How Europe's Best Move Ever Led to Cyprus

Mario Draghi, president of the European Central Bank, during a press conference at the ECB headquarters in Frankfurt, Germany, Jul. 5, 2012. Photograph by Rao Bo/Xinhua via Redux

A new analysis by economists from JPMorgan Chase says that the crisis in Cyprus can be traced back to an action taken last summer that was correctly regarded at the time as a stroke of brilliance. The chain of logic is complicated but compelling, and it makes Germany look quite bad.

Here’s the idea: Last summer European Central Bank President Mario Draghi vowed that the central bank would do “whatever it takes” to save the euro. I called it “the speech that saved Europe.” In September the ECB’s Governing Council backed up Draghi’s bold words with a commitment to buy unlimited quantities of governments’ bonds if the countries agreed to strict conditions aimed at getting their finances back in order.

Draghi’s promise worked: Investors were reassured and accepted lower yields on their bondholdings, which made financing more affordable for the likes of Spain and Italy. To date the ECB hasn’t had to buy a single bond. As ex-Treasury Secretary Henry Paulson said, “If you have a bazooka in your pocket and people know it, you probably won’t have to use it.”

But Europe frittered away the time that Draghi bought for it. The right move would have been to stimulate continentwide economic growth so Spain, Italy, Portugal, Ireland, Greece, and Cyprus could have earned their way back toward fiscal soundness. That didn’t happen. Instead, Germany saw the respite as an opportunity to get tough. Perceiving that the ECB would prevent sovereign defaults, Germany began to insist that debtor countries take more responsibility for saving themselves. That was apparent as early as last fall in the harsh conditions imposed on aid to Spain and Greece. It was even more apparent in Cyprus, which appears headed for a long and severe recession because of a miserly bailout package.

In short, Mario Draghi did exactly the right thing, but it has led to exactly the wrong result. “The seeds of the decisions made in Cyprus this week were sown by last summer’s OMT program,” JPMorgan Chase economists wrote in their March 28 Global Data Watch. (OMT stands for Outright Monetary Transactions, the name of the ECB’s bond-buying program.)

As the market comes to understand that debtor nations are more on their own, banks in those countries are having a harder time raising the money they need to make loans. Investors are nervous that, as in Cyprus, they might not be able to get their money out. The cost to protect against default in the credit default swap market has jumped, from its mid-January low, 37 percent for Spain’s Banco Santander, 60 percent for Italy’s UniCredit, and 67 percent for Italy’s Intesa Sanpaolo, according to Bloomberg data.

German Chancellor Angela Merkel, who faces parliamentary elections in September, is understandably reluctant to push her people for more generous bailouts. But the risk of doing too little is that Europe will unravel.

“As it becomes obvious that the austerity programs produce unnecessary sufferings especially for the millions of people who have been thrown into unemployment and poverty, resistance against these programs is likely to increase,” Paul De Grauwe and Yuemei Ji wrote in a January article for De Grauwe teaches at the London School of Economics and Ji at Belgium’s University of Leuven. Austerity, they wrote, “may lead millions of people to wish to be liberated from what they perceive to be shackles imposed by the euro.”