Wednesday, September 12, 2012

Irreversible Euro

The Euro is Irreversible” - said Mario Draghi at least twice in the last few weeks, both in his 26 July Speech in London, and at the 2 August Press Conference in Frankfurt following the ECB Governing Body meeting. On the second occasion, the ECB President was specifically asked by a journalist: “What is the real meaning of the statement that the euro is irreversible?”

Draghi explained: “There is no going back to the Lira or the Drachma or to any other currency. It is pointless to bet against the euro. It is pointless to go short on the euro. That was the message. It is pointless because the euro will stay and it is irreversible.”

On Thursday 6 September Mario Draghi delivered on his promise. Outright Monetary Transactions (OMTs) are the new instrument being added to ECB powers, without any need for a change in the Treaties, making the ECB all that much closer to the Fed precisely because of its own independence in monetary policy and the requirements of effective mechanisms of monetary transmission.

These transactions involve “unlimited” purchases of government bonds (i.e. without pre-set limits in quantities and time), mostly within the one-to-three-years-residual-maturity range (in place of the earlier programme of bond purchases, now terminated), immediately sterilised, without asserting ECB seniority. And (in cauda venenum) OMTs are conditional on a specific request by a country for EFMS/EMS assistance and the strict monitoring of agreed fiscal policies and structural reforms associated with the programme, under penalty of cessation in case of non compliance.

The spread of Italian and Spanish bonds quickly dropped by over 100 points; the euro strengthened significantly; stock exchanges surged. But by Monday 10 September a new hurdle was placed in Draghi’s path, in the form of an emergency case brought by German MP Peter Gauweiler (and 37,000 other signatories) to the German Constitutional Court to treat the OMTs as a significant change to the EMS already under consideration by the Karlsruhe Court, whose ruling was due the following day, with a view to obtaining a postponement. But the Court promptly rejected the new case, and on 12 September it swept away that final hurdle, as widely and confidently expected, though reserving to a later date the assessment of the implications of OMTs. Spreads, euro exchange rate and stock exchanges resumed their initial response.

"Super Mario to the Rescue" read a New York Times column praising Draghi for his latest plan on Sunday 9 September (and on Monday 10 in The International Herald Tribune), comparing Draghi to “a star soccer player able to dodge through opposition and turmoil to achieve his goals.”

"I prefer to see him as Andrea Pirlo, the Italian midfielder with 360-degree vision, never hurried, always assured, master of the short and the long pass, bane of Germany, a fantasist who hits the target with precision," reads the column.

In particular the columnist Roger Cohen praised Draghi's ability to overcome German opposition to seeing his bond-buying plan come to life, describing how "Super Mario" is able to undo Germany "...with a series of feints that have left hardline Bundesbank bruisers looking as nimble and effective as beached whales"... "Little by little, Mario Draghi, the Italian president of the European Central Bank, has taken an institution whose overriding mission was to keep inflation in check...and turned it into a lender of last resort prepared to throw everything into buying the distressed euro-zone sovereign debt of countries like Spain and Italy and so preserve the euro".

After the European Summit of 28-29 July Mario Monti had been likened to Mario Balotelli, another footballer who also had contributed to the Italian team’s victory over Germany a few days earlier. But Monti’s would have remained a Pyrrhic victory without the subsequent backing of Draghi’s unerring diplomacy and inventiveness, that produced the “Big Bazooka”.

The OMTs have been widely criticised, not only by the usual adversaries of the euro (for instance in the British press, that immediately disparagingly dubbed them On My Tab), but also by respectable, pernickety commentators nitpicking on some aspect or other of Draghi’s scheme.

In his FT column, Martin Wolf argues that a conditional programme of bond purchases is not credible “because the ECB is unlikely to cause a financial crisis the moment a country fails to meet conditions”, by cessation or, worse, reversal of OMTs. But a bazooka can always change its target, trifling with the ECB on conditionality would - of course - be very dangerous; it would be more worrying if there were no penalties, or only lenient ones. Wolf is right, of course, in recommending a more aggressive monetary policy promoting more growth and jobs in the periphery. Since Germany is unlikely to accept this, he concludes that the ECB has only won some time. Even so, for once time comes cheap, and the progress is undeniable.

