manageable," said Kathleen R. McNamara, director of the Mortara Center for International Studies at Georgetown University. "But I give kudos to the ECB for managing what really has been a tightrope situation."
The amounts the central bank has spent directly are much smaller than some economists and political leaders would like but over time have grown substantial. It has spent $280 billion intervening in government debt markets since May 2010. Last week alone, it spent nearly $5 billion in bond markets.
The political deliberations and negotiations in Brussels and, increasingly, in Berlin have been as important as the central bank's moves. Anything but a sideshow, they were a precondition for the central bank's actions and continue to carry importance.
"I don't think it's a coincidence that this happened only after we had a change of government in Italy and Spain," said Kirkegaard of the Peterson Institute, referring to the replacement of Silvio Berlusconi as prime minister of Italy by Mario Monti, a technocrat, and the victory in Spain of Mariano Rajoy.
"From the perspective of the ECB, they have fairly consistently in my opinion not done anything big in this crisis without getting a big juicy quid pro quo," Kirkegaard said.