The Last And Only Solution For Eurozone Survival

Includes: BEP, TLT
by: Erwan Mahe
ECB active but timorous
While the situation in Europe is becoming more and more uncertain in the context of imminent Greek default rumours, which are further weakening the Italian debt market, the largest in the eurozone, the ECB is trying mightily to stabilise the latter by intervening almost daily via its Securities Market Program (SMP).
The decision to reactivate the SMP August 4th, following over a year of dormancy, and especially its implication in the Italian and Spanish markets, has dramatically changed the rules of the game, given the much larger amounts to be raised stemming from the size of the debt loads involved and, above all, because these countries are not the ones that have been dependent on loans from the EU and IMF.
During the panic of May 2010, the ECB bought €16.5 billion the first week, €10 billion the second, and €8.5 billion, €6.50 billion, €4 billion, and €4 billion for each successive week, ending with €1 billion for its last real week of activity on July 9, 2010, for a total of €54.5 billion seven weeks of operation.
Since the week of August 4, it purchased €22 billion the first week, followed by €14.3 billion, €6.6 billion, €13.3 billion, €13.9 billion and €9.8 billion last week for a total of nearly €80 billion in six weeks. This represents about €13.3 billion per week, i.e. over 71% higher than the weekly purchases begun in May 2010.
These heftier purchases were needed to snuff out the fire that was spreading from country to country and beginning to affect the core eurozone, starting with France, where the interest rate spread with German debt on the 10-year segment widened to nearly 90 bps in early August from 30 bps at the beginning of June!
However, as you can see in the graph, below, following an initial positive reaction, probably due to surprise at the intervention and the amounts purchased the very first week, Italian and Spanish interest rates gradually shifted back upward. After briefly falling back to around 5%, which some saw as the point differentiating a liquidity from a solvency crisis, they have since returned to 5.67% (Italy) and 5.35% (Spain).
German, Italian and Spanish rates on 10-year segment
What ever happened to the "awe" in "shock and awe"?
(Click chart

These rates reflect investor scepticism about the conviction of our central bank and the comments by the next Bundesbank president, Mr Weidmann, this morning will surely not help matters either:

The Eurosystem has taken "significant risks" on its balance sheets, thereby blurring the barriers between monetary and fiscal policy. We must reduce these risks again.

EB bond buys could crowd out private investments.

Aside from the total absurdity of his statement that "EB bond buys could crowd out private investments," which recalls the Austrian prehistoric school of macroeconomy, the fact that Mr Weidmann has taken the liberty to openly criticise the actions taken by the ECB Governors Council that he has just joined shows that Germany really needs to define once an for all its vision for the eurozone.

Especially if, as I believe, if it will soon lose all theoretical control over the ECB.

