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.