Benefit of ECB's Bond Buying: Fiscal Breathing Room

By Greg Ip 

        When the threat of Greek insolvency first erupted in 2010, the worries rapidly spread to the eurozone's other peripheral economies, sending borrowing costs skyrocketing.
        This time around, what's happened in Greece has stayed in Greece. While yields on Greek bonds hover around 11%, they're below 2% in Ireland, Spain and Italy--less than what the U.S. Treasury pays to borrow.
        This matters for more than just the markets. It is also critical to the eurozone's most indebted members' efforts to fix their finances. As European Central Bank President Mario Draghi said last month in unveiling a much-anticipated plan to purchase government bonds: "All monetary-policy measures have some fiscal implications."
        That would be an understatement. By driving rates so low and promising to buy government bonds, the ECB makes it much easier for peripheral economies to stabilize their crushing debts. It obviates the need for added short-term austerity, which could provoke a political backlash that derails the economic reforms essential to bringing down debt in the long run. In other words, monetary policy is central to the success of fiscal policy.
        To understand why, consider some simple arithmetic. A stable debt is one that stays the same as a share of gross domestic product. If the interest rate the country pays on its debt is higher than the growth of nominal GDP (that's real GDP plus inflation) that debt ratio automatically goes up--unless the government runs a surplus in the budget excluding interest. Conversely, when the interest rate a country pays on its debt is below its growth rate, the ratio automatically drops, unless there's a deficit in the budget, excluding interest.
        The latter scenario--having interest rates below the growth rate--is like having the wind at your back. And that's the situation Spain, Ireland and Portugal should all be in this year. Italy is close.
        A few years ago, those countries were in the opposite situation, with soaring interest rates and shrinking GDP. What changed?
        Investors typically don't worry that a government will default on debt issued in its own currency; in a pinch, the central bank can print the money needed to repay that debt. That option, though, isn't available to members of the euro, who can't order the ECB around.
        After European governments bailed out Greece in 2010, they wanted investors to share the pain and so embraced the principle that government bonds could be subject to a "haircut"--or a repayment of less than 100 cents on the euro. The prospect of Greek default or exit from the euro sent Italian and Spanish yields over 6%, Portuguese and Irish yields above 10%, and Greece's over 30%. At such punishing interest rates, fear of default becomes self-fulfilling.
        Mr. Draghi largely put an end to those fears in 2012 by promising to do "whatever it takes" to save the euro. So long as a country abides by the terms of a bailout, the ECB vowed to not let it be forced out of the euro.
        Those actions helped narrow, though not eliminate, the difference in yields between peripheral and what is seen as safe German debt. Then, last spring, Mr. Draghi opened the door to quantitative easing--the outright purchase of government bonds with newly created money--in an effort to push the region's inflation rate back up. QE will soon begin.
        That has brought yields throughout the region down even further, to levels that significantly improve the region's debt dynamics. Goldman Sachs estimates that a one percentage point drop in interest rates reduces the deficit cuts needed for Italy to stabilize its debt by 1.3% of GDP, and Spain by 1%. That won't happen immediately: Existing debt has to be refinanced. It helps, then, that QE could have several years to run. Investors are betting that Spanish and Italian yields will remain around 2.5% five years from now, notes Zsolt Darvas of Bruegel, a Brussels-based think tank.
        Because Italy already runs a sizable budget surplus excluding interest, that means it needs no new austerity for its debt-to-GDP ratio to drop. Spain still has a deficit excluding interest, but the task of stabilizing its debt is now nearly complete.
        It's not enough for peripheral countries just to stabilize debt, of course; eventually the debt-to-GDP ratio has to come down. But the ECB has given them breathing room to ease austerity and give structural reform the necessary time to raise long-term growth. All that assumes no contagion from Greece.
        There are big caveats to this upbeat picture.
        First, the reason the ECB has acted on QE is because eurozone growth is so weak and inflation is running well below its target of near 2%. If even modest growth fails to materialize, or low inflation turns to deflation, stabilizing the debt as a share of GDP becomes much harder. As Angel Ubide and Adam Posen note in a recent report for the Peterson Institute, a U.S.-based think tank: "The high level of euro-area debt is not sustainable with weak nominal GDP growth."
        The second big risk is political. Austerity-weary voters may follow the path of Greece and abandon not just near-term austerity but long-term reform.
        The ECB could well abandon them then, and the deadly dynamics of 2010 would be back. The ECB is a crucial player in solving the euro zone's fiscal woes; but it won't do it on its own.
        (END) Dow Jones Newswires

        February 11, 2015 19:16 ET (00:16 GMT)

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