It has also been alleged that concentration on the short-end of maturities would have no effect on longer and especially 10-year bonds on which the spread over Bunds is measured. Worse than that, investors would sell 10-year maturities to buy those under three years, thus worsening the spread. But the proof of the pudding is in the eating: 100 points fall in the spread as a mere announcement effect is no joke. And the fall in the yield on shorter maturities (capable of rising above longer to signal an imminent danger of default) is usually followed by a yield fall in longer maturities.

We are now confronted with a dilemma, whether to starve because of the austerity imposed by a programme, or to starve because of the high spread (argues Marcello de Cecco, Repubblica A&F of 10 September). But a 100 points fall in the spread, other things remaining equal, frees non negligible resources (the best part of €20bn in Italy’s case) that can be used to stimulate the economy and promote growth.

However, one remaining ambiguity of OMTs is whether the up-to-three-years-bonds would or would not be renewed at maturity. If they were not, this would set a limit, possibly a very serious limit, to the ECB control over monetary transmission mechanisms. But if they were renewed, Mario Draghi could no longer argue that OMTs do not represent debt monetisation. And if they were not, the possibility would return of the spread rising to non-sustainable levels when a country re-attempts market access, or even of failure to access financial markets at any price.

In this case the likely ensuing default would inflict a loss on the ECB, falling fairly and squarely on all of its shareholders (including non EMU members) proportionately to their ECB shares. This could be regarded as a form of genuine mutualisation of the failing government’s debt, without the burden unfairly falling on the richer EMU members as it would be the case with the ill-starred, ill-conceived standard Eurobonds, understood as bonds covered by joint and several responsibility of EMU member states. Importantly the ECB loss in case of default could be covered by the present value of the seigniorage that the ECB possesses in the hidden depths of its balance sheet, all €3.5 trillions in the famous, unchallenged estimate by Willem Buiter (2011).

Thursday, August 23, 2012

The ECB Firepower

The idea of multiplying the EFSF/ESM firepower by using purchased government bonds as collateral to borrow from the ECB thus proceeding to buy more bonds, and so on, was firmly rejected by Mario Draghi at the press conference of 2 August after the ECB Governing Body meeting.

Draghi said that he was “a little surprised by the amount of attention that [the possibility of an EMS banking licence had] received in recent press coverage, and in public opinion”… “After all, I have said at least twice that the present design of the ESM does not allow this. It is not up to us to issue a banking licence – this is a matter for the governments. What is up to us to decide is whether the ESM – evenwith a banking licence – can actually be a suitable counterparty that is eligible for central bank financing. And I have said at least twice – at a press conference, and on other occasions – that the current design of the ESM does not allow it to be recognised as a suitable counterparty”  (emphasis added).

Moreover, Draghi referred to “a legal opinion of the ECB on this, which was issued way back [on 17] March 2011”. The Press Conference report actually gave the link to that legal opinion.

Specifically, the ECB legal opinion argues that “Article 123 TFEU would not allow the ESM to become a counterparty of the Eurosystem under Article 18 of the Statute of the ESCB [European System of  Central Banks]. On this latter element, the ECB recalls that the monetary financing prohibition in Article 123 TFEU … is one of the basic pillars of the legal architecture of EMU both for reasons of  fiscal discipline of the Member States and in order to preserve the integrity of the single monetary policy as well as the independence  of the ECB and the Eurosystem”.

Article 123 of the Consolidated Treaty on the Functioning of theEuropean Union of 2009 (ex-Article 101 of the earlier consolidated version of 2006) stipulates that:

“1. Overdraft facilities or any other type of credit facility with the European Central Bank or with the central banks of the Member States (hereinafter referred to as ‘national central banks’) in favour of Union institutions, bodies, offices or agencies, central governments, regional, local or other public authorities, other bodies governed by public law, or public undertakings of Member States shall be prohibited, as shall the purchase directly from them by the European Central Bank or national central banks of debt instruments.”

Although: “2. Paragraph 1 shall not apply to publicly owned credit institutions which, in the context of the supply of reserves by central banks, shall be given the same treatment by national central banks and the European Central Bank as private credit institutions.”

