With U.S. fiscal policy in a political bind, markets and pundits alike have been obsessed with the Fed. How bad have things got to get before it launches QE3? Was QE2 a success? What else can they do? Operation twist?
All of these questions pale into insignificance if you consider what is happening in the euro area. As we have argued extensively before, the area faces near insurmountable problems which can escalate at any moment. Without a really major turn-around in political action, it is likely to end in tears.
But the politicians seem unequal to the task. Germany is against an increase in the European rescue fund, the EFSF, which is insufficiently large to deal with a crisis in Italian bonds. Up to half of its 440 billion euro is already pledged in support for Greece, Ireland and Portugal.
The Germans are also against the introduction of eurobonds, and without a large EFSF or eurobonds, it's very difficult to see any solution to the sovereign debt crisis that is not involving a default or even countries leaving the euro altogether, events that could bring down the European banking system and plunge the world into another financial crisis and deep recession.
The ECB's own QE
However, there is still one line of defense between the euro and the abyss, the ECB-- its highly controversial bond buying program and the provision of liquidity to the battered banking system.
There can be little doubt that without these programs (the ECB's own QE), yields on Italian and Spanish debt would have spiraled out of control. Below you can see the yield difference between 10 year Italian and German bonds rising rapidly from July until the ECB started buying Italian bonds.
Without that ECB's intervention, the ensuing vicious cycle (higher financing costs, bigger deficits, more austerity, reduced economic growth, etc.) could easily escalate or destroy market confidence to such an extent as to cut them off from the markets altogether.
With public debt at 120% of GDP, the sustainability of Italian public finances especially are very sensitive to interest rates. The figure below from a Barclays Capital report shows how Italian public debt/GDP ratio would rise inexorably if the yield spreads remained as big as they were just before the ECB started buying Italian bonds.
Not only has the ECB saved the day (for now), it has also taken the lead in policy. In a thinly veiled quid-pro-quo, the Italian government has to deliver decisive austerity action to get the deficit (which, unlike the debt, is not terribly large at 3.8% of GDP) under control.
When the Berlusconi government seemed to backtrack on reforms the ECB stopped buying bonds and rates back up, causing European equity markets to fall 3.5%-5.5%. A day later, Berlusconi hastily introduced additional austerity measures, like increasing VAT rates and pension age for women.
Can the ECB keep this up?
Well, basically, they'll have to! There is simply no alternative. The Slovak government said they won't vote on the extension of the EFSF powers (amongst which its ability to buy bonds in the secondary market for which the present ECB intervention is supposed to be a stop-gap).
This will not make the EFSF operative before February next year, if all other euro member parliaments approve the increased EFSF powers. Also, the German constitutional court has ordered that the German parliament should have a say in the spending of rescue funds. This will further hamper the EFSF's effectiveness in dealing with an acute crisis, making us ever more dependent on the ECB.
But the ECB bond purchases are highly contentious. The Bundesbank is dead set against, and even German president Christian Wulff argued it is against article 123 of the EU (Lisbon) treaty.
And there is no doubt that the ECB is not allowed to directly buy Italian bond from the Italian government, and Italy's refinancing needs are very large. Italy must redeem €14.6bn of debt this week and €62bn by the end of September, the highest ever in a single month. It must roll over €170bn by December. We'll see soon enough how that goes.
Conclusion
So there really isn't any credible alternative to ECB interventions. The EFSF won't be ready anytime soon, and in any case, it is inadequately funded. Eurobonds are a mere pipe dream at present. The ECB really does stand between us and the abyss of another financial crisis and deep recession.
In principle, the ECB can keep this up, and as the Italian example has shown, the mere threat of stopping buying bonds is quite effective in forcing countries to comply with austerity. It provides a de-facto elusive EU measure to control countries' budgetary policies and keep them from free-riding.
The main casualty is Germany's hard money tradition. This must be a nightmare to the Germans and it's deeply ironic that it's the ECB is undoing decades of Teutonic financial rectitude. After all, The Maastricht treaty (the one founding the EMU) sculpted the ECB on the model of the Bundesbank.
It is still possible that they'll revolt, as the remarks by politicians, the Bundesbank, and even the German president testifies. But any alternative (a greatly expanded EFSF, eurobonds) isn't any more attractive to the Germans, and it's no coincidence that the route to destroy the German hard money tradition is via the ECB, the institution under least democratic control.
There is another way that the German hard money tradition reasserts itself, but this could very well be self-defeating as well. By forcing austerity upon the aid and / or ECB intervention receiving countries, it could create a vicious cycle in which austerity reduces growth, creating its own need for more austerity. This scenario is currently already playing out in Greece, and even when the IMF is warning against it, it must be a real danger.
Luckily enough, there is just one chart to keep track of all this. The Bloomberg 10-year Italian-German yield difference provides even intra-day development of this most crucial of market temperatures. At present, it really is the measure of all measures. Obsessed with the Fed, but it's the ECB that really matters. The fate of the world economy hinges on the money men in Frankfurt.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.
