Thank you Germany, Italy, Spain and, especially, the European Central Bank. They all said enough to provide markets and investors with a tranquil August so far. The question now is whether they will be able and willing to pivot -- from reassuring words to the series of actions required to enable this tranquility to grow deep roots.
Let us start with some key facts. By the close on July 25th, Europe finances were at a critical level -- again. The yield on 10-year Spanish bonds had surged to 7.3%, rendering the country's debt dynamics highly unstable; and it was probably only a matter of days before it would have lost market access.
With Spain tottering, there were concerns that Italy could not be that far behind. Accordingly, the 10-year yield there had risen to 6.4 percent, fueling concerns that it too would eventually need a bailout.
Such recourse to European funding packages by two of the eurozone's largest economies would have probably overwhelmed creditors' willingness to lend. It would have also undermined the economic and financial fabric of Europe's historic economic integration initiative.
Mario Draghi, the president of the ECB, suddenly (and dramatically) pressed a pause button on all these concerns. In an historic speech in London on July 26th, he reassured the world that "the ECB is ready to do whatever it takes to preserve the euro;" and to be crystal clear, he added "believe me, it will be enough." At his ECB press conference a week later, he wrapped these remarks with partially-defined promises of both financing and conditionality.
Mr. Draghi's words struck that delicate balance between creditors and debtors. The conditionality element opened the door for supportive comments out of German officials; and the financing component was music to the ears of Italian and Spanish officials. With that, hedge funds rushed to cover their shorts (reflecting both perceived changes in risk and high maintenance costs of these positions).
The result was a tumble in yields -- to around 6.2% for Spain and 5.6% for Italy as of August 21st. Front-end bonds experienced an even greater yield compression, providing more reasons for other risk markets to rally. And they did, with the S&P gaining almost 6% in the four week period after Draghi's speech.
The critical challenge now for Europe (and beyond) is to build on these gains, not only to spread financial stability but also to counter the notable weakening of global economic prospects at a time of high unemployment on both sides of the Atlantic (with the notable exception of Germany).
Words alone will not be enough for that. A series of mutually-reinforcing actions are needed, focusing on six key areas:
- First, Italy and Spain would need to strike, and implement in a consistently credible fashion, a better balance between immediate austerity and measures to promote competitiveness, growth and jobs.
- Second, these efforts would need to be supported by more comprehensive and ample provision of financing from the ECB and other European facilities.
- Third, in order to crowd-in private flows that are critical to economic sustainability (instead of continuing to finance their exit), the ECB and European governments would need to limit the subordination of private creditors.
- Fourth, politicians in both surplus and creditor countries would need to do a much better job in conveying this multi-faceted, multi-year initiative to domestic constituencies, and convincing them of its necessity and viability.
- Fifth, the time has come to take a more decisive and courageous approach towards Greece's membership as continuous flip-flopping serves only to undermine the credibility of the eurozone as a whole.
- Sixth, all this would need to be underpinned by a meaningful structural and institutional revamp of the eurozone, including immediate progress towards greater fiscal integration and a region-wide banking union.
This is a challenging list, especially for the next few weeks; and it requires the type of political leadership and coordination that, hitherto, has tended to elude the eurozone.
Slippage on any single issue would risk a renewal of financial market turmoil and, with that, a further slide into recession for Europe (accentuated by high youth unemployment, explosive debt dynamics and social unrest).
August was indeed tranquil, and thankfully so. While hoping that this tranquility extends to September and beyond, policymakers and investors would unfortunately be well advised to guard against the return of heightened financial volatility.
This post originally appeared at CNBC.com.
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