Last week I promised to provide a little more insight into what the ECB is doing with its OMT program and what this should mean for the euro, economic growth, and European sovereign bond markets. This weekly post is dedicated to that theme. On the whole, the OMT decision is a significant move by the ECB, especially given Bundesbank opposition. But hurdles still remain both in terms of the German constitutional court challenge to the ESM and in terms of capital flight and likely bank resolution burdens.
Fundamental problem in Europe
Since this is a weekly, I want to look at the issue comprehensively. And that means framing the euro zone’s problem. At heart, the issue is the nexus of sovereign indebtedness and bank solvency in a fixed currency union without a lender of last resort. The euro zone has been set up to tie the hands of sovereigns like Italy and Greece in order to maintain fiscal discipline. The thinking was that, if there can be no central bank funding of sovereign states – aka monetization, then Italy and Greece would be forced to become more like Germany and the Netherlands and run more disciplined fiscal regimes. European policy makers believed this was central to maintaining price stability as it had been a central component of German economic success after the second world war. See my 2010 post “How Belgian debt, Italian anarchy and Greek profligacy lead to economic chaos in Europe” for more on this theme.
This setup was designed for failure for three reasons. First, Europeans assumed deficits were the central issue. The euro zone’s setup then assumed that markets would penalize countries for ‘fiscal profligacy’ by making their ability to finance deficits onerous. The thinking was that, without the central bank to monetize the deficits, the spending would then be brought to heel. But, markets are not self-correcting. And so the fairy tale of market discipline as a primary actor in correcting imbalances has been proved false.
Second, resolving current account problems are the real problem of fixed exchange rate regimes. Deficits were never going to be the primary reason for euro zone problems. Especially in the absence of so-called market discipline, large current account imbalances were destined to open up within the euro zone, creating asset bubbles that would lead to a fiscal virtuous circle. In Spain and Ireland, for example, the countries had huge current account deficits as money from Germany and elsewhere poured in, fueling an asset bubble that swelled government coffers and produced fiscal surpluses. So, it wasn’t about government deficits and surpluses. In fact, fiscal surpluses are usually a sign of capital spending or household debt binges that will end badly just as we saw in the US in the late 1990s. See “Spain is the perfect example of a country that never should have joined the euro zone“.
Third, the institutional structure of the euro zone is woefully incomplete. When these imbalances formed and then bubbles burst, the euro zone had no way to alleviate the burdens of adjustment. Instead, the rules of the euro zone have amplified distress by necessitating public sector cuts to match post private sector cuts. This will always lead to debt deflation, depression and economic nationalism as I predicted in 2010’s The origins of the next crisis.
The end result of Europe’s policy and institutional failures is the present sovereign debt crisis.
Banking system and regional government distress makes things worse
If all of this weren’t problem enough, it should be clear that current account balances that fund capital spending and household spending binges are going to leave a wake of bad debt and insolvent financial institutions. Who’s going to pay for that: bank shareholders and creditors, national taxpayers or euro area taxpayers. Clearly if the sovereign is already distressed because of a gaping budget deficit and rising government debt, even more debt in the form of bailouts for banks is going to make things worse.
Moreover, having the national government’s hands tied also makes the ability of national governments to aid struggling regional governments very limited. In Span, the regional governments have been shut out of bond markets and so the Spanish sovereign has tarn over funding of them in exchange for promises of more cuts. But this is only viable if the ECB helps hold down Spanish yields via implicit or explicit backstops as it has just ordered with the OMT program.
So that’s the backdrop here. Starting last year, all of this came into play not just for economic minnows Greece, Ireland and Portugal but for Spain and Italy too, countries that are economic giants in the euro zone.
Spain and Italy are too big to fail
For the past two years I have explained that there are three options for the euro zone: monetisation, default, or break-up. European policy makers are trying to avoid the euro zone’s breaking up. Yet, Greece has defaulted and will probably do so again. Even Portugal and Ireland could default without it causing a seismic change in the euro zone. We understand this now after the Greek restructuring. And Greece was the largest of the three economies and bond markets that entered into Troika agreements over the past two years before Spain. So in each of these cases, default is not synonymous with breakup. Europe does not have to monetize Greek or Portuguese or Irish debt in order to get a resolution that policy makers are comfortable with ideologically.
