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Will The European Central Bank's Bond-Buying Plan Work?

A giant logo of the euro currency stands in front of the European Central Bank in the banking district of Frankfurt, Germany.
A giant logo of the euro currency stands in front of the European Central Bank in the banking district of Frankfurt, Germany.
The European Central Bank (ECB) has announced a program in which it could buy bonds of struggling eurozone countries like Spain and Italy.

The program to purchase sovereign bonds in the secondary market -- called "outright monetary transactions" -- aims to lower borrowing costs for debt-burdened governments and soothe fears of a euro collapse.

What does the plan entail?

Under the plan announced on September 6, ECB President Mario Draghi says Europe's Central Bank is prepared to act as a "backstop" by purchasing a potentially unlimited number of short-term bonds in the secondary market.

That doesn't mean the ECB would buy bonds directly from cash-strapped governments, the so-called primary market.

Rather, the plan aims to lower the risk associated with bonds by reassuring initial buyers that they won't lose their investment in case of a government default because the ECB is there to buy up the bonds later.

In this way, the ECB hopes to drive down the interest rates governments must pay to borrow money through bond issues by making those bonds less risky to the initial buyers.

That's because less risk means governments can sell bonds at lower interest rates.

ECB President Mario Draghi characterized the plan as a "fully effective backstop to avoid destructive scenarios."
ECB President Mario Draghi characterized the plan as a "fully effective backstop to avoid destructive scenarios."
The ECB would also have the same status as the private bond holders. That part of the plan is meant to calm would-be bond purchasers who fear they may be the first hit with losses if a government is unable to pay off their debts.

Draghi says countries that want the ECB to buy their bonds on the secondary market must first seek help from European bailout funds and agree to "strict and effective" budget policies to reduce their deficits.

Greece, Ireland, and Portugal have already done so, but Madrid and Rome have been reluctant to take the politically unpopular step.

What has the reaction been to the ECB plan so far?

Spain's government said on September 7 that it would not make an "overnight" decision on whether to qualify for the new ECB plan by seeking a bailout.

Nevertheless, European bond markets on September 7 showed initial benefits for Spain. That's because investors were gambling that Madrid will soon seek a bailout and this sent Spain's borrowing costs down to levels not seen in four months.

The yield on Spain's 10-year bond fell by 0.32 percentage points on September 7 to 5.68 percent -- the first time it has gone below 6 percent since May. A rate above 7 percent is generally considered unsustainable in the long run.

Italy's Prime Minister Mario Monti also said it was "premature" to discuss potential Italian requests for a bailout.

Yields on Italian 10-year bonds, meanwhile, have fallen by 0.42 percentage points since just before the ECB plan was announced -- down to 5.09 percent on September 7 -- prompting Monti to call the plan and its boost to investor confidence "an important step forward."

How far does the ECB plan to go in fixing Europe's debt woes?

Some financial analysts argue that the boost of confidence brought about by the ECB plan could spur longer-term investor confidence and provide enough breathing space for indebted Europe to make significant financial rearrangements.

But many say that while the ECB's plan is likely to provide relief in the short term, it will not necessarily stimulate growth in cash-strapped countries.

Six eurozone countries -- Spain, Italy, Portugal, Malta, Cyprus, and Greece -- still languish in recession.

According to Dalibor Rohac, the deputy director of economic studies at the London-based Legatum Institute, the plan can only do so much if indebted countries do not aggressively tackle their budget-deficit problems on their own.

"Ultimately these countries have to either fix their internal imbalances through internal devaluation, which is proving to be very costly, or they will have to try to find some other arrangement that might even involve an explicit devaluation by leaving the eurozone," he says. "Ultimately the ECB can't fix these countries' fiscal problems and can't fix these countries' imbalances. And so we are still waiting for a solution to that longer-term problem."

European business leaders also say the clock is ticking for Spain and Italy to make a decision as soon as possible -- probably within weeks -- in order to benefit in the long run from an easing of the financial pressure on them.

This article has been amended since it was first published.