Q: So what the hell is up with the Europe banking whatever today? The market is up, so I guess it’s good news. But I’m just your typical American with a public school education … I’m lucky if I can find France on a map.
A: Actually, if you’re a typical American, there’s a chance you can’t even find America on a map (cue viral Miss Teen USA video). But let’s focus on ECB president Mario Draghi, not how cool Mario Lopez was in that disaster of a YouTube clip.
Here’s what happened: European Central Bank President Mario Draghi pulled back the curtain on a what he calls a “fully effective backstop” for the eurozone debt crisis. Namely, it’s an unlimited bond-buying program where the ECB will purchase debt from member states in the 17-member eurozone.
Q: No kidding, that headline is everywhere. Tell me what it means.
Well, the big problem is that countries like Spain and Italy could find few buyers for their bonds — and as a result, had to offer huge interest payments on their debt to entice investors to shoulder the risk. This summer, Spain was borrowing at rates above 7% — on par with what I pay for my personal credit card debt.
So troubled European nations were doubly at risk: First, they couldn’t find the money to pay all their bills. Second, when they did find money, they paid through the nose for it.
Here’s where the European Central Bank comes in. Other measures have been taken to prop up the EU bond market (that is, help finance government debts), including bailing out Spanish banks so they would in turn bail out the Spanish government. But all have been stopgaps or indirect solutions — until Draghi finally said that the central bank will step in, ensuring that there is decent demand for government bonds.
The phrase “lender of last resort” is a popular shorthand here.
Q: That sounds like cheating.
A: Well, to folks like Ron Paul, it certainly is because the central bank is messing with free markets. But in times of great crisis, most economists believe that leaving the free market to its own devices would ultimately cause more harm than good — such as the collapse of the U.S. financial system or the unraveling of the eurozone.
Consider that a similar thing happened as subprime mortgage debt in America got that pleasant label of “toxic assets.” Nobody wanted these things, and there wasn’t even a real market for the securities as buyers disappeared. Thus, rather than allow the credit markets to implode, the Fed stepped in as a lender of last resort for mortgage debt.
The European Union believes the crisis is so dire that it has no choice but to step in. Otherwise, the whole thing would unravel. We could debate whether Mario Draghi is getting dangerously loose with money or making a power grab for the ECB. But I assume you don’t give a hoot about European power politics.
Q: Obviously. OK, so in review: Stocks jumped because now Europe is fixed and governments won’t go bankrupt. Got it.
A: Well, that’s a gross oversimplification. For starters, the ECB hardly stroked a blank check. Draghi offered no specifics or immediate help or a clear date when the program will begin. (Read paragraphs four and five of this New York Times article … or better yet, just take my word for it). There’s also the sticky point that the bank left the next step to governments — demanding they formally ask for help and then follow a fiscal discipline checklist before the central bank would buy any of its bonds.