On the other hand, It goes without saying that a default by Spain or Italy would be catastrophic for the European banking system, which is why questioning Italy’s solvency leads inevitably to monetisation. German, Dutch and French banks have enormous exposure to Italian sovereign and bank debt. Running through Italian default scenarios demonstrates just how devastating such an event would be. The same goes for Spain. And I am sure that European policy makers now understand this as was made plain both by the LTRO and the OMT program.
Unfortunately, policy inertia is such that there is only so far that European policymakers are willing to move in order to accommodate circumstances on the ground. That’s the reality of the psychology of change. And this will limit how far Europe will go every step along the way. The object of European policy is to move as little as possible from previous policy choices and ideological stances while making some sort of meaningful adjustment to meet the situation on the ground and avoid crisis escalation. Each move policy makers make is in this vein – and this will continue to be the way policy is designed.
The Outright Monetary Transactions program is as far as Europe can go now
For the time being, OMT is as far as Europe is willing to go. Here’s what the Europeans have signed up to. Countries in distress, who find their bond yields at unsustainable levels can apply to the Troika for an adjustment program and bailout. This program will include a memorandum of understanding that commits the governments to adjustments that will include deficit reduction to meet the Maastricht Treaty 3% hurdle as well as privatization to bring down government debt and labor market reform to boost competitiveness with an eye toward higher growth. That’s the thinking. Now I don’t believe these programs will work as designed but that’s not the point of this essay. The point here is that this is the first step that must be taken before an OMT program by the ECB is operational.
After the MoU is in place, the hope is that the ESM will be operational pending a German Constitutional Court challenge. If it is, then the ESM would provide its bailout via primary market purchases of a country’s sovereign bonds. That is to say, the bailout approach the OMT works with differs from previous bailouts in that the sovereign will not be shut out of bond markets. The sovereigns will continue to issue bonds and the ESM will buy as many bonds as they must in order to make sure those auctions don’t fail. This is different from the existing programs of Ireland, Portugal and Greece where the countries simply elected to not issue bonds and take money directly from the bailout funds set up for them. The benefit of this approach is that each country has a market signal for how much of their debt investors are willing to buy and can use this signal in order to ascertain the perceived efficacy of their program in the markets. Ostensibly, this would mean the ESM would have to use fewer funds and that the program would be shorter in duration.
After the ESM primary market purchases come into play, the ECB’s Outright Monetary Transactions are vital for keeping yields down. If the ESM program is to be effective, meaning limit in amount and duration, bond yields in secondary markets will have to be much lower for countries with economic distress. And so the ECB will provide potentially unlimited liquidity to buy sovereign bonds on the secondary market. They will by only in the one, two and three year maturities and those purchases will put the ECB pari passu – i.e. on equal footing – with all other investors. The lack of ECB seniority is important because it means that increased ECB purchases do not have the perverse effect of decreasing the worth of bonds bought by other bondholders who would be lower in the capital structure. That means then that more ECB purchases will not lead inevitably to the ECB being the only player in the secondary market – which also means that the ESM has a shot at getting other market participants to bid at auction. These purchases by the ECB will be sterilized, meaning they will be offset by sales of other assets so as to prevent the purchases from increasing the monetary base.
In short, the OMT program is supposed to be a dual-pronged approach that has the ESM buying in the primary market and the ECB buying in the secondary market, as I explained in July. Spain and Italy are the OMT’s targets because they are too big to fail. But, any of the other countries could transition to this program when their existing programs expire. The program operates as a end-run around an ESM banking license. The banking license would leverage the ESM to provide more firepower. The OMT allows the ESM to remain unleveraged but effectively leveraged via the ECB secondary market backstop. Everywhere I have seen, the OMT has been envisaged as a tandem effort. So if the ESM doesn’t happen, it creates problems. This is why the German Constitutional Court challenge would be a huge blow to Draghi’s scheme.
Rationalisation of the OMT
The question then is how the ECB sells this as a monetary operation when many see it as a financing of the periphery. The ECB has set it up as designed to avoid these problems. I outlined the variables which have influenced the ECB’s OMT program in the last weekly. But only a few of these need highlighting here: Redenomination risk, conditionality and transparency of yield caps.
First, the ECB has said repeatedly now that the reason it must act is that its monetary transmission mechanism has been rendered ineffective because of redenomination risk. In plain English, the ECB is saying that yields on Spanish and Italian bonds have an unwarranted euro zone breakup premium which is very high and makes monetary policy ineffective in those countries. Moreover, redenomination risk in Spain has caused a bank deposit run. Joerg Asmussen was the first to use this line of argument. Mario Draghi has since confirmed that this is the rationale behind ECB actions.
