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ECB fires big guns, but with strings attached

The European Central Bank is moving more forcefully than ever to ease the euro zone debt crisis and keep the region intact, but distressed governments that decide to take advantage of the bond-buying scheme may do so at their peril.

ECB chief Mario Draghi sparked a global market rally Thursday, buoying the hopes of investors with a big-gun approach in what could be the central bank's last chance to stop the 17-member monetary union from fraying. The plan comes one year after an earlier bond program failed to end the long-running troubles.

The move comes at a crucial period, as Europe's economic woes mount and some countries sink deeper into severe downturns. Mr. Draghi and his colleagues have been under extreme pressure to make a bold move.

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The ECB's new program – called Outright Monetary Transactions, or OMT – would see the ECB buy the sovereign bonds of embattled governments in unlimited amounts in an effort to bring down their crippling financing costs and keep the euro zone together. Declaring the currency union "fragmented," Mr. Draghi said the program "will enable us to address severe distortions in government bond markets which originate from, in particular, unfounded fears on the part of investors of the reversibility of the euro."

His comments came after the ECB's regular rate-setting meeting, at which the central bank decided to hold its benchmark rate at 0.75 per cent.

While markets and the euro rallied on Mr. Draghi's plan – which had been widely leaked in recent days – several economists and strategists warned that the success of the bond-buying effort is far from guaranteed. That's because the program would come with strict conditions, such as continued austerity and economic reform. With no growth, and soaring unemployment in the weakest countries, such as Spain, the threat of the euro zone's breakup cannot be eliminated.

"In all, the ECB interventions attached to conditionality under an adjustment program will eventually address liquidity concerns, and therefore it buys time for governments to implement reforms," Toronto-Dominion Bank senior economist Martin Schwerdtfeger said in a research note. "However, the ECB interventions will not remove the threat that the negative feedback loop between fiscal austerity and poor economic growth performances could make the adjustment processes unworkable."

The OMT will differ in two main ways from the earlier – and now defunct – limited bond-buying program, which was most recently used in August, 2011, to bring down Italian bond yields, albeit only temporarily.

The first is that the program is unlimited, that is, it is not constrained by yield thresholds. The second is that it is highly conditional. Countries that want the ECB to buy bonds with three years or less of remaining maturity – the ECB would not buy long-term paper – would first have to apply for assistance from one of the two European rescue funds, the European Financial Stability Facility (EFSF) or the European Stability Mechanism (ESM).

The rescue funds would buy long-term bonds only if the country agreed to strict reform and austerity measures, which, Mr. Draghi said, would probably be monitored by the International Monetary Fund.

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Only then would the ECB swing into action with its own short-term bond purchases.

Writing in the New Economic Perspectives blog, Denver market strategist Marshall Auerback, a director of Toronto's Pinetree Capital, said the austerity conditions might only make the European recession worse by weakening the countries that apply for the program.

"In addressing the solvency issue, the ECB's conditionality ironically will make the very problem of fiscal profligacy and higher government deficits much worse, as demand gets crushed by yet more austerity," he said. "In effect, one is left with the Scylla of a quick death via exit from the euro zone, or death via slow strangulation of aggregate demand via the fiscal austerity conditionality laid out by Mario Draghi today."

Mr. Draghi expressed confidence that the OMT will succeed despite the ECB's poor track record in employing its firepower to bring down yields. "Under appropriate conditions, we will have a fully effective backstop to avoid destructive scenarios with potentially severe challenges for price stability in the euro area," he said.

But at least once member of the ECB's governing council – thought to be Germany – voted against the new plan. The German central bank has never approved of sovereign bond purchases, arguing they finance governments in violation of the ECB's mandate, and detract the organization from its central role as an inflation fighter.

Spain is the likeliest candidate for the program as its banks seek a bailout, its economy sinks deep into double-dip recession and unemployment rises to 25 per cent, the highest in Europe. If the euro zone recession gets much worse, Italy, the region's third-largest economy, might also have to tap into the program.

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The ECB also reduced its growth outlook for the euro zone, forecasting the economy to shrink between 0.2 per cent and 0.6 per cent this year. It expects growth of only 0.5 per cent next year, down from its previous estimate, of 1 per cent, made in June.

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About the Author
European Columnist

Eric Reguly is the European columnist for The Globe and Mail and is based in Rome. Since 2007, when he moved to Europe, he has primarily covered economic and financial stories, ranging from the euro zone crisis and the bank bailouts to the rise and fall of Russia's oligarchs and the merger of Fiat and Chrysler. More


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