ECB to the rescue

The European Central Bank has agreed to a new program to purchase potentially unlimited bonds of fiscally challenged countries in the eurozone in a bid to regain control of interest rates and lower borrowing costs.

Pledging to do whatever it takes to preserve the euro, ECB President Mario Draghi told reporters on Thursday (06.09.2012) that the new plan, with no set limit, would address the "unfounded fears" of investors about the euro's survival and serve as "a fully effective backstop to prevent potentially destructive scenarios."Draghi said the plan, officially called Monetary Outright Transactions, was strictly within the ECB's mandate to maintain financial stability. But, in the same breath, he underscored the need for governments to continue with deficit reduction plans and labor market reforms.

Addicted to bond buying

Countries that wish to benefit from the scheme must request a bailout from one of the eurozone's two rescue funds, the European Financial Stability Facility (EFSF) or the European Stability Mechanism (ESM), to ensure they continue reforms.

In a related move, the ECB decided to keep interest rates on hold, leaving its main rate unchanged at 0.75 percent.

The decisions, Draghi said, were also prompted by economic contraction; the ECB expects the eurozone economy to shrink by 0.4 percent this year.Draghi was able to win the support of all but one of the ECB council's members - Jens Weidmann, the president of the German Bundesbank, who voiced stiff resistance to bond buying. Weidmann has said he believes the ECB bond-buying scheme could become an "addictive drug" for governments unwilling to carry out painful reforms. He is also worried that it could trigger inflation

Experts have mixed views on the new scheme.

"Draghi is very capable and his latest move is the right thing to do," said Thomas Kirchmaier from the London School of Economics. "Some people worry about inflation, but that's clearly a non-issue. Inflation rates in the eurozone are low, and we're actually seeing a degree of deflation."

Sterilizing the money supplyClemens Fuest with the Said Business School at Oxford University agreed that inflation isn't a concern in the short term but warned it could become one in the long term if the ECB cannot "sterilize" the bonds. Sterilization is a step taken by central banks to avoid an increase in the money supply - and consequently in inflation.

"This could happen if countries get used to selling bonds to the ECB and running high deficits," he said. "Then we would have a situation that could lead to inflation."

Benedicta Marzinotto with the European think tank Bruegel said she believes sterilization will give a lift to the euro. "If the ECB doesn't sterilize, there is more risk of inflation," she said.

Fuest also pointed to legal questions about the ECB bond-buying move and how the central bank interprets the various statutes that give it the leeway to pursue such action."The ECB is selling this as a 'must' move but it's not evident to me that the currency union would fall apart or disaster would strike if the bank didn't do this," he said.

Reflecting Bundesbank concerns, Johann Eckhoff with the Institute for Economic Policy at Cologne University warned that the new ECB scheme could reduce pressure on countries to reduce their debt.

"We could have the effect of some countries not meeting agreed conditions and the others having to give in, as we do with Greece," he said. "The pressure to damn debt is reduced here, and that's dangerous."