The legal merits of the case rest exclusively on the ECB's own interpretation of its own rules, not on a Higher Court or on an “authentic” interpretation. Nevertheless, clearly we must take no for an answer: regardless of the legal position there is no willingness in the ECB Governing Body to transform the ESM into the Lender of Last Resort (to governments) arm of the ECB. Draghi’s rejection of this weapon is compounded by similar declarations by Merkel, Schauble, CDU politicians, the Dutch and the Finns.

What about the ECB acting as an EFSF/ESM agent, within the relatively small EFSF residual budget (about €150bn) and/or - subject to the approval of the German Constitutional Court expected on 12 September - the limited but more substantial ESM (€500bn), with a view to reduce the spread on the bonds of “virtuous” governments?
Here there are more encouraging developments:

1)      On 20 August the Bundesbank Monthly Report confirmed its President’s view that “bond purchases are problematic and lead to risks for stability”. At the same time Jorg Asmussen, the other German representative on the ECB Governing Body, actively and loudly supported “unlimited ECB [government bonds] purchases, for the ECB wants to take out any doubts among market participants about the future of the euro” (, 21 August);

2)      The details on the use of the EFSF/EFM as an anti-spread shield are still under discussion, but the proposal has already been endorsed by Angela Merkel repeatedly over the last month, while the (bad) idea that threshold spread levels would automatically trigger bond purchases has been denied by the ECB;

3)     The credibility of Jens Weidman’s stance has been pre-emptively eroded by the revelation that, back in 1975, the Bundesbank had actually broken its own policy principles and possibly its own statutes by purchasing German government bonds to the equivalent of 1% of its own GDP at the time. (see FT, 7 August, and the excellent piece by Evelyn Harriman of BNP Paribas.

True, the German Central Bank buying German bonds is not the same as the ECB buying Italian and Spanish bonds, but if the ECB bought government bonds of all the EMU member countries, in the same proportions in which they hold ECB shares, re-distribution should not be an issue. As I wrote in my previous post in answer to a comment by a reader:

"Suppose the ECB bought a balanced packet of 100bn of EMU government bonds in the same proportions in which EMU countries hold shares."

"Roughly 30% of ECB shares are held by 10 EU members who are not EMU members (with the UK at 14.5%), the rest is divided among EMU members: Germany 18.9%, France 14.2%, Italy 12.5%, …, Spain 8.3%, Greece 2%, Portugal 1.75%, , Ireland 1.11%, … Malta 0.06%. Therefore the bond packet bought by the ECB would contain 100/70 or roughly 1.43 times each EMU member’s share in ECB capital, eg Spain €11.869 bn."

"Suppose that subsequently Spain defaults and its bonds lose 50% of their value. Germany [as ECB shareholder] loses 0.189*0.5*11.869bn euro, or €1.1216205 bn. An equivalent amount out of the €18.9bn outstanding German debt purchased by the ECB could be cancelled, and so on for all  corresponding losses of other EMU members."

"Non-EMU-member Shareholders would have to be compensated by the ECB for 30% of the loss of value of Spanish bonds, i.e. would have to be paid dividends of 0.30*11.869 bn euro; all ECB outlays to come from ECB profits (including seigniorage if need be, in which case non-EMU members might not be entitled to compensation …)."

"In conclusion, EMU non-members would be compensated for their participation in the cost of Spain’s default with dividends, while EMU members would be compensated by the withdrawal of a corresponding value of their bonds (without prejudice for the present entitlement of non-EMU members to benefit or not to benefit from euro seigniorage)."

So, there is no reason for peripheral (i.e. high spread) eurozone members to panic - yet. Where there is a will there is a way. And financial markets believe in the “Draghi rally”.

