The ECB, A Red Herring Justification, And What It Means For The Euro

Aug.31.12 | About: CurrencyShares Euro (FXE)

On quite a few occasions, I have drawn attention to what I consider to be a very important point about the ECB and its forays into the sovereign debt market. The ECB is forbidden from the monetary financing of governments by Article 123 of the Treaty on the Functioning of the European Union, and therefore, in order to justify its sovereign debt purchases, it must establish a plausible link between those purchases and the administration of monetary policy.

Mario Draghi has thus far sought to establish that link by blaming the breakdown of the monetary policy transmission channel in the periphery on widening sovereign spreads. Goldman Sachs assisted its former vice chairman and managing director in perpetuating this idea by publishing a research note entitled "Broken Transmission and Non-standard ECB Policy."

Specifically, the ECB was concerned about the uneven transmission of its July rate cut. What this means is that while retail rates in the core countries moved in tandem with the rate cut, retail rates in the periphery did not. Goldman notes that

"Up to the crisis, retail bank interest rates moved in lockstep (albeit with a spread, and after a lag) with changes in the ECB policy rates. The financial crisis has altered this picture."

As the crisis has evolved, Goldman notes that retail rates in the Eurozone have become "heterogeneous". Borrowers in Germany and France enjoy low rates commensurate with the ECB's official rate, while borrowers in Spain and Italy have actually seen their rates decouple completely from the ECB's policy rate. In fact, the periphery is experiencing "transmission reversal" wherein the negative effects of deteriorating economic and financial conditions outweigh the positive effects of official rate cuts resulting in a scenario wherein rates rise in the periphery even as the official rate falls.

Goldman comes to the same conclusion as Draghi: the culprit is sovereign spreads (high borrowing costs for the sovereign). Here is Goldman's rationale:

"Because of the interconnectedness of bank and sovereign balance sheets, developments in sovereign bond markets...also affect wholesale refinancing costs.. [furthermore], the dislocation of government bond markets erodes bank capital: for holders of government debt, capital losses are incurred as yields rise [which] constrains credit expansion."

Having established this link, Goldman draws the only conclusion than can be drawn once you have accepted the premise:

"re-establishing transmission through non-standard monetary policy measures to restore market functioning appears a more appropriate line of policy action."

So there you have it. It has been proven that sovereign spreads are what is preventing the ECB's rate cuts from translating into lower retail rates in the periphery so the purchase of sovereign debt (i.e. the monetary financing of governments) is justified because it is the only way to repair the monetary policy transmission channel and thereby ensure that the central bank can perform its duty. Perversely then, the very act that is expressly forbidden (the financing of governments) is the only thing that can ensure the ECB can conduct monetary policy - the only way to uphold the law is to break it.

Applying Occam's Razor, however, one can see that there may be another reason for the broken transmission channel at least in regards to Spain. As SoberLook suggests,

"the transmission issue is really driven by liquidity conditions that are not balanced across the Eurozone"

This is a far more elegant and plausible explanation. Consider that as loans have declined in Spain so too have deposits. Spain lost 74 billion euros in deposits in July alone, equal to 7% of GDP; the country has lost a total of 1.7 trillion in deposits this year. As you might imagine, this has had quite an effect on Spanish banks' willingness to lend (and also on retail rates) as the following chart shows:

Source: JPMorgan via SoberLook

What this demonstrates is not that all periphery countries have a deposit flight problem that is the culprit of the broken monetary policy transmission channel (indeed some periphery countries are not experiencing bank runs), but rather that it is disingenuous to assert that widening sovereign spreads are responsible for the problem across the board.

Indeed the fact that part of the new plan is likely to be 'conditional' purchases by the rescue vehicles suggests that the promotion of uniform monetary policy cannot possibly be the ECB's sole concern. That is, the ECB claims it is purchasing sovereign debt in order to ensure that monetary policy works in a uniform fashion across the currency union. How can it make that uniform functioning conditional upon fiscal reforms?

Surely the ECB cannot say to Spain: "You have not met your deficit targets, therefore we will no longer buy your bonds, and if that means your country doesn't get to enjoy the benefits of our accommodative monetary policy then so be it." As The Wall Street Journal puts it,

"If the bond buying program is really about transmitting monetary policy to certain countries, it's hard to justify making that conditional at all."

Given this, it seems the real reason for blaming the broken transmission channel on sovereign debt is to effectively force Spain and Italy into signing Memorandums of Understanding and in the process get them moving in earnest on the institution of reforms. The new plan allows the ECB to accomplish this by using the rescue funds as conduits and thus avoid the contention that it is dictating fiscal policy. An added bonus is that the central bank gets to attempt to end the crisis by throwing its balance sheet around.

The downside here is that the ECB is clearly overstepping its bounds and it is going to great lengths to justify doing so. Ultimately, however, what you have is a situation wherein the central bank is financing governments with the press and simultaneously dictating what nations' fiscal policies should be.

Of course, one doesn't have to understand everything discussed above to see through what is going on here. All one has to do is look at what the ECB and the rescue funds are trying to accomplish - to stabilize sovereign spreads and to mandate the institution of reforms that promote fiscal sustainability at the national level, and then compare the resources of the two entities involved - a depleted EFSF and a not-yet-operational ESM with 408 billion euros in uncommitted funds compared to a central bank with a theoretically unlimited balance sheet. It becomes abundantly clear who is really pulling the strings.

As such, I ask investors to again consider the fact that the ECB is more than willing to throw caution to the wind and step well outside of its mandate while justifying its actions with illogical assertions (breaking the rules to uphold them and implementing conditional uniformity). The ECB has, in my opinion, lost all credibility and before the crisis is over, I contend that this will cause the currency it prints to fall precipitously against its peers. As such, I believe circumstances continue to warrant a short position in the euro (CurrencyShares Euro Trust ETF: FXE).

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.