After all, while these ECB moves have undoubtedly provided temporary relief to European markets that have recently suffered from periodic bouts of hysteria, they are still sorely lacking in scale.
The example presented by the Fed on the other side of the Atlantic should provide European financial players will plenty of gist for reflection, especially given that US central bank may very well provide a new demonstration of proactivity at its upcoming 20-21 September meeting.
An unflattering comparison with the Fed
The difference in the reaction of these two major banks is truly striking, whether in entails monetary policy (key interest rates), the magnitude of the resources employed or the inventive way in which they were used to confront this crisis.
In the first place, the differences in monetary policy in the "pure" sense of the term, that is the movement of key interest rates, and their direction of overnight rates, really stand out. I will spare you a recap of the historic error of July 2008 when the ECB decided to hike its key overnight rate to 5.25% in contrast to the Fed that had already begun to lower its rates in September 2007 and whose fed funds rate was already at 2% since May 2008.
That mistake is consubstantial to the thinking of the Austrian School, which continues to hold to the idea that tightening a country's monetary policy, even when inflation is temporarily surging due to rising commodity prices, will somehow result in higher oil extraction/production and grow and grow more wheat, as if monetary policy could make such problems disappear with the flash of a magic wand. After being forced to backtrack, you would think that they would have reconsidered their ideologically inspired plans. But sadly, it hasn't worked out that way.
This type of thinking that has led the ECB since the beginning of the year to navigate interest rates higher, as it proudly distinguished itself from its central bank peers in the United States, the UK, Japan and even Switzerland. As you can see in the graph below, the European overnight rates (EONIA), which were still at the same level of their American peers, the fed funds, at 0.20% in March 2010, began moving upward in early June and now stand at a high of nearly 1.40%, while the fed funds remain at a rock bottom 0.12%.
The ECB's unfortunate rate hikes of April and July 2011 played a role in this movement, as has the decision to soak up liquidities injected into the market during SMP operations, whose effect would have otherwise been to bring down the EONIA to the 0.75% rate on deposits. In contrast, the Americans announced in early August that their key rates would remain close to 0 until at least mid-2013.
We can always seek consolation in the recent decline in European rates, given investor expectations that the ECB will again have to backtrack on its policy in recognition of today's harsh reality, and lower rates again in the next six months.
As for those who consider that these "little" hikes are no big deal, check out this excellent exposé by Gauti B. Eggertsson and Benjamin Pugsley, The Mistake of 1937: A General Equilibrium Analysis (pdf). Written in 2007 to warn Japanese authorities against repeating the mistakes made by American government and monetary leaders in 1937, it emphasise the importance of communication in the conduct of monetary policy. Their approach is original and well worth reading. Given the ECB's emphasis on expectations, with Mr Trichet's endless repetition of the importance of "anchoring inflationary expectations", such an error of judgement leaves me speechless.
Fed and ECB short-term rates
Why so much hate and so little love?
Other might criticise me for my praise of Mr Bernanke, given my conviction that we are undergoing a de-leveraging crisis whose consequences are at least comparable to those of the lost Japanese decades, and for being overly impressed by one of the worlds leading specialists in the Great Depression and liquidity trap related problems. In response, I suggest the reading of "In Fed We Trust." In the meantime, I suggest taking a look at the following graphs.
Unemployment rate: US and Eurozone
Where do you think it will be easier to find work in the next five years?
Not only do historic trends heavily favour the US employment market but recent trends are even more encouraging for the US, especially since the Fed is keeping a close watch on this indicators and President Obama has finally decided to make it a priority.
Investors have gotten the drift, as you can observe in the graph below tracking the performance US and European stock markets since the beginning of 2010.
S&P 500 and Eurostoxx 50
51% performance gap: does Europe merit such a deep discount?
If we now wish to estimate the quantitative in action, as opposed to limiting ourselves to interest rates, between the Fed and the ECB, all we need to is look at the figures published by each central bank.
Since the beginning of its unorthodox interventions, the Fed has bought $1,657 billion in US government debt, representing 16.50% of outstanding federal government debt, amounting to more than the entire US budget deficit for 2010, or about 8.7% of GDP. In addition, there is the $885 billion in MBSs.
In Europe, the ECB bought via its SMP €152.5 billion in eurozone government debt, representing less than 2% of total outstanding European debt. Its purchases of covered bonds from June 2009 to June 2010 totalled €60 billion, which pales in comparison with the Fed's purchases of $885 billion in MBSs.
In short, the difference in the amounts acquired by the two central banks amounts to a factor of 10 in favour of the Fed!
Some may object that the Fed can take a certain liberty with these purchases, given its less "active" commitment to keeping inflation low compared with the ECB whose tracked record, as Mr Trichet loves to say, is impeccable.
It is debatable whether or not the average annual eurozone core CPI of 1.60% since 2000 might even be a bit too low, but one thing is for sure; the average annual rate in the United States for the same period, 1.9%, is nothing to be ashamed about.
Does this 0.3% lower inflation in the eurozone really justify the extra millions in unemployed?
We cannot emphasise enough that the ECB's self-declared one needle compass, which Trichet has constantly used to justify his obsession with prices in Europe is a farce. As we have explained before, the ECB statutes, as clearly described in the Maastricht treaty, provide for employment market support:

without prejudice to the objective of price stability, the ESCB shall support the general economic policies in the Community with a view to contributing to the achievement of the objectives of the Community as laid down in Article 2." (Treaty article 105.1).

