Europe Heads Down The Deflationary Road

There is a major ongoing debate in the eurozone about what to do about the “virtuous” countries, such as Spain and Italy, that have lost access to the bond market due to high risk spreads (as opposed to fiscal profligacy).

One side of the debate has argued that the eurozone is a currency union, not a mutual assistance society, and that these countries should regain the market’s trust on their own via greater austerity. The other side argues that it is the duty of all members to do what is necessary to “defend the euro” and that, if these countries pursue the path of virtue, the eurozone should provide temporary assistance in their time of need.

In the last few weeks, both the ECB and Germany have joined the latter (more charitable) group and have stated that the eurozone should offer help to innocent countries that have lost market access, such as Spain and Italy.

Both Draghi and Merkel (but not the Bundesbank) have agreed to the idea that if these countries apply to the Troika for assistance, both the EFSF/ESM and the ECB will purchase their bonds in an effort to drive down “excessive” risk premia. This has suggested to the capital markets that a medium-term solution is in the cards, and all may be well.