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The euro zone crisis has tuned to a slow burn. Government bond spreads now discipline, rather than terrorize governments. But they can still hurt local economies and are, by several measures, higher than they should be. It shows the success, and limits, of ECB policy.
ECB President Mario Draghi's plan to buy sovereign bonds under certain conditions to keep the monetary union whole has brought yields back to less irrational levels. The spread between 10-year Italian and German bonds has fallen to 280 basis points, a far cry from its 2012 crisis peak of 530 basis points. Yet the euro zone bond market remains different from pre-crisis days. Between 2000 and 2008, the same spread between German and Italian bonds averaged 24 basis points.
Today's divergence is justified. Mr. Draghi's mooted "outright monetary transactions" are predicated on the notion that the central bank should remove the risk of a euro zone breakup, but not stop markets from pricing credit risk accurately. Today's spreads fulfill their task: the 4-per-cent yields on Italian 10-year bonds won't force the country out of the euro, but are uncomfortably high for a country in recession.
The new market-based regime isn't perfect, however. For one, what if markets are wrong? Analysis by Deutsche Bank, based on economic fundamentals, suggests Italy's spread is nearly 70 basis points too high, while France's nearly 100 basis points too low. Inaccuracy may be a necessary evil: If markets are to do their job, they must be allowed to be wrong. Second, spreads hurt economies if they are too high, forcing up bank and corporate borrowing costs. Discipline paradoxically makes adjustment harder.
Bond spreads are only one part of the problem: Weak banks are starved of capital, and wary of lending to weak economies. The planned banking union should help by ensuring banks are centrally supervised, and weak lenders wound down.
Relying on the banking union may not work. It could take a long time. The ECB may have to act sooner by providing more long-dated funds, or buying low-risk secured bank debt, like covered bonds to bring down borrowing costs. Such measures would be controversial. They shouldn't be – governments need discipline, but economies need support.