"The objectives of the Union (Article 2 of the Treaty on European Union) are a high level of employment and sustainable and non-inflationary growth

It remains to be shown that, despite the hue and cry raised by hyperinflation hysterics, that the Fed's unorthodox actions will have a durable and negative (upward) impact on US inflation. In contrast to the assertions of the American equivalent (Fisher-Plosser-Hoenig) of our unhappy Germanic sires (Weber-Stark-Weidmann), the surplus reserves created during quantitative easing operations do not in any way affect the ability of American banks to lend money to the real economy. These only lend when dealing with clients who wish to borrow and whom the banks consider to be credit-worthy, which is a rare species in times of de-leveraging. They do not need these reserves to lend money because, to "borrow" a favourite expression of partisans of endogenous money, "Loans create deposits."
To illustrate the point on this subject, which led me into some quasi-theological discussions, let me cite Alan R.Holmes, Senior Vice President de la Federal Reserve Bank of New York from a text he wrote in 1969 -monetarists suffered from “a naive assumption” that:

the banking system only expands loans after the [Federal Reserve] System (or market factors) have put reserves in the banking system. In the real world, banks extend credit, creating deposits in the process, and look for the reserves later. The question then becomes one of whether and how the Federal Reserve will accommodate the demand for reserves. In the very short run, the Federal Reserve has little or no choice about accommodating that demand; over time, its influence can obviously be felt.

