For long, Germany has been opposing to ECB’s monetization for purchasing securities of troubled countries.

Following the positive reaction of the market’s to European Central Bank (ECB) president Draghi’s comments, I started to seek an answer to the question “is the worst part over?” During Tuesday’s commentary, I discussed the underlying reasons for the positive response. Now it’s time to discuss why there is a risk that the positive mood of the markets might be temporary.

As you might remember, Draghi argued that high returns on government securities of some European countries weakened the influence of monetary policy on the economy. He also implied that if the hike in security returns eliminated the influence of monetary policy efforts, the ECB would purchase securities in the secondary market until interest rates decreased. Later, it was rumored that this operation will be carried out in collaboration with the EFSF, the temporary stability fund. In addition, it was raised as a issue that measures must be taken to authorize European Stability Mechanism (ESM) that is to replace the EFSF for operating as a bank and purchasing securities of troubled countries at amounts significantly beyond its capital amount in order to work as a leverage mechanism (that is, to give the ESM a banking license).

Nevertheless, there is the risk that the positive mood caused by Draghi’s statements in particular and positive expectations on arrangements regarding the ESM to some degree might be temporary. Here are some reasons why:

First, the decision on the ESM becoming operable, let alone its having the authority to carry out leverage transactions, has been waiting for Germany’s Constitutional Court. The case will be negotiated in September. Moreover, German authorities have recently stressed once again that Germany opposes to a banking license for the ESM.

Second, for long Germany has been opposing to ECB’s monetization for purchasing securities of troubled countries. After all, Germany suffered from hyperinflation before and there is a vast public opposition to monetization at large amounts. Therefore, the government has to create a public support for monetization. Would German officials ever be willing or able to do this? They haven’t been so far.

Third, steps required to overcome the essential problems of Europe hasn’t gone beyond rhetoric. Though some steps were taken to penalize fiscal indiscipline, how to establish a joint banking regulation and supervision agency and with which authorities this authority must be furnished are yet to be decided. The most fundamental challenge above all is that European countries have very diversified levels of productivity. Those with low productivity suffer from weak export performances. One way to overcome this challenge in the short-term is devaluation, which is impossible due to the single currency regime.

Therefore, even if German officials succeed in reversing the opposition to ECB’s monetization, all Europe will have will be monetization if essential problems are not solved or a credible resolution is not developed. But if they had developed a solution, things wouldn’t have got this complicated in the first place.

Under these circumstances, it is way too early to claim that the worst part is over. When I was writing these lines, the Federal Reserve’s meeting was not held yet. The decisions the Fed will (or will not) make are also of importance.

This commentary was published in Radikal daily on 02.08.2012