The euro zone is inching towards a new plan to tackle its debt crisis in a three-dimensional game of chicken among all the main players.
The European Central Bank’s heavily qualified offer last week to step in and buy bonds to bring down the borrowing costs of Spain and Italy was the latest gambit in this game.
Each of the main protagonists - the central bank, the countries under pressure, EU paymaster Germany, and governments already under a bailout program - is angling for others to make the first move and carry the brunt of the cost.
There is also a game of chicken between the ECB and bond market investors, who have driven the 17-nation currency area to the brink of dislocation due to a lack of confidence in its policymakers’ ability to overcome the crisis.
Draghi sought to intimidate speculators out of betting against the single currency, saying European monetary union was “irrevocable” and it was pointless to short the euro.
Expect things to get worse in the markets, in political arm-wrestling and perhaps on the streets of Athens and Madrid before decisive action is forthcoming in late September.
Spain and Italy had hoped the ECB would step in to support them on the basis of their existing austerity measures without having to endure the political stigma of applying for a bailout.
But the ECB, the only federal institution capable of rapid and massive intervention, is willing to act only if Spain first requests assistance and accepts strict policy conditions and surveillance, and if euro zone governments commit their own money by activating their rescue funds.
“The Spanish seemed to think they could get a free ride from the ECB without conditions. That was never going to happen,” said a senior euro zone policymaker, speaking on condition of anonymity because of the sensitivity of the matter.
Spanish Prime Minister Mariano Rajoy has now opened the door to requesting help, saying he will take a decision in “what I believe to be in the best interest of the Spanish people” once he knows what is ECB was prepared to do and on what terms.
Italy, with a bigger debt mountain but a far better budget position, strong domestic savings and more robust banks, is hoping its borrowing costs will fall once the ECB intervenes to back Spain, without having to request a program itself.
Italian Prime Minister Mario Monti sought to nudge Rajoy in that direction when they met last week, diplomats said, although he is aware of a risk that if Madrid gets a bailout, markets may speculate that Italy will be next, and turn their fire on Rome.
Germany, the biggest contributor to euro zone rescue funds, is maneuvering for others to do their “homework” so that its overall financial liability does not increase. Chancellor Angela Merkel does not want to go back to parliament to seek more bailout money in a pre-election year, least of all forGreece.
Merkel and Finance Minister Wolfgang Schaeuble have kept quiet on vacation, deflecting pressure from the United States and the International Monetary Fund for quick action to support Spain and Italy.
EU leaders cannot do much until the German Constitutional Court gives an expected green light to the euro zone’s permanent bailout fund, the European Stability Mechanism, on September 12. The caretaker Dutch government is also keen to avoid any new rescue before a general election in the Netherlands on the same day.
Meanwhile Greece, which could run out of money next month, is hoping international lenders will be so scared of the mayhem a Greek euro exit would wreak on the European economy and the single currency that they will give it more time to implement a second bailout program and write down more of its debt.
And Ireland, bailed out in 2010, is seeking to ensure it gets the same concessions granted Spain or Greece, to reduce the cost of cleaning up its own shattered banks.
ECB President Mario Draghi’s carefully hedged announcement of possible bond buying should not have surprised investors, although the initial market sell-off reflected dismay that there would be no immediate action.
Draghi has his own constraints, with Germany’s powerful Bundesbank looking suspiciously over his shoulders. For the sake of the ECB’s credibility he cannot print money unconditionally to support indebted governments.
The ECB was burned last year when then Italian Prime Minister Silvio Berlusconi reneged on reform commitments as soon as the central bank began buying Italian and Spanish bonds to bring down their borrowing costs.
So Draghi was bound to look to the European Commission and euro zone governments to enforce stricter fiscal and economic reform conditions on any assistance this time.
Furthermore, the ECB said it would buy shorter-term debt, easing the immediate funding stress and repairing the transmission of its monetary policy while maintaining longer-term pressure on the beneficiaries for economic reforms.
The aim of the plan taking shape is to keep Madrid and Rome in the capital markets at an affordable cost both to them and to euro zone governments, whose rescue funds are too small to cover Spain’s full funding needs for three years, let alone Italy’s.
The ECB remains the only body with unlimited firepower to make the markets blink. Aware of design flaws in its previous limited bond-buying program, Draghi did not rule out much more massive intervention this time, saying it would be “adequate”.
The trick in the ECB’s game of chicken will be to cow speculation against the euro zone without losing German support or letting the assisted member states off the reform hook.
Rajoy’s shift suggests it may be “game on”.