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).


Tom said...

Doubts have also been expressed about the feasibility of sterilisation. Is that not a problem?

D. Mario Nuti said...

Obviously any attempt at permanent sterilisation is problematic against the framework of possible Long Term Re-financing Operations. And otherwise sterilisation can be costly.

But nobody can seriously argue that the current threat to the Eurozone is inflation, instead of a terrible depression, so OMTs cannot do any damage even if they were not fully sterilised.

Debbie said...

Even if falling yields on under-three-years-maturity bonds are followed by falling yelds on longer dated bonds, as you suggest, there would still be an incentive for governments to reduce the average maturity of their debt, thus making themselves more vulnerable.

Will said...

You seem to endorse the Treaty on Stability, Coordination and Governance in the Economic and Monetary Union, euphemistically called the Fiscal Pact. But this is nothing of the kind, only an anti-Keynesian recipe for a Europe-wide (and indeed global)recession.

Kurt said...

The euro rose to $1.2906, its highest level since mid-May. Is this a good thing?

D. Mario Nuti said...

Debbie: what matters for debt sustainability is the relationship between interest and growth rates. If OMTs lower the average interest rate paid on government debt and therefore free resources to fund the resumption of growth, their effect can only be positive, even though - ceteris paribus - shorter average maturity involves greater vulnerability. Lower interest and higher growth do not correspond to ceteris paribus.

Will: I am not endorsing the TSCGEMU (damn Euro-acronyms). Of course fiscal consolidation ideally should be slower, more gradual and steadier, and made more effective by credible pre-commitments, with respect to what it is stipulated in that Treaty. But it is hard to contemplate the unlimited funding of digging holes to fill them with banknotes at this stage. And the drop in government bonds yields that followed the OMTs announcement (over 100 points for Italy and Spain in sheer announcement effect, before a single cent was spent or committed) is large enough to allow for the resumption of some growth promotion, thus alleviating the recessionary impact of austerity.

Kurt, it is nearly $1.30 today, actually. Good for lowering inflation, and bad for competitiveness and foreign trade, unless it cools industrial relations and money wage settlements.

Bob said...

Why have elections, if the basic economic policies of elected governments are pre-determined by international organisations like the Troika? Clearly there is a democracy deficit in Europe today.

D. Mario Nuti said...

Definitely a democracy deficit, Bob, when nine unelected persons dressed in scarlet robes and wearing funny hats can decide the future of the euro.

Credible pre-commitments by democratically elected governments at least are a way of bringing forward the benefits of future austerity.

And it is open to question whether the respect of budgetary constraints, and its associated effect on borrowing costs in financial markets, is an infringement of democracy or just a fact of life, like the laws of thermodynamics.

Eva said...

The problem is not that those nine persons are unelected, for most constitutional judges are appointed rather than elected, but that nine German citizens appointed by Germans should decide the future of Europe, instead of the European Court of Justice or some such all-European institution.

D. Mario Nuti said...

Of course, Eva. Mind you, the fact that the German Constitutional Court did not oppose the ESM or the OMTs has been widely regarded in the German Press as a sign of weakness and withdrawal on their part.

Wolfgang Janisch writes in today's Suddeutsche Zeitung that the German constitutional court has so far refused to take matter to the European Court of Justice, for fear of losing its own influence (today's

D. Mario Nuti said...

For the English version of the Federal Constitutional Court judgement of 12/09/2012, see

David said...

Bernanke is concentrating on the long end of the Fed's latest round of quantitative easing. Why does Draghi, on the contrary, concentrate on the short end of the bond market (up to 3 years)?

D. Mario Nuti said...

Bernanke is trying to stimulate investment and employment, by reducing the long term interest rate, and he is allowed to operate on the longer term (and any other) market segment.

Draghi is allowed to operate in the shorter setment of the market, in order to mobilise efficient mechanisms of monetary transmission. He is not allowed by the ECB Statutes and the Treaties to monetise government debt, which is what would be implied if he purchased long term bonds (or if he rolled over shorter term bonds, something which has not been tested yet, though he might try in an emergency, just like the Bundesbank did in 1975).