Can Draghi be believed?

LONDON – Mario Draghi, the president of the European Central Bank, has repeatedly claimed that the ECB will do everything necessary to save the euro. Nothing has been formally agreed yet, but the ECB is expected to announce a new government bond-buying program following next week’s meeting of its Governing Council. Will it work?

To have a significant impact on Italian and Spanish borrowing costs, the latest effort must be big enough to dispel the convertibility risk that underlies the extreme polarization of government bond yields across the eurozone: investors are loathe to hold Spanish and Italian debt, because they fear that both countries might be forced to leave the currency union. Unfortunately, it is highly unlikely that the ECB will do enough to persuade investors that membership is unequivocally forever, not least because Germany’s Bundesbank opposes any open-ended commitment to capping borrowing costs.

Spain, Italy, and the eurozone periphery face unprecedentedly high real borrowing costs, which are preventing a recovery in investment and hence economic growth. Without a return to growth, they cannot quell investors’ doubts about their fiscal sustainability and their banks’ solvency.

The Italian and Spanish governments argue that their high borrowing costs largely reflect convertibility risks, and that the ECB should do as much as necessary to address them. But eurozone members that currently benefit from exceptionally low borrowing costs – Germany, Austria, Finland, the Netherlands, and, to a lesser extent, France – maintain that Italian and Spanish borrowing costs largely reflect these countries’ failure to reform their economies and strengthen their public finances.

There is merit in both positions – but much more in the Spanish and Italian argument.

Opponents of open-ended ECB action argue that Italian and Spanish borrowing costs are not actually that high: interest rates have merely returned to levels seen in the run-up to the introduction of the euro, when investors distinguished properly between the countries that now share the euro. High borrowing costs are needed to focus minds and instill discipline. Were the ECB to take aggressive action to bring them down, moral hazard would result: countries would face no punishment for delaying reforms.

In nominal terms, Italian and Spanish borrowing costs are indeed comparable to the levels of the late 1990’s. But it is the real (inflation-adjusted) cost of capital that is crucial, and for both countries it is much higher now than it was in the run-up to their adoption of the euro.

Moreover, it is erroneous to compare the present with the late 1990’s. Italy and Spain are at very different points in the economic cycle now than they were then. In the late 1990’s, both economies were growing (rapidly in the Spanish case), whereas now they face hard times and a mounting risk of deflation. And countries facing depressions and rapidly weakening inflation typically face very low borrowing costs: investors purchase government bonds for want of profitable alternatives. This is what we see in the United Kingdom and the United States, where borrowing costs remain at all-time lows, despite both countries’ weak public finances and poor growth prospects.

To be sure, investors must differentiate between eurozone governments, in order to ensure that risk is correctly priced. The Italian and Spanish authorities acknowledge as much. But the current spread between the yield on German sovereign debt and that of the Italian and Spanish governments far exceeds what is required to ensure that investors differentiate appropriately.

The polarization of borrowing costs has politically explosive distributional effects: Germany is borrowing and refinancing its existing debt at artificially low interest rates. According to the Kiel Institute for the World Economy, investor flight from the government debt markets of the eurozone’s struggling members to Germany has already saved the German government almost €70 billion ($88 billion).

Other countries, by contrast, face ruinously high borrowing costs, which are simultaneously increasing the scale of their reform challenges and narrowing their political scope to address them. The longer Italian and Spanish borrowing costs remain at such elevated levels, the greater the damage to those economies, and the harder it will become to marshal the necessary political support for further reforms.

The Italians and Spaniards are right: the principal reason for the size of the spread between the periphery and Germany is convertibility risk. Investors are demanding a hefty premium to insure against the chance that Italy and Spain are ultimately forced out of the eurozone – thus bringing that day closer by weakening countries’ fiscal positions and raising their private-sector borrowing costs (which are set by government bond yields).

With private and public consumption in both Italy and Spain set to remain depressed for years to come, economic recovery requires stronger investment and exports. But the steep fall in the value of Italian and Spanish banks’ holdings of government debt, combined with mounting bad loans as a result of recessions exacerbated by punitive borrowing costs, is forcing the banks to rein in business lending further.

The ECB’s latest program of bond purchases will be big enough to ensure that Draghi does not lose face. But it will not be big enough to dispel convertibility risk and hence demonstrate the ECB’s credibility as a lender of last resort. And it is the ECB’s credibility problem, not that of member states, that is the principal reason for unsustainably high borrowing costs in Italy, Spain, and other distressed eurozone countries.