New ECB Boss Inherits a Thorny Euro Zone Debt Challenge

Consider it a parting gift.

After eight years as head of the European Central Bank, Jean-Claude Trichet firmly blocked efforts by French President Nicolas Sarkozy to make the central bank promise to keep buying Italian and Spanish bonds as part of Europe’s debt agreement last month. Trichet, who began the controversial bond purchases with Greece in 2010 only to see two German ECB board members resign in protest, was determined to extricate the central bank from the bond market and put the burden of rescuing the euro zone periphery back on the Treasuries of Berlin, Paris and other capitals.

In practice, however, the ECB and its new president, Mario Draghi, will find it much harder to pull back. As Trichet himself demonstrated, the central bank is the only European Union institution with the capacity to act swiftly and boldly in a crisis.

The latest EU agreement includes a big increase in the haircut on Greek debt for private investors, to 50 percent, designed to restore Greece’s solvency; a deal to leverage the EU’s bailout fund, the European Financial Stability Facility, by as much as 5-to-1; and increased capital requirements for banks.

The package initially eased market fears and prompted a rally in the euro, but the deal still faces some big obstacles. Banks and other investors could balk at the new haircut, which would only reduce Athens’s debt-to-GDP ratio to 120 percent. Hans-Werner Sinn, president of the Munich-based Ifo Institute for Economic Research, says Greece needs nothing less than a major devaluation to regain competitiveness. “They have no chance to prosper in the euro zone,” he says.

EU leaders failed to spell out exactly how they would leverage the EFSF — by using it to provide first-loss guarantees to bond investors or buttressing the facility with money from China and sovereign wealth funds. But even leveraged resources of about €1 trillion ($1.4 trillion) could be quickly exhausted in a panic given that the Italian bond market alone is worth €1.9 trillion.

“They won’t have overwhelming firepower,” says Paul De Grauwe, an economist at the Catholic University of Leuven in Belgium. “It’s only when you have that that you acquire credibility.” Only the ECB can make unlimited interventions in the bond market, he says. So far, however, the bank has put itself in no-man’s-land, insisting that its sole job is to prevent inflation, then intervening reluctantly in a crisis to prevent a breakup of the euro area.

德拉吉需要embrace the lender-of-last-resort role for the ECB to stem the crisis, De Grauwe says, adding, “The toughest job is still to come."