Can the ECB Save Europe, and Will It?

In a few days the European Central Bank gets a new head, and after almost a year of knowing who that will be there is still a great deal of confusion as to what Mario Draghi will bring to the post and what his core ideas may be. As Draghi comes to office the situation in Europe could hardly be more stressed, and there are no shortages of suggestions as to what the ECB should do now.

At the top of the list is for the ECB to take a risk and move away from the orthodox policies that have thus far failed to arrest the financial distress in Europe. It would make the ECB lender of last resort to the troubled states of Europe and, in the process, force the ECB to accept a much greater level of risk than many would be comfortable with. The majority of analysts assert that the three key issues are getting Greece on some path toward financial independence, somehow keeping the major nations in Europe from a public debt meltdown and, finally and most importantly, preventing a collapse of the banks. For a variety of political reasons euro zone leaders seem incapable of dealing with any of the three, and that is throwing the whole mess back into the lap of the ECB.
Analysis: What is the ECB expected to do? There are those who suggest that, in the absence of any real policy from the political leaders, the ECB has no choice but to act in a manner that will make the inflation hawks in Europe go into apoplexy. The assertion is that the policies of the ECB have worsened the debt situation for the major nations.

Investors look at the situation facing Italy, Spain and the others, and they have to assume the worst. If the Italians are not able to borrow enough money to cover obligations, they will face untenable alternatives. They could try to emulate the Greeks with massive austerity efforts designed to slash the budget, but we have all seen how well that strategy works. The investor has to assume that Italy is entirely capable of sliding into default and that drives up the yields of the bonds that Italy wants to sell to bolster its economic growth. That is a doomed strategy, and without options these states face nearly impossible short-term challenges.

What is needed is the ECB as a backstop—the place that these nations can always turn to when they need the money. If the investor thinks that Italy, Spain and the others will have an alternative, they become somewhat more willing to take risks and perhaps purchase those beleaguered bonds. The objections are strenuous, as many are very uncomfortable with an ECB that is pursuing such a loose strategy, one that seems to invite inflation as well as excessive risk exposure to nations that don’t have good fiscal track records.

Source: Chris Kuehl, NACM Economist

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