After months of resistance, euro zone bond markets are losing some of their immunity to infection. The gap between German and other yields is growing rapidly because of an increasingly acrimonious stand-off between Greece and its international creditors. Investors, who fear a Greek default or worse, could easily push spreads out further.
The first line of defence in any such crisis would be Mario Draghi. The yield spread between benchmark 10-year German bonds and comparable Italian, Spanish or Portuguese debt is already wider than it was in January when the European Central Bank (ECB)'s president unveiled plans to buy government bonds. Draghi said on June 15 the ECB would react to any unwarranted tightening of conditions. He certainly has ways of combating further sharp increases in yields or yield spreads.
Draghi could increase the quantity of debt the ECB is buying in its quantitative-easing programme or announce that the programme will be extended. The central bank could also activate a different bond-buying programme, known as Outright Monetary Transactions, which offers more discretion over the bonds it buys. Conveniently, the European Union's top court has just rejected a legal challenge to the programme. Draghi could also offer banks more long-term loans, on even more generous terms.
However, if Greece ever leaves the euro zone, even Draghi might need help calming bond markets. European politicians would be compelled to prove that the exit was a one-off, not a precedent. That would require measures to strengthen economic and monetary union and a show of political and financial solidarity.
Governments could, for example, reduce the hurdles that need to be overcome to access bank recapitalisation funds from the European Stability Mechanism. They might also set up some sort of pan-euro zone bank deposit guarantee scheme to backstop and complement national safety nets.
Even better, they could speed up work which is already underway to deepen monetary union. After all, giving up some national sovereignty might seem less irksome if the alternative was catching the Greek infection.