Thursday, July 26, 2012

The ECB weaponry

The current euro crisis was named by Nouriel Roubini and several bloggers as “a slow motion train wreck”. In the last twelve months the trains have continued their collision course and actually have accelerated their speed, but the crash is not a foregone conclusion. There are still courses of action - though admittedly problematic - that might avoid the collision.
Germans are opposing the so-called “mutualisation of European government debt”, through the issue of bonds for which each and all EMU member states would be responsible jointly and severally. Quite reasonably, we argued in our last post, for inevitably they and the few AAA-rated members would end up paying for all.
Germans are also opposing an increase in the funds of the European Stabilisation Mechanism, much less reasonably in view of German exposure to the euro crisis. Indeed, the operation of the ESM as an anti-spread shield, which seemed to have been agreed at the Economic Council of 28-29 June and would gain a bit of time to look for other solutions, is being delayed when it is most urgently needed, by the temporizing tactics adopted by the German Constitutional Court. 
Also, Germans are not even contemplating the sheer possibility of reflating the German economy, most unreasonably because this not only would cost them nothing but would benefit them first and then the whole eurozone by reducing the German trade surplus and facilitating overall re-balancing of the entire eurozone. Paul Krugman had suggested that Germany should pay all of its citizen a 1000 euro voucher to spend in Southern Europe - an excellent proposal which naturally fell on deaf ears.
The current euro crisis has reached a new depth, with bankrupt regions and metropolitan cities in Spain (Valencia, Mursia, Cataluna) and in Italy (Alessandria; allegedly Sicily; with another 10 cities feared to be at risk of default given high debt and bad investment in derivatives, see La Stampa, 23 July); record spreads; rating downgrading and negative outlooks leaving only Finland at a stable AAA grade; a tough line on Greece taken by the troika (EU, ECB, IMF); and the inexorable recession induced by excessively fast fiscal consolidation.
In these circumstances, the European Central Bank is the only institution left that has the means to intervene with any effectiveness. Granted, the ECB is not allowed to act as Lender of Last Resort to governments, because of the No Bail-Out clause in the Treaties. It can acquire government bonds of countries under speculative attacks on a limited scale under its Securities Markets Programme (SMP), that started on 10 May 2010, which however has already come under criticism. And in December and February the ECB has injected a total of €1 trillion of liquidity into the European banking system through its Long Term Refinancing Operations (LTRO, also re-labelled as Lourdes Treatment and Resuscitation Option, 28/04/2012). This could be repeated, but not indefinitely, and in any case it is a rather blunt instrument, for only a fraction of the injected liquidity finds its way to support government bonds.
Nevertheless there are still two awesome, unused arrows in the ECB’s quiver.
One of the ECB weapons is the possibility of leveraging the European Stability Mechanism (and/or the European Financial Stability Facility for its residual life) via a banking licence. The government bonds purchased by this/these institution(s) would be used as collateral to borrow from the ECB additional funds to finance further purchases, and so on.
Last December the European Union President Herman Van Rompuy himself suggested that the ESM would be more effective if it becomes a "credit institution." The Germans immediately (WSJ on line, 8/12/2011) and repeatedly afterwards rejected such an idea, with reference to both ESM and EFSF. But it turns out that this is a matter of ECB policy, not subject to a German veto: the ESCB [European System of Central Banks] and ECB Statutes,  Art. 18 on Open Market and Credit Operations, stipulates that:
“18.1 In order to achieve the objectives of the ESCB and to carry out its tasks, the ECB and the national central banks may:
— operate in the financial markets by buying and selling outright (spot and forward) or under repurchase agreement and by lending or borrowing claims and marketable instruments, whether in Community or in non-Community currencies, as well as precious metals;
— conduct credit operations with credit institutions and other market participants, with lending being based on adequate collateral [emphasis added].” And
“18.2. The ECB shall establish general principles for open market and credit operations carried out by itself or the national central banks, including for the announcement of conditions under which they stand ready to enter into such transactions.”
The EFSF/ESM are undoubtedly “other market participants”, and Italian and Spanish bonds are still regarded by the ECB as “adequate collateral”. And it is the ECB itself to establish “general principles” and announce the “conditions” for such transactions. (I am grateful to Carlo Clericetti for pointing this out in a comment to my earlier post and in his article in Repubblica - Affari e Finanza). No German veto can be exercised, Mario Draghi can do it if he really wants to do it.
The second arrow in the ECB’s quiver is the conduct of a monetary policy like the Federal Reserve Quantitative Easing. This has been recommended by many commentators in the past, but of 24/7/2012 reports an article by Federico Fubini in Il Corriere della Sera of the same date.  “According to Fubini, a European QE is not against the EU Treaties, if the ECB would buy governments bonds from every Eurozone countries [emphasis added]. Bank of America-Merrill Lynch also said yesterday that the ECB should start a QE as soon as possible. "It’s a way to change that situation, to break the European stalemate," analysts said.”
The odd thing is that both the original article by Fubini, and the earlier statement by BoA-ML, do recommend Quantitative Easing but make no mention of the alleged compliance with EU Treaties “if the ECB would buy governments bonds from every Eurozone countries”. Maybe this was an after-thought by the Director Wolfgang Munchau, or by another collaborator. In any case, the qualification is brilliant. If the ECB purchases a balanced package of government bonds in the same proportions in which countries hold shares in the ECB, there is no mismatch between the two, and nobody - including the Germans - has any reason to complain. Presumably a satisfactory way of compensating gains (including the capital thus raised by the richer countries) with losses (inflicted by the poorer ones in case of default) could always be settled beforehand.
It is true that the ECB has a capital of only €6bn in the process of doubling over 5 years, but - even setting aside Paul de Grauwe’s powerful argument that a Central Bank does not need equity capital at all - the ECB has off-balance-sheet resources of the order of at least €3.5 trillion being the estimated present value of its seigniorage (see Buiter, 2011).
The existence of such formidable weapons in the ECB armoury does not indicate whether and when they will be used. But the very fact that they might ought to set a limit to the downwards spiral of credit ratings and the escalation of spreads. 
Today Mario Draghi, in London at the Global Investment Conference, declared:  “We are ready to do everything that is needed for the euro. And, believe me, it will be sufficient”… "It is impossible to immagine that a country might exit the Eurozone”, … and “the control over spreads is part of the BCE mandate when they impede monetary transmission mechanisms”. He was not bluffing, and financial markets believed him, bringing Italy’s spread down by over 50 points to below 470 points, and the euro exchange rate up by over 1.5 cents.


