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