A few weeks ago we wrote that only when the European Central Bank did get seriously involved in the markets, the crisis management scheme would be complete. Last Wednesday the ECB did provide an unprecedented amount of liquidity to markets through the new 3-year credit line to banks. We see this event as a potential game changer.

Before we jump directly in the liquidity provision issue, let us step back and use Mario Draghi’s lens to provide a framework of analysis for what is happening in Europe. In his second press conference announcing an ECB decision, on December 8, ECB President Draghi was extremely candid and touched upon many relevant issues. Its Q&A is almost a must watch for anyone interested in what is happeing in Europe (click here to watch it). In the response to the first question he described what are the three necessary pillars necessary to save the euro:

1- Measures that address the current fiscal situation as well as the competitiveness situation, in order to produce fiscal stability, growth and job creation. These can be seen as measures to address today’s fundamental problems.
2- Fiscal rules, in order to make fiscal stability credible in the medium-term. He said the EU needs new automatic and ex ante fiscal rules enshrined in primary legislation (i.e. treaties), which should include limits on deficits and debt. This he labeled as a ‘re-design of the fiscal agreement’.
3- A stabilization mechanism, which is usually associated with liquidity provision (for sovereigns and banks). Here he referred to the EFSF and the ESM, and made it clear that the EU Treaty does not allow the ECB to fund governments, and that he thinks the spirit of such rule needs to be respected, not only the letter.

Mr. Draghi claimed to be puzzled to the almost exclusive focus on (3) while it is from (1) and (2) that market confident, or lack thereof, should be hung. He said he sees this as an eminently political process, where key institutions are being re-designed. When pressed about the market negative dynamics and talk about a euro break-up as becoming a self-fulfilling prophecy he said that he thinks facts dominate psychology. If enough progress was done on (1) and (2), confidence would return.

Since July it is clear that politicians are working on the right direction along the first 2 pillars, though pace and details seem to always be insufficient. While on (3) most expected to be the ECB who would follow through once politicians produced enough on the fiscal side. The dominant view was that a premature ECB entrance could damage the incentives on the fiscal side. But then Draghi became too explicit about the ECB respecting not only the letter but also the spirit of the treaty, and markets thought the third pillar would never materialize.

In that same press conference the ECB announced something very important: 3-year credit lines for banks, against almost any collateral. Last Wednesday the ECB opened that facility, and euro-zone banks took out 500 billion euros in one scoop. This is very significant and it could mark the beginning of real monetary expansion by the ECB, in magnitudes only reminiscent of that of the Fed. The latter expanded its balance sheet by directly buying assets (from mortgages to US Treasury securities). The ECB seems to prefer the indirect route, using its banking system as the vehicle.

Back in September, at the IMF Meetings, some of these ideas were first floated, and at least one prominent American ex-policymaker opined that it was preferable to have the ECB act directly, as opposed to indirectly through a banking system that was actually deleveraging and preserving capital. One ECB board member, when confronted with this view, said that the relationship between regulators and banks in Europe is different as that in the US. In other words, it seems the EU regulators feel confident they can direct banks to provide the necessary liquidity, funded by this ECB facility.

By this analysis, based on Mario Draghi’s three pillars, one could conclude that things are in place for crisis management to succeed. However, looking back at the end of 2008 and beginning of 2009, a simplistic but acute view of those days says that only when markets got convinced that US policy makers were willing to do ‘whatever it took’, then markets regained confidence. The question now is whether this is the first 500 billion of ECB balance sheet expansion, and if it produces that same impact. In other words, do markets think that EU policymakers are now willing to do whatever it takes to save the euro? Most likely, not yet. But the direction is clearly the right one.