Mario Draghi's speech at the Global Investment Conference, London, 26 July 2012. 

Wednesday, July 11, 2012

The Monti-Merkel Double Act

A simpleton, or a con-man, might attempt to persuade the richer members of a club, like the Germans the Dutch and the Finns in the Euro-zone, to accept the mutualisation of European governments debt through the large scale issue of Eurobonds with joint and several responsibility of all members. For inevitably those richer members would end up paying for all. No other kind of Eurobonds would solve the euro crisis, whether project bonds or mini-Euro-bills on a small scale, or with pro-rata responsibility, or Eurobonds issued by any European agency other than the European Central Bank (that is statutorily prevented from issuing them) and which in view of the minute size of the EU budget would be necessarily treated as junk bonds.

A simpleton or a con-man, or perhaps a wrecker, someone knowingly making unacceptable suggestions thus providing an alibi for the refusal of more plausible, useful suggestions, such as raising the size of the European Stabilisation Mechanism, or re-balancing and reflating the German economy.

Why, then, have Mario Monti and Francois Hollande so insistently and persistently, indeed obsessively pressed for the issue of such Eurobonds, ignoring loud and clear, repeated refusals? That Hollande should do it should not surprise: he is a well-meaning socialist, and an ill-advised beginner with no previous experience in government. But why Monti, the shrewd economist and experienced former Eurocrat?

There is a rational explanation. By knowingly making an unacceptable demand, Mario Monti gave the German Chancellor a wonderful opportunity to take a spectacular stance: “Not in my lifetime!”. It is no accident that according to a poll conducted after the EU summit her popularity rating rose to the highest level recorded in the last three years.  The poll also confirmed strong support for her stance in the euro-zone debt crisis, showing that 66% of Germans were satisfied with her performance, an increase of eight percentage points from a month before and the highest reading since 2009 when she won a second term. “Some 58% of Germans believe Merkel's stance in the euro crisis is correct and decisive, although 85% of those polled also expect the crisis to get worse.” (, 7 July). 

