The last week has been- to put it modestly- very eventful for global markets, but despite the finger-pointing that always occurs in times like these it’s wrong to pin blame for the turmoil on a singular cause. Many things have gone wrong- the U.S. debt ceiling debacle, very weak second quarter economic data, the European sovereign debt crisis, the S&P downgrade of the United States credit rating- but one thing is clear: the volatility the market has seen over the past week has been primarily due to a massive crisis of confidence, not market fundamentals.
Besides a downgrade to the United States credit rating (which provided markets with precisely zero new information), no new economic data or event has emerged to justify a 14 percent drop in U.S. equity prices. Rather, markets looked at the global macroeconomic picture, which is filled with uncertainty, and have run en masse to what they perceive as safe investments (Treasuries, Swiss Franc’s, and gold). The risk and uncertainty investors see right now has a common denominator: US and EU policy makers, and their inability to move decisively to attempt to solve the problems in their respective economies.
With this in mind, it is extremely encouraging to see the European Central Bank (ECB) announce this week that it will begin buying Spanish and Italian bonds on the open market in an attempt to bring yields in those countries under control, and to put a stop to the contagion in European debt markets. It remains to be seen how aggressive the ECB’s purchases will be, and how much they sterilize those purchases (a method of purchasing assets on the open market, while accepting an equivalent value of term deposits from banks- effectively restricting the net expansion of the money supply).
Given the seriousness of a potential full-blown debt crisis in Europe, the ECB should make aggressive, large-scale purchases of unsterilized (or partially sterilized) Italian and Spanish bonds. This would have two major effects: it would keep the bond market vigilantes at bay by lowering Italian and Spanish bond yields (as it did Monday when the program started), and it would inject liquidity- via an expansion of the money supply- into a European market with multiple countries that are more or less insolvent.
Granted, there are great risks inherent in this sort of program. Much of the euro zone doesn’t need extra liquidity right now, and the program comes with the real possibility that it could spark higher inflation, violate the ECB’s mandate, and punish euro area countries that have been less fiscally profligate than those currently in trouble. The program would also dramatically expand the ECB’s balance sheet, and could be very painful to unwind once the crisis has passed.
However, the bond purchases are worth the risk. European political leadership has dithered in its response to this crisis, and there are real doubts as to their willingness to take the steps needed to corral contagion, and hold together the European Monetary Union. There are already signs that European governments might not increase their woefully undercapitalized stabilization fund. If properly funded, European governments could use it to aggressively purchase Spanish and Italian bonds on secondary markets, easing pressure on the ECB to purchase unsterilized bonds, and avoiding the risks that large-scale quantitative easing entails. But in the absence of political leadership, the ECB is the only line of defense against a severe financial panic, and the possible dissolution of the Euro.
In the coming days we’ll start see how far the ECB is willing to go in purchasing Spanish and Italian bonds. Already there appears to be some internal push-back against the plan, notably from Germany’s Bundesbank, which feels- quite reasonably- that Germany will carry a disproportionate share of the downside risk associated with the program. Despite concerns, the ECB should act decisively to stem the contagion in Spanish and Italian bond markets. If bond market vigilantes close in around Spain and Italy the European Union will not be able to bail them out- they’re far too big- and the consequences will be far more severe than any harm an aggressive quantitative easing program could potentially do to the region.
Unsterilized bond purchases are a bazooka for the ECB. They should pull the trigger.