For the first time the European Central Bank is recognizing the need to address a core drawback in the euro architecture, itself. – Brookings Institution

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An increasing number of observers have hastened to declare that the European debt crisis has been practically resolved or at least stemmed for a few years. This view was reinforced by the falling yields at the last Italian government bond auctions of 2011, which suggested a significant reduction in the perceived sovereign default risk. Since Italian bonds are regarded as the bellwether of the European sovereign crisis, many see this development as an indication of the stabilization of the euro sovereign debt market.

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The “solution” to the crisis was facilitated by the European Central Bank’s decision to lend to commercial banks for three-year terms in unlimited amounts at a very low rate. However, the ECB’s decision to do this is only part of what a central bank can normally do to fulfill its natural role as lender of last resort. Why then is there all this renewed optimism?

The immediate answer is that with the ECB’s new decision, commercial banks can now borrow cheaply from the ECB and invest in short-term sovereign bonds, pocketing a sizeable sovereign spread—a profitable “sovereign carry trade”. If banks do indeed play along, and despite the inefficiencies and distortions arising from such roundabout way of monetary financing, the European Central Bank might very much provide some lasting room to breathe for sovereign finances.

But the real reason why this otherwise standard policy decision appears to be such an important step forward is that for the first time the European Central Bank is recognizing the need to address a core drawback in the euro architecture, itself.

Source: brookings.edu

Read More @ Two Versions of the European Debt Crisis – Up Front Blog – Brookings Institution.