At the same time, Angela Merkel obliged by making, in return, moderate, ambiguous and double-edged concessions, that involved support for the re-capitalisation of Spanish banks, the deployment of ESM funds to provide Monti’s “anti-spread shield” through the purchase of virtuous governments’ bonds (and not just to finance imbalances by rogue governments under troika’s supervision), as well as the Europe-wide monitoring of major banks with ECB involvement, a step construed as an anticipation of a banking Union. Francois Hollande got a modest investment injection of 120-130 bn euro, of which only 10 bn could be regarded as additional to already available resources. A win-win solution for all, then? Certainly enough for Mario Monti to return home to a hero’s welcome, portrayed on Facebook like the footballer Balotelli who on the same day scored the crucial winning goals against the German team. The threat of the Monti government crisis subsided. Italy’s 10 year bonds’ spread over German Bunds fell significantly though temporarily.

It is immaterial whether Merkel and Monti staged a concerted Double Act, or Merkel reacted predictably to Monti’s Eurobonds pressing, with Monti then demanding a modest reasonable concession which Merkel made more comfortably than otherwise might have been the case.

That Merkel’s concessions were moderate, ambiguous and double-edged it became clear very soon; indeed it took financial markets only 48 hours to have second thoughts about the deal. Partly, the devil is in the details, and the concessions were downsized when the details were specified.

The ESM was expected to inject equity directly into banks, breaking the link between banks and government debt, whereas it was clarified by officials that a national government guarantee would be retained; and the Karlsruhe Constitutional Court is taking its time to study the ESM and Fiscal Pact before taking a decision; and the ESM involvement will have to wait for new Europe-wide monitoring of banks to be established to the ECB satisfaction, probably not before 2013.

The size of the ESM remains what it was before, 500 bn euro of which 275 bn are already earmarked and committed to the support of Greece, Portugal, Ireland and Spain. The maximum liability that might be incurred by the Germans as a result of ESM operations therefore remains unchanged, in spite of the broadening of ESM responsibilities towards banks and holding down spreads of “virtuous” countries. We do not know yet what the spread ceiling will be; the ESM intervention will not be automatic but will require a specific request by a country, which might be deterred from making it by the stigma that will necessarily be attached to such a request. The ESM will buy government bonds through the ECB as its agent, thus to a Martian the process will be initially indistinguishable from the ECB acting as Lender of Last Resort to Governments; but any earthly investor will be aware that the ECB intervention will be limited at the very outset to the residual 225 bn funds uncommitted at present and, as pointed out cogently by Paul de Grauwe, will start selling his bonds of the governments involved long before those modest funds come to an end, thus triggering off the rise instead of the fall of the spread.

“Monti obtained the Anti-Spread Shield”. “Yes, and he was given a brand new Damocles’ sword in return” (a cartoon in Il Fatto Quotidiano of 10 July).  The so-called Anti-Spread Shield provides a mouthful of oxygen ("una boccata d’ossigeno", commented an Italian former Premier, or rather we should call it "una Bocconi d’ossigeno").  It is not a solution, but a way of “buying time for a solution without actually providing one” (Paul Collier, 10/07/2012). At a cost, of course: the probability of a crisis is reduced, at the cost of making the crisis all that much more serious if and when it occurs - not necessarily a superior trade-off.

At a Press Conference of 9 July in Rome, Monti was asked whether he regarded the current and unchanged size of the ESM as adequate. He answered that interventions could be effective even on a small scale, but that he “might be wrong”. So he might, just think  how the UK and Italy were kicked out of the European Monetary System by a couple of Hedge Funds in 1993.

Clearly the time has come now to forget and bury Eurobonds, even in the long term. To recognise that so-called structural reforms will have no positive effect on growth for at least the next five years; and that austerity has already gone too far and more austerity can only yield more recession, worsening debt/GDP ratios and spreads. That the ESM size needs increasing, the sooner the better, and/or be granted a banking licence so as to enable to ECB to legitimately lend to it and raise the scale of its operations. And that the time has come for Germany to end its rabid obsession with inflation and austerity, and raise wages and public and private expenditure reducing its external imbalance (surplus) and turning on its growth wheels.