The Eurozone’s new quick fix risks papering over much deeper cracks

In today's City AM, we argue:

With European politicians still nursing their holiday sunburns, speculation has already returned to the Eurozone crisis. Unsurprisingly, the focus is again on European Central Bank (ECB) intervention, not least because its president Mario Draghi’s commitment to “do whatever it takes” to save the euro may now require him to follow through.

The main plan being mooted is for the ECB to cap the difference in borrowing costs between stronger and weaker Eurozone nations. The logic is that growing yield spreads drive investor fear, do not represent the true strength of these economies, and threaten a self-fulfilling bond run. Germany is naturally wary.

The plan would place the ECB directly in the realm of fiscal policy and political decision-making – a dangerous and almost untenable position for an unelected, independent central bank. Bond spreads are ultimately the market’s judgement of the fiscal policy and domestic politics of each Eurozone country. Any failure or uncertainty in either area would see the level of ECB bond-buying directly influenced by national governments’ decisions. This is even more concerning given that, if borrowing costs have an effective cap, the incentive for governments to reform quickly and effectively would be severely reduced.

The oft-cited upside is that the ECB’s unlimited commitment would be enough to deter investors from challenging the ceiling on borrowing costs, meaning that the ECB may not be required to intervene much at all. But this impact may be overstated.

Take the peg between the Swiss franc and the euro, equipped with its own “unlimited” backstop from the Swiss National Bank (SNB). The SNB has had to defend the peg, causing it to accumulate reserves equal to 65 per cent of Swiss GDP. Clearly markets didn’t take the bank at its word. It’s not clear that the ECB would be any more successful, especially in the face of similar safe haven flows into northern Eurozone countries, and investors’ desire to offload risky assets at a decent price. Don’t forget that the ECB has also seen its own credibility dented over the past two years.

It’s been contended that current borrowing costs are irrational and therefore warrant ECB intervention. While yields may not accurately represent the economic fundamentals of each nation, they are a result of markets trying to price in the domestic and European political risk, as well as the structural flaws in the Eurozone. Using the ECB to try to “correct” these issues would damage the price determination mechanism in markets.

This leads us to another area of potential political controversy. The ECB would be taking a huge step towards risk and debt pooling by allowing an EU institution to redistribute problems around the Eurozone – since all Eurozone members stand behind the ECB. Such a huge decision, integral to the future of the Eurozone and Europe, should not be taken by an unelected apolitical institution.

The fact that such a decision can’t be made at the intergovernmental level is a sign that the Eurozone is not ready for such a move. Using the ECB to force the pace of integration may well backfire. It seems many have forgotten the problems caused by pushing ahead with an unfinished economic and monetary union, lacking clear political will, in the first place.

On top of all of this, such a move stands on incredibly shaky legal ground (thanks to its clearly defined statute, which stops it from financing sovereign states). It also fails to offer a solution. This is why intervention has little support in Germany.

The spreads in borrowing costs are a symptom of the crisis rather than a cause, although they have admittedly made things more difficult. However, artificially forcing them together will only paper over deeper problems. The best such a move can do is to buy time.

With the ECB already having bought Eurozone leaders two years, which were promptly wasted, we must ask whether this latest proposition is worthwhile.

There is, as of yet, no definitive answer. But the first move must be at the intergovernmental level. Until progress is made there, any move by the ECB would simply jeopardise its fundamental mandate, putting more money at risk and dragging the crisis on further, all without any clear end in sight. The ball is firmly in Eurozone leaders’ court and should stay there.