Second, this program is designed as an ESM bailout operation which is conditioned strictly upon a Memorandum of Understanding with the Troika of the EC, IMF and ECB. Only once the MoU is in place and the ESM bailout has gone into operation would the ECB’s role come into play. And the ECB is designing its role as a support role in the secondary markets instead of as a primary role, which the ESM has. It has done this specifically to counter the talk of its monetizing debt. In my view, this is just a fig leaf for optics but necessary in order to ale this step.
Third, the ECB has chosen to hide its yield or spread target. The ECB’s Bagehot Rule Policy which uses an explicit target is out because this would be perceived as giving sovereigns a free ride even if the target is well above so-called risk-free rates. Moreover as I wrote before the ECB made this decision:
My suspicion is that the ECB may not follow a rules-based approach like this but rather an ad-hoc approach like the Fed, which provides insolvent financial institutions with liquidity and which doesn’t discriminate between good and dodgy collateral. Moreover, any ECB activism is destined to be fought tooth and nail by those that want to punish so-called fiscal profligates without any support. But my sense is that we are at a momentous moment in the history of the euro zone. The ECB is about to go all-in.Other players are going to call its bluff. It has the cards to beat back bond investors; after all it has unlimited liquidity since it can print money. But it may not have the cards to beat back the political uproar its actions would cause. If it does have the cards, the euro zone will continue. If not, it will break apart entirely.
The point here is that the ECB’s decision is not just abut liquidity for sovereigns but one of liquidity for banks. And it is also a political decision. The ECB must be cognizant of the politics of policy inertia and stay well within the bounds of what is politically acceptable. The fact that the Bundesbank has voted against the OMT tells you we are on the edge of what is acceptable. It is only Angela Merkel’s defense of this that has allowed it to happen.
Will it work?
I think this is the big question. It will work for a while and it will wrk better than the SMP. So the short answer is yes, it will work. The long answer is a bit more complicated.
The sovereign debt crisis is at heart about deciding whether sovereign states in Europe are insolvent or just illiquid. Greece has defaulted and been revealed to be insolvent. But what about the others? The solvency problem for the euro zone is about currency user status combined with high and increasing government debt levels. Unless the ECB gives an open-ended backstop, illiquidity becomes insolvency. But now the ECB has intervened but with contractionary preconditions that makes solvency a harder hurdle. My sense is that even if the euro zone chooses a contractionary route to tamping down on deficits, it can resolve the problem over time if the ECB has enough political support to continue this program.
Unfortunately, capital flight makes debt deflation not just a problem in terms of social unrest but in terms of real money going for bailouts to Spain. Germans are not going to pony up. They will offer guarantees in exchange for oversight and austerity but no real money as general elections are coming. The Spanish sovereign is on the hook all the way. This is Why Angela Merkel has hitched her wagon to the ECB
If she wants to have any hope of re-election, she needs to act like she’s playing hardball. But she also needs to give Spain and Italy enough leeway to prevent Germany’s economy from rolling over in a way that could prove fatal for her party next year. Up until now the schizophrenic policy of bailouts and austerity accomplished this. But bailouts are out. Monetisation with strings attached is the new policy.
I still think the problem can be resolved with Spain and Italy remaining in the euro zone but the Spanish bank problem is the big nut to crack. Huge toxic assets because of the imploded property sector become more toxic because of austerity. And so much more than 100 billion euros will be needed. What I think will happen is that the Basel timetable will be pushed back and the ECB will work out some sort of swag as EU bank regulator to bridge the capital shortfall gap indefinitely. In conjunction with Spanish sovereign money, this will see Spain through. But sovereign debt to GDP will go well over 100%. The model here is Ireland.
In the meantime, the ECB have oversight over Spanish banks now. So they can both give the Spanish sovereign money via the OMT while telling people the Spanish banks are just fine, so that the sovereign needs to pony up less money. The ECB has just been made king in Europe!
For now, we are in an uncomfortable but contractionary equilibrium of unlimited support in exchange for austerity. And that will work. But, the King still needs the support of the Dukes and Counts if it wants to pull this off. And so the longer the economic pain, bank capital outflows and bailouts continue, the greater the potential for the ECB’s plan being upended.
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