Central bank action eases Europe's crisis, for now

The European Central Bank pulled Italy and Spain back from immediate financial disaster on Monday, driving down the countries' dangerously high interest rates by buying up billions of euros worth of their bonds on the open market.

But the rescue mission does not address the roots of Europe's 21-month-old financial crisis — such as how to stop countries from building up the towering debts that led Greece, Ireland and Portugal to take bailouts after bond markets wouldn't lend them more money at affordable rates.

Europe's central bank has long resisted shifting from its traditional job of controlling inflation to a lead role combating the crisis. It relented last week and revived a dormant program that had earlier made just under 80 billion euros ($113 billion) in Greek, Irish and Portuguese bonds. The purchases drive up their face value and reduce the interest rates to be faced on new bonds, which soared as a result of investor fears about the countries high debt and slow growth.

Italy and Spain are so much larger that the euro zone would find it virtually impossible to bail them out if they default. Supporting their debt could be a massive effort: Traders said the bank spent around 2 billion euros ($2.84 billion) Monday, while analysts at Royal Bank of Scotland see the bank racking up 600 billion euros per year in bonds at a rate of 2.5 billion euros a day.

Eventually, the bank could wind up with 850 billion euros ($1.2 trillion) of Spanish and Italian debt, the analysts added.

The ECB has been "sterilizing" its bond purchases by withdrawing funds from the financial system so that the overall amount of money in circulation remains the same, warding off any inflationary effects.

Still, massive purchases will freight the central bank's balance sheet with potentially risky assets. And some economists say such purchases damage the bank's credibility by opening it to charges that it's using its powers to bail out irresponsible governments.

As a result, ECB President Jean-Claude Trichet has consistently pushed for European governments, not the central bank, to buy up their neighbor's troubled bonds. That reluctance could mean the bank will limit its bond purchases and hand off the role of bond-buyer to the European bailout fund, which will grow to €440 billion after its expansion is approved by national governments, most of which are waiting until the end of the summer vacation season.

Unlike the central bank, with its power to print money, economists said that fund may not be big enough to keep Italy and Spain's yields down, allowing bond market turmoil to erupt again.

France says it's willing to contribute even more to the European Financial Stability Fund but Germany and many other countries with solid finances oppose boosting its size.

"You need somebody who is known to have unlimited firepower, and that's what the ECB has," said Paul De Grauwe, an economist at the Catholic University of Leuven. "There is no limit to the amount that the ECB can intervene."

Trichet left himself some leeway when asked last week: His "working assumption" is the stability fund would "eliminate the reason while we, from time to time, intervene on the bond markets."

But he also said, "We never pre-commit."

Commerzbank analyst Michael Schubert said Trichet would likely stick to his position, rather than risk the bank's reputation.

"If people do not believe or are convinced that the ECB is only responsible for monetary policy, but is in effect supporting governments, then this could be a severe loss in reputation and the consequences would be that inflation expectations would go up," Schubert said.

By the close, the yield, or interest rate, on Italy's 10-year bonds had dropped 0.7 percentage point to 5.3 percent while the equivalent rate on Spain's tumbled 0.9 percentage point to 5.14 percent.

Stephen Lewis of Monument Securities said the questions about the program would lead to more market confusion.

"It is too early to judge how effective the ECB's expanded bond-buying will be, but early results are not encouraging," Lewis said. "One problem is there still appears no plan to raise the EFSF's planned capacity... The lack of clarity is typical of the confusion that has followed so many recent euro zone initiatives to stabilise markets."


Pan Pylas in London, Greg Keller in Paris, Daniel Woolls in Madrid, and Angela Charlton in Paris contributed to this article.