08/02/2012 03:36 EDT | Updated 10/01/2012 05:12 EDT

ECB's Draghi: Bank may intervene on to drive down countries' borrowing costs

FRANKFURT - European Central Bank President Mario Draghi said Thursday the bank would make a new effort to buy government bonds to drive down the high borrowing rates squeezing the continent's indebted governments. And he urged leaders of the 17 countries that use the euro to use their bailout fund to do the same.

However markets were disappointed that, while Draghi had committed the ECB to action, the plan was too short on detail.

Markets across Europe fell, while borrowing costs for countries such as Spain and Italy rose. Those costs are at the heart of the crisis, threatening indebted governments with a financial disaster that could rock the global economy.

Draghi said ECB policymakers will work on a more detailed plan in coming weeks, including how much money to put into the effort, which would aim to lower the interest rates on governments' short-term bonds. The ECB chief's remarks followed a decision by the ECB to keep its benchmark short-term interest rate unchanged at a record low 0.75 per cent.

The message from the ECB was clear: Europe's financial crisis is getting worse and requires more forceful remedies than leaders have so far been able to come up with.

"There wasn't any specific instance that led us to the decision we had today, just a sense of the worsening crisis and the worsening consequences," Draghi said. He said a recent spike in interest rates for the short-term bonds of countries such as Spain and Italy was a "symptom" of the stresses being felt across the region.

Investors, however, did not get the clear plan of action they were hoping for. They pushed stock and bond prices lower. As he spoke, Germany's DAX was down 1.4 per cent at 6,657 while the CAC-40 in France fell 1.3 per cent to 3,278. The FTSE 100 index of leading British shares was down 0.7 per cent at 5,675. The euro was 0.2 per cent lower at $1.2215.

Borrowing costs for Spain and Italy, the latest indebted eurozone countries to be the subject of speculation that they are the next for a full-blown bailout rose to 7.03 per cent for Spain and 6.19 per cent for Italy. Spain's main stock index dropped 4.85 per cent, while Italy's stocks fell 4.2 per cent.

This would not be the first time the ECB has purchased government bonds from banks on secondary markets to help drive down interest rates. That effort began in May 2010 and has been left unused since March after it did not decisively lower borrowing costs. The ECB purchased more than €210 billion in government bonds back in 2010, an intentionally modest effort that had limited capacity.

"It's pointless to bet against the euro," Draghi said, following up comments he made last week that the ECB would do "whatever it takes" to preserve the currency union.

In his comments, Draghi was careful to add that the bank would be acting independently to determine monetary policy and interest rates. It is forbidden by the EU treaty from using its monetary powers just to support government finances. He acknowledged skepticism on the part of Germany's Bundesbank head Jens Weidmann, who sits on the ECB board, and said the program would need a further decision of the board before it could be launched.

The ECB has been cautious about getting more aggressive because its charter states that the bank cannot finance governments' debts.

Still, Draghi emphasized that ECB action alone cannot save the euro. He pressed leaders of the euro region to "push ahead with fiscal consolidation, structural reform and European institution-building with great determination."

Draghi said the bank would act independently to determine monetary policy and interest rates — a signal that the ECB would not be influenced by political leaders who have been pressing the ECB to take a more active role.

The signal from the ECB that more help is on the way came a day after the Federal Reserve hinted it was leaning toward taking further action to stimulate growth in the U.S. if hiring remain weak. The Fed said in a statement it would closely monitor economic data to determine whether and when to take additional steps. Many economists believe the Fed could announce a new bond-buying program at a September meeting. The goal would be to further reduce long-term interest rates, which are already at historical lows.

He said the eurozone governments "must stand ready" to use their bailout funds, the European Financial Stability Fund and its successor, the European Stability Mechanism, in direct market interventions themselves. Countries would have to ask for that help first, which would take time, while the ECB can act at any time.

The bailout funds could play a key role because they can enforce tough conditions in return for help, such as further economic reforms. That way the bond market intervention could take pressure off governments while not undermining governments' resolve to cut their deficits and clear away regulation that slows growth and makes debt harder to pay.

Draghi also addressed a technical issue that has been worrying markets, saying private investors concerns about being behind governments in the line to get paid "will be addressed."

So far the ECB has insisted on being fully repaid on any bonds it buys in case of default, leading other creditors to fear there would be no money left for them.

Draghi said that such interventions could give governments time to fix their budgets and reform their economies in order to convince lenders they can pay debts and get out of the crisis. He warned that the bank's efforts couldn't replace that.

"Monetary policy will not be enough. unless there is action by governments." The bank "cannot fill this vacuum, this lack of action."

Member governments of the 17-country euro have had to bail out Greece, Ireland and Portugal after high borrowing costs left them unable to pay their maturing debts. Countries must constantly sell new bonds to pay off old ones that are coming due. Spain and Italy are much larger and if they should be cut off from affordable borrowing, any bailout would strain the eurozone bailout funds resources. Letting them default could meant heavy losses for banks and markets worldwide and could choke off credit to the wider economy.

The temporary EFSF has €440 billion in lending power, most of it committed to the bailouts for Greece, Ireland and Portugal. The ESM has not come into effect yet and will have €500 billion, €100 billion already committed to a bank bailout for Spain. Yet Spain and Italy together have some €2.5 trillion in debt. Italy's €1.9 trillion is the world's third largest bond market, after the U.S. and Japan.

Draghi noted that some of the excess interest demanded by investors comes from fear that the euro will break up and their investments will be denominated in a currency that is worth less. He issued a fierce warning to financial markets, saying premiums based on expectations of euro break up were unacceptable because the euro is "irreversible."