Economists Hiss at ECB President’s Commitment to EU Protection

European Central Bank President Mario Draghi has pledged to do whatever it takes to protect the Euro Zone from collapse - including fighting unreasonably high government borrowing costs. The European Central Bank has opened the door to emergency support for the Spanish and Italian bond markets, setting off a blistering rally on bourses across the world.

Picking code words instantly understood by traders, Mr. Draghi said the violent spike in bond yields in recent days was hampering the functioning of the monetary policy transmission channels - the exact expression used to justify each of the ECB's previous market interventions.

Yields on Spanish two-year debt plunged 72 basis points to 5.47 percent in barely an hour, with comparable moves on Italian debt - easing the pressure before a string of debt auctions in Rome over coming days. In effect, the MIB index of stocks in Milan surged by 5.6 percent. Madrid's IBEX rose 6 percent, the biggest jump in two years, led by an explosive rise in bank shares.

Mr. Draghi's comments came as Spain claimed backing from France and Germany for activation of the Euro Zone’s rescue fund to buy Spanish bonds, though this would require calling the Bundestag's finance committee back from holiday for a vote. Action by the EFSF would provide political cover for the ECB to join the fray in a two-pronged attack.

However, skeptics abound as Mario Draghi's ECB bond bluff electrifies global markets. Joint statements from Madrid, Paris and Berlin said market turbulence does not reflect the fundamentals of the Spanish economy, or the sustainability of its public debt. The wording seems scripted to clear the way for intervention.

The euphoria is unlikely to last long unless the ECB comes through with concrete action after its pre-holiday meeting next week. Angel Gurria, head of the OECD, honed in on Mr. Draghi's caveat, saying the legal constraints are the nub of problem. The ECB must explore the flexibility of its mandate.

Others were blunter. Marc Ostwald from Monument Securities said Mr. Draghi's words were cheerleading bluster, while Gary Jenkins from Swordfish called them a bluff to get through the summer. Spain is very close to the precipice and its pretty much game over already. Yesterday’s action was a short-covering rally. The real trick is getting bond investors to come in alongside the ECB, and that is much harder.

Markets have become sensitive to the risk of subordination after the ECB and other EU bodies refused to take losses on holdings of Greek debt. Private creditors suffered bigger haircuts as a result. Mr. Jenkins further warned that the purchases of Spanish and Italian bonds risk setting off further capital flight unless the ECB makes it contractually clear that it does not have senior status. Investors will just try to get out.

Critics say the ECB's pin-prick purchases of Greek, Irish, Portuguese, Spanish and Italian bonds have fallen between two stools: enough to create subordination fears, without being enough to eliminate the risk of sovereign default. It would now take massive intervention by the ECB to repair the broken trust. Any such move would risk a showdown with the Bundesbank and its hawkish allies in the Teutonic bloc.