Mario Draghi (ECB President) once again showed leadership at crisis management, when he announced the details of his plan to use the Central Bank’s balance sheet to help the euro and its troubled countries in their transition through structural reforms. Mario Draghi shows a rare and privileged combination of leadership and pragmatism. The size of the liquidity provision needed in case Spain and Italy need help is clearly beyond what the EU institutions have set aside and seem capable of allocating, which is why the ECB is so important. However, the ECB can only help in the transition. Politicians need to reform institutions and implement adjustments; otherwise countries would continue to diverge in terms of their debt dynamics, growth rates and competitiveness.

But the justification for forceful ECB action and some key elements of the rules just announced seem to rest heavily on a not so subtle theoretical interpretation of economic reality: multiple equilibria. In this branch of economic theory, an economy could be in at least 2 possible situations, one better than the other, which begs the question of why and how to get to the “good equilibrium”.

Basically, multiple equilibria would argue that a big part of the reason why Spain and Italy are unsustainable is due to the very high interest rates at which they refinance, which are due to their potential unsustainability (not necessarily all due to fundamentals different from debt dynamics). In other words, their unsustainability is mostly due to a self-fulfilling prophecy, or what can be called ‘being stuck in a bad equilibrium’, when there is an alternative good equilibrium in which lower interest rates allow for sustainable scenarios to be possible. Thus, if only some large strong player could reset the system, moving them from the bad equilibrium to the good equilibrium, the probability of success would be higher. In this case, that large strong player is the ECB[1].

Mr. Draghi not only explained this during his press conference last week, but he used the terms ‘bad equilibrium’ and ‘self-fulfilling prophecy’. Moreover, a key element of the new intervention mechanism seems motivated by this theoretical interpretation of reality. The new bond purchases would apply to countries that get to a full bailout from the EFSF/ESM in the future, while countries that already are under a program would only get the benefit of the ECB buying its bonds once they recover market access. Basically, once there is a chance at there being in a good equilibrium.

These announcements by the ECB could amount to a serious game changer. Mr. Draghi called it “an effective backstop”. However, there are a few potential bumps on the road: politicians could still fail to deliver the structural reforms and adjustments needed to make the euro sustainable; the German Constitutional Court could declare the ESM a violation of German law; and, Spain and/or Italy could delay their application for help for too long, pushing them beyond the point of no return. The latter might be equivalent to waiting beyond the point in which a “good equilibrium” is possible. Finally, with the ECB’s balance sheet providing an effective backstop, the potential damage of Greece leaving could be lower or minimized, which is why the current negotiations between the troika and Greece matter again these weeks.

Germany is obviously essential to the euro’s sustainability, as it is its anchor. Its constitutional court should rule this Wednesday whether the ESM is a violation of German law or not. Moreover, the Bundesbank has been the dissenting voice in the ECB’s governing council. Though the Bundesbank seems to be alone at the ECB, it is not alone in Germany, where it is a reflection of what many politicians, economists and commentators think about Draghi and his plan. This is not a minor issue to monitor.

All in all, Mr. Draghi has eliminated the extreme bad scenario in the short-term. He has shown he is maybe the only European policy maker that is up to the task. We hope politicians join him and fulfill their roles to make the euro sustainable. Now that the ECB is finally fully onboard we are more optimistic about it.

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[1] It has to be said, that among theoretical circles there is a large group of economists that think that multiple equilibria comes into play when researchers cannot find other more logically sound explanations for a phenomenon or situation. I tend to believe that is the case, though there are some real life situations that seem to render themselves well to this approach.