With the high budget deficit and public debt, the perception that the existing fiscal policies were not sustainable became prevalent.

ECB President Draghi declared on Thursday that high returns on government securities of some European countries weakened the influence of monetary policy on the economy. He reminded that among the ECB’s duties were to clear up the channels through which monetary policy influences the economy. He thus gave a clear message: if the hike in security returns eliminates the influence of monetary policy efforts, the ECB will take action to lower interest on securities. In other words, the Bank will purchase securities in the secondary market until interest rates decrease to acceptable levels. Analysts who closely monitor the developments in Europe – even those who were skeptical of previous attempts – welcomed Draghi’s statement. In order to understand the reasons for the positive attitude, we need to take a brief look at the process.

The challenge of high interest rates
To begin with, European countries that are in trouble either had undisciplined budgets and high public debts from the very beginning (e.g. Italy) or disturbed budget dynamics while they were trying to “solve” the banking sector problems (e.g. Spain). In the end, with the high budget deficit and public debt, the perception that the existing fiscal policies were not sustainable and that the relevant countries will face difficulty in paying debt became prevalent. Therefore, savers demanded higher interest rates for government securities the troubled countries offered in order to finance their public debt.

Second, troubled countries first had to create a sustainable path for fiscal policy. For this, policies to discipline the budget were necessary, but lowering public expenditures and raising taxes caused aggregate demand to decrease. Therefore, the common view was that troubled countries will not be able to grow and thus to pay their debt. As a result, countries in turmoil were going back to square one, with savers eventually asking for higher interest on their securities. This in the end aggravated budget deficits and existing challenges.

Third, if the troubled countries could access sufficient amounts of low-interest bridge loan, in other words borrow on low-interest in the current period of high risk perception; they could avoid borrowing from the markets for some time. At the same, if they could devotedly pursue measures for budget discipline, they could lower risk perception and thus ensure a fall in interest on securities down to normal levels.

Fourth, when it comes to Spain and Italy, the ECB was the only agency that could provide sufficient amounts of bridge loans. Whereas, the ECB was not willing to purchase government securities via monetization unless the underlying reasons for Europe’s problems are overcome as this meant sweeping under the carpet. Moreover, some Nordic countries, Germany to begin with opposed such option. 

Sanctions on the table

Fifth, in December 2011, European leaders agreed on introducing a regulation that will impose certain sanctions for member countries that violate the budget discipline. This was a step to overcome one of the main culprits of the current state in Europe. In response, the ECB lent banks a substantial amount of funds on two installments, though it did not directly purchase government securities. With the ongoing risks and own financial problems, however, bank did not choose to purchase securities on the ECB loan. Therefore, the high-interest terror was not overcome.

Sixth, recently European leaders came to an agreement on establishing a single institution that will individually regulate and supervise all European banks. The ECB interpreted this as a step to solve one other main reason for Europe’s crisis. Later came the aforementioned statement by Draghi.

Then, is the worst part of the crisis over? Some analysts disagree. I will continue with summarizing the unsupportive accounts.

This commentary was published in Radikal daily on 31.07.2012