On Wednesday, ECB President Mario Draghi published an Op-Ed in the German Die Zeit entitled "The Future Of The Euro: Stability Through Change". The piece reads like what it is: a plea for Germany complicity in the coming critical months. Draghi flatly admits that the decision to enter into a currency union without first establishing political integration has led to the outright failure of the EMU to meet any and all of the original objectives upon which the establishment of the common currency was based. Because "currencies ultimately depend on the institutions that stand behind them [and] the euro area has not yet fully succeeded as a polity", the single currency is now failing to live up to its promise of 1) promoting price stability and growth, 2) rendering the unification of Europe irreversible, and 3) raising Europe's financial and political standing on the world stage.
Draghi acknowledges that tighter political and fiscal integration is a necessity but says that this integration is not necessarily a precondition for a successful currency union; they can, according to Draghi, "develop in parallel." Notice that this is exactly the opposite of what was said initially. Draghi acknowledges that
"The euro was launched as a "currency without a state"...but this institutional framework left the euro area insufficiently equipped to ensure sound economic policies and effectively manage crises."
It would certainly seem then, that the currency needs to have a state, not be left to its own devices while a state supposedly develops around it in the midst of the economic ruin this policy has already brought about.
In pandering to the German public Draghi first attempts to make it seem as though Germany's very survival depends upon its membership in the euro:
"...the root of Germany's success is its deep integration into the European and world economies. To continue to prosper, Germany needs to remain an anchor of a strong currency, at the centre of a zone of monetary stability and in a dynamic and competitive euro area economy."
Note however that none of these ideas are dependent upon the existence of the euro currency. Germany can be deeply integrated into the European and world economies without the existence of the currency union. Similarly, in the absence of the euro, the German economy can still remain the anchor of a strong currency -- it is called the Deutsche Mark. Finally, Europe can eventually be a zone wherein every country's currency is generally stable and most economies are dynamic and competitive. None of that requires a single currency and in fact, if the events of the past three years tell us anything, a single currency is an impediment to these eventualities.
In any case, Draghi goes on to say what he thinks the Germans want to hear. He acknowledges that large TARGET2 (im)balances amount to subsidies and cannot be allowed to persist. He says there must be mechanisms in place to wind down failed financial institutions without putting taxpayers from other countries on the hook. Finally, he notes that countries cannot be allowed to pursue economic policies that will harm other countries.
Lastly, Draghi makes a halfhearted attempt to reassure Germans that the ECB will not overstep its bounds and use German money to finance other nations' governments (of course he doesn't need to, TARGET2 does that for him):
"The ECB...will remain independent and it will always act within the limits of its mandate."
Just one sentence later, Draghi renders that assurance null and void the only way he can: by equating periphery spreads with monetary policy by reference to the broken transmission channel:
"When markets are...influenced by irrational fears, our monetary policy signals do not reach citizens evenly across the euro area. We have to fix such blockages to ensure a single monetary policy and therefore price stability for all euro area citizens. This may at times require exceptional measures."
These exceptional measures of course, entail the financing of governments through bond purchases and extensions of national central bank t-bill ELA acceptance limits.
In fairly short order, Bundesbank President Jens Weidemann responded to Draghi's piece in an interview with Spiegel. Weidemann comes across as far more measured, practical, and logical. Notably he says that in the absence of an agreement on a new structure, the only legal way to approach the issues is by reference to the Maastricht Treaty which clearly states that "the consequences of [a nation's] poor budgetary polic[ies cannot be] passed on to others." Weidemann explicitly rejects the notion that the ECB isn't stepping outside of its mandate with sovereign bond purchases:
"Such a policy is too close to state financing via the money press for me...the Bundesbank...has...succeeded in building...an enormous amount of confidence. It has proved effective for a central bank to...not finance government budgets...if monetary policy allows itself to be used as a comprehensive political problem solver, its real objective [price stability] threatens to recede increasingly into the background."
Weidemann then, does not buy the excuse that because sovereign spreads are dictating retail rates in the periphery, the central bank thereby must purchase sovereign bonds to effectively enact monetary policy. When pressed on the issue of the U.S. buying its government's bonds, Weidemann makes an important (and comical) statement which speaks to how Germany views its relationship with other European countries:
"[The Fed is] purchasing bonds issued by a central government with an excellent credit rating. It doesn't buy Californian bonds or bonds from other U.S. states"
What is interesting about this statement is that if the analogy is to hold Weidemann must mean that the only bonds the ECB should buy would be bonds issued by a theoretical central government of Europe. Germany has always insisted that Eurobonds can never be a reality without complete fiscal integration. Therefore, the idea that political and fiscal integration can, in Draghi's words, "develop in parallel" to the currency union, is unacceptable to Germany. This of course makes perfect sense: if the lack of political integration was what caused monetary union to fail to achieve its goals in the first place, then political integration must be recognized before the currency union's problems can be fixed. That logic does not fail to hold simply because there is a crisis.
Weidemann goes on to say that there is no reason to assume that the currency union in its current form must be kept intact at all costs and notes that it is governments who decide who stays and who leaves, not the ECB. Furthermore, Weidemann notes that once the ECB "opens the door" to limitless bond buying, that door will be quite difficult to close. Finally, perhaps most disturbingly, he reminds the world that central banks can only inspire confidence in the short-term. In the long-run, LTROs and bond purchases
"...do not solve the fundamental problems. Actions are based on trust. Doing more and more does not always engender more trust. Over the long term, the central bank can only preserve trust if its actions conform to the mandate that it has been entrusted with."
In my view, the idea of trust is critical. Weidemann is effectively saying what most observers are forced, in the final analysis, to admit: fiat currencies are based strictly on trust and confidence. Excessive spending and printing causes that trust to deteriorate. It is then, quite ironic that the ECB would attempt to justify limitless sovereign bond purchases by citing its duty to maintain price stability. Printing money to purchase bonds will not, in the end, promote price stability because it will facilitate a lack of trust in the euro and a lack of confidence in the ECB's willingness to keep its actions confined to its mandate.
Ultimately then, there are two options: 1) cap rates with unlimited bond purchases and in the process alienate Germany, the euro's most important economy by failing to respect the legitimate concerns of its officials, or 2) acknowledge that Germany is correct and begin allowing periphery nations to default. I ask investors to consider the consequences for the euro currency (FXE) of either of those two options. In my view, all roads lead to parity with the dollar in the best case scenario, and a complete devaluation of the euro in the worst case (as predicted by Kieth Weiner).