Is Europe’s Financial Crisis Over?

LONDON – The European Central Bank’s recently announced policy of bond buying, what it calls “outright monetary transactions” (OMTs) marks a convergence of European central banks with their Anglo-Saxon counterparts. While the ECB’s actions represent the best chance yet to put an end to a crisis that has been playing out since 2010, the Bank has markedly raised the stakes for governments.

The ECB’s policy framework is well suited to fighting systemic blazes, but poorly suited to local fires, which thus can spread uncontrollably. The OMT program, which allows the ECB to buy sovereign bonds of countries that have agreed to reform their economies, significantly levels the playing field between the Bank and its advanced-economy peers. Spain has the same fiscal and structural problems that it had prior to the OMT program’s launch, but now it has an external lender of last resort. That is a game-changer.

Under the pre-OMT regime, a capital outflow from Spain, whether through the sale of government bonds or the liquidation of private claims, resulted in tighter monetary conditions. The sale of sovereign bonds under the fixed exchange-rate regime put direct upward pressure on their yields, while sales of private securities by foreigners had a similar effect, but through indirect channels. Monetary tightening was forestalled only to the extent that another source of foreign capital (either private or ECB) could replace the outflow.

The point at which credit risk becomes exchange-rate/redenomination risk is ambiguous. But the metamorphosis tends to go hand in hand with localized monetary contractions that exacerbate the correlated risk of sovereign default and bank failures. In Spain, as in Greece before it, the monetary squeeze has become chronic as banks run short of ECB-eligible collateral.