(Many thanks to Steve Keen for this important historic reminder)
The survival of the eurozone at stake
The ECB retains a colossal intervention capacity to ensure the survival of the eurozone, and make no mistake about it, that is precisely what is at stake today.
These who claim that a Greek default can be controlled or isolated at the eurozone periphery without wrecking havoc in the rest of the eurozone are no more than dangerous illusionists and demagogues, and the pitiful example of the German FDP, whose vote in the recent Berlin elections fell to a paltry 2% should lead these individuals to reconsider their course.
How can they imagine that international investors, who have been repeatedly assured that no eurozone country will be allowed to default, would not be scared silly, given their debt investments in the other struggling countries of the eurozone?
How do they think the indignant movement in Spain and Portugal will view such a gift (and that is precisely what a unilateral default amounts to) to the Greeks who have been accused of cooking their books while they are being told to maintain harsh austerity measures into the indefinite future?
And who can really gauge the impact on the highly interdependent European financial system of the crystallisation of discounts practiced today on Greek government debt and then on there other European debts?
The time needed for a democracy to push through such measures, including agreement from so many leaders and parliaments, which will may indeed require the holding of referenda in case of major institutional changes (Eurobonds, European Treasury), hardly meets the time expectations of financial markets. Moreover, they are susceptible to bouts of risk aversion, as per "animal spirits," which worsen crises and lead to multiple imbalances that result in the self-fulfilment of insolvency fears.
The only institution capable of responding to these tensions is the lender of last resort, the ECB, which must accomplish the same for governments as it does for banks.
Today, when a eurozone country is confronted by an exogenous shock, like the crisis of 2008/09 entailing an automatic upward shift in deficits (automatic absorbers of economic situation with increased social spendings, such as unemployment insurance, as tax receipts fall), it is exposed to markets, which can refuse to provide it financing from one day to the next, thereby, plunging the country into a vicious illiquidity cycle entailing higher interest rates and insolvency, etc.
In all the other major monetary areas (US, UK, Switzerland, Japan), central banks see it as their role to confront this type of situation. Experience shows that when a country's debt is denominated in its own currency, which is not the case for eurozone countries, its repayment promise is based on payment within its own money, which it can generate as it sees fit.
At the same time, any financial losses generated by a central bank, be it on its unlimited forex interventions whereby it sells its own currency (Swiss National Bank) or on its own sovereign debt stocks (Fed, ECB, BoE, BoJ), has absolutely no accounting consequences. A central bank's balance sheet is not comparable to that of a private-sector business of household, because its debt is denominated in a currency that it can, in the worst case scenario, create as circumstances warrant! More "elegant" techniques exist (in the eyes of monetarists), like in the case of the Fed, which has given itself the possibility of booking losses in a retained earnings account as it updates future seignorage income.
The ECB can thus decide at any time to engage in unlimited interventions on the eurozone's secondary debt market by setting, for example maximum interest rate that must not be surpassed.
Such an approach would definitively validate the reasons expressed by the Governors Council for setting up the SMP, i.e. to restore the monetary policy transmission channel. A central bank traditionally limits its attempts to regulate the major aggregates to its modulations of key interest rates in the hope that such action combined with its communications effort and market expectations will influence the yield curve. In the current macroeconomic context, with short term interest rates hovering around 1%, the rate on 10-year debt should be around 3.5%-4%. Accounting for some small distortion relating to each country's situation, it is easy to imagine a ceiling of 5% on the debt of those eurozone peripheral nations still raising money on bond markets, which coincides pretty much with the target set by the ECB in its purchases carried out in August. It can thus stop hiding behind the excuse that such a task must be left to the EFSF, since it falls well within its mandate.
Such a decision, however, is not incompatible with the notion of conditionality, so important to this sort of intervention, required to avoid the phenomenon of moral hazard to which a large body of studies has already been published. Check out this excellent report written by Giancarlo Corsettiy, Bernardo Guimaraes and Nouriel Roubini in 2002, International lending of last resort and moral hazard: a model of IMF's catalytic finance.
However, certain "decision-makers" assure me that the Germans are so viscerally opposed to this type of measure, due to their obsessive fear of Weimar Republic style monetization, that such a plan has zero chance of being approved. But some eurozone countries are undergoing real wage deflation, such as Ireland (-3.5% y-o-y) and Greece (-3.7%), which compares to +3.5% for the zone overall. As such, this leaves plenty of elbow room for intervening on their debt, and this indicator could also be one of the conditional elements taken into consideration. Given the current low money supply growth statistics, which are well below official targets, and the low consumer credit in the eurozone, the ECB would be wrong to take a timid approach.
While Bundesbank officials are all vehemently opposed to this type of action, bear in mind that the ultimate decision-maker in Germany is the government itself, which has not at all taken such a decisive stand on the issue. I recommend (especially to my friend, Charles G) a fantastic and very current report, written in 2001 by Martin Karl Gerog Heipertz, describing the relations between the Buba and governmental authorities, notably during reunification and, later, the euro's creation: How strong was the Bundesbank?: A Case Study of Policy-Making of German and European Monetary Union (pdf).
As Mr Trichet stated, once again, at his latest press conference, ECB decisions are made on a majority basis. If the German members are so ideologically opposed to this so called"monetization" (which it is not: it is a swap of maturities, like in the case of the Fed's QE, which injects no new money ex-nihilo into the system while we remain confronted with a liquidity trap), all they have to do is resign from the ECB council. In reality, the time of reckoning for Germany will come if and when the ECB takes a path it judges to be unacceptable; at that point, it will have to decide whether or not it will remain within the eurozone.
In making such a decision, it will have to answer two basic questions:
  • What would be its future position in Europe? I am not so optimistic on this first point, given its refusal to participate in the Libyan intervention and its go-it-alone approach on nuclear energy.
  • In terms of an initial reaction, what would be the consequences for the stability of its financial and business system of a new German currency, which would be quickly revalued by 30% to 50% vis-à-vis those of its clients, rivals and trading partners in Europe? Total household and business savings would thus be affected by the same amount, given the country's trade surpluses, and that leaves aside possible future defaults. Second, despite assurance by their engineers, would German industry be able to hold up to such a competitive shock?
I tend to think that Germany will balk before taking such drastic action, because we are talking about the mother of all deflationist shocks. For those unfamiliar with the country's economic history, it is well worth recalling the Brüning episode (1930-1932), which had much more to do with the Nazis coming to power than the ensuing hyper-inflation.
However, if Germany decides to move out of the eurozone and create a northern bloc with Austria, Finland, the Netherlands and our Flemish friends, that would probably be the lesser evil for the other eurozone members.

Disclosure: Long 18 years OAT and 28 years BTP Zero Coupons, EDF Corp 3 Years 4.5%, Greece 1 Y and 8 Y bonds, Thaler's Corner.