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Waiting for Prime Minister Mariano Rajoy to ask for lending assistance to Spain is enough to make you ask: Where are the bond vigilantes when you need them? The verbal intervention by Mario Draghi, president of the European Central Bank (ECB), on July 26, followed by the ECB's new Outright Monetary Transaction (OMT) program in early September, have succeeded in reducing the cost of debt for Italy and Spain—without the ECB having to buy a single euro worth of debt (figure 1).
These steps have been so effective that, in fact, Rajoy is playing the role of great procrastinator with seemingly plenty of time to sit on his hands. He is thus able to avoid the politically unpleasant request for aid from the ECB and the European Stability Mechanism (ESM). As someone who has predicted an expeditious request for aid by the Spanish government, this is an unfortunate turn of events. What did I get wrong?
Maybe I was too pessimistic over the euro area crisis— admittedly a novelty for me—in thinking that the mere announcement the ECB about lending as a last resort would not have been sufficient to calm down markets and ensure that Spain and Italy could achieve interest rates enabling them to be unambiguously solvent. Now it appears that neither Spain nor Italy will have to request this aid. The ECB's bazooka stays in the pocket, markets have calmed down and everyone lives happily ever after. Unfortunately, none of this passes the smell test.
More probably, I underestimated not only the market effect of the ECB's announcement but also the political obstinacy of Rajoy. Markets seem to have already priced in a Spanish approach to the ESM, but are not pushing up Madrid's yield for fear of being caught on the wrong side of future ECB interventions. After all, if the US axiom is that "you don't fight the Fed," it is probably also not wise to tangle with the ECB. Thus one ironic result of Draghi's actions has been to deter financial markets from ratcheting up the pressure on reform by recalcitrant euro area governments. Political moral hazard never goes away in the euro area. By stepping up to help, the ECB appears to have facilitated the government's dawdling.
On the other hand, as we were reminded on October 10 when Standard and Poor's (S&P) downgraded Spain to BBB-/A-3, which is near junk status, Spanish yields could well rise sufficiently for Rajoy to fulfill his promise to apply to the ESM if interest rates are too high. It would be a cruel irony for the euro area and the ECB—which have both tried to marginalize the effect of credit ratings on euro area policymaking and terms of collateral—if rating agency downgrades for Spanish bonds to junk status (preventing many investors from buying them) were what spurred Madrid to apply for help. Draghi may have declared that the euro area's future is in the hands of the governments now. But governments still need to be pushed by markets. And if Rajoy's government fails to restore confidence in Spain, approaching the ESM is in the offing.
The question of the timing of Spain's (delayed) request remains to be answered.
Madrid is likely to remain cautious unless market pressure quickly re-emerges. For Spain's political leaders, the domestic political costs from a bailout are well-known. As I have discussed, the costs can be mitigated if the government makes preemptive announcements of domestic austerity and structural reform measures before the actual ESM approach, so that they are not seen as kowtowing to pressure from their masters. As the Spanish government's 2013 budget illustrated last week, this process is under way.
Because the International Monetary Fund (IMF) will likely become involved in Spain without contributing financially, a Spanish program could be politically characterized as different from a program dictated by the IMF. (This would let the Spanish say to themselves: "We are not Greece!") Without a vote by the IMF Board to release funds, Rajoy's political concerns about conditionality are eased. Instead, Madrid may be concerned about the political approval process of a Spanish ESM program in other euro area countries. For Germany, that will require a vote in the Bundestag. Since this political process is related to the broader issue of ESM financial resources and parliamentary opposition to a Spanish program, a Spanish request is thus indirectly linked to the political situation in other crisis stricken euro area countries. This means that Madrid will be concerned about the potential political price for a parliamentary approval of such a program in other countries. In political horse-trading everything can be linked. One cannot therefore rule out that some euro area parliaments might suddenly demand Spanish political concessions on other issues, such as the new EU budget or Kosovo's status. It could thus be potentially politically costly for Madrid to apply for financial aid immediately after the Bundestag votes for a new ESM package for Cyprus or—much worse—additional financing for Greece.
It is well known that political systems in Europe and perhaps everywhere have the memory of fish—i.e., no memory at all. Accordingly, it would be best for ESM applications to be sequenced at intervals of every few months to allow for enough time between each tough vote. Given the situation in the euro area right now, however, sequencing the votes that way is not realistic. Consequently, euro area governments should bundle multiple simultaneous ESM requests into one big package, which—while politically unpleasant—would at least only require one parliamentary vote.
Unfortunately, at a time when market pressure is not acute, this situation makes the timing of a Spanish request dependent on clarification of the situation in both Cyprus and probably also Greece.
At the earliest, Rajoy can try to clarify the parliamentary approval process for his ESM request with his fellow heads of government at the EU Council on October 18. (The finance ministers won't have many insights on this issue.) He may then defer any request beyond that date. Since regional elections are to take place three days later on October 21, a Spanish approach to the ESM lies beyond that date.
More important, Rajoy is likely to defer his request until after action on Cyprus and after the upcoming report of the Troika (the European Union, the ECB, and the IMF) on Greece. Since the Greek situation is unlikely to be fully resolved until after the US elections on November 6, and new demands in euro area parliaments could emerge before then, this means that a possible Spanish approach will not take place until later this year.
Alas, the euro area still seems unable to be proactive in this crisis.
