At this point in time, the main factor that is driving the crisis in Europe is the panic in bond markets. It’s not the debt, its not the deficits, it’s not the fiscal plans. It’s the action in the bond markets that is in control of events.
There is a way to put a stop to this market-fueled crisis in one fell swoop. And it is so easy, and yet so effective, that it is difficult to believe.
The solution: The ECB announces, effective immediately, that it will exercise unlimited authority to purchase as much sovereign debt of member countries in the secondary market as is necessary to bring interest rates in line with the underlying fundamentals.
End of crisis. It is that simple.
By promising to buy as many bonds as are necessary to keep interest rates at reasonable levels, the threat of sovereign default is taken off the table. The implicit “put option” that this would represent would guarantee ample demand for all euro area sovereign bonds and guarantee financing for all member states.
Essentially, by taking the threat of default off the table, the existential threat to the euro area is taken off the table.
The euro can survive a bit of inflation. Even a great deal of it. The euro cannot survive the default of member states.
What is the ECB Waiting For?
If the solution is as easy as I posit, one may ask why the ECB has not done this already. Actually, the ECB has already been purchasing member state bonds on the secondary market. Indeed, its recent intervention along these lines proved highly effective in that it caused Spanish and Italian bond yields to plummet despite a relatively minor expenditure on the part of the ECB.
The problem is that the ECB is doing this on a totally inadequate scale and without any long-term commitment.
The mere announcement that the ECB had adopted a long-term commitment to hold the yields of sovereign bonds to reasonable levels would cause sovereign bonds in Europe to rally and yields to plummet.
Is this a free lunch? No. There are moral hazard problems. Inflation could also pick up. However, this is clearly a small price to pay compared to allowing the euro project to collapse.
So the question again arises: Why isn’t the ECB doing this already?
The first reason is ideological opposition. Most Europeans, and the Germans especially, have a highly orthodox bent in regard to monetary matters and are therefore opposed to US-style QE. European officials have repeatedly said that bond purchases of this nature would hurt the credibility of the ECB.
The problem is that this argument has become increasingly feeble. The US experience has plainly showed that sovereign bond purchases by a central bank need not be followed by inflation or a loss of confidence. US inflation is low and the price of US Treasury Bonds are at record highs (and their yields at record lows). The concern of European central bankers are completely misplaced: They need to realize that not purchasing sovereign bonds in order to stabilize bond markets is leading to an existential questioning of the euro.
The second reason QE has not been done already is political. Europeans, and Germans in particular, are extremely loathe to bail out countries perceived to be undeserving of help. In this context, it is difficult for the ECB to go directly against the public’s wishes. The ECB does not wish to be viewed as undemocratic or unrepresentative by taking actions that democratically elected European parliaments are not willing to take.
Having said all of this, it must be recognized that the opposition to massive ECB intervention in sovereign bond markets is more ideological and political than legal or constitutional -- although there is some degree of ambiguity on this point.
For example, German President Christian Wolf has openly questioned recent purchases by the ECB of Spanish and Italian bonds. Speaking at a forum of Nobel economists at Lindau in southern German, Wulf remarked: “I regard the huge buy-up of bonds of individual states by the ECB as legally and politically questionable. Article 123 of the Treaty on the EU’s workings prohibits the ECB from directly purchasing debt instruments, in order to safeguard the central bank’s independence.”
The problem with Wulf’s interpretation is that Article 123 only prohibits “direct” purchases of bonds from the treasuries of member countries. The article does not prohibit purchases in the secondary market. Some might argue that this is a technicality and that ECB purchase would amount to a violation of the spirit of the law. However, such an argument is of little consequence from a legal point of view.
The fact of the matter is that if push comes to shove, the ECB has the power to purchase as many bonds as it wishes on the secondary market. It has already been implementing this policy on a small scale. And, if need be, it can do so on a massive scale. The legality of the one or the other is the same – either both actions or illegal or they are both legal. This matter is a little like being “half pregnant.” Either it is or it isn’t legal. And a plain reading of Article 123 demonstrates that secondary bond purchases are not illegal. They are legal.
The ECB should have intervened aggressively in bond markets long ago. The current crisis would never have reached its present state. Indeed, it could be rightly said that the failure of the ECB to intervene in the bond markets has become a primary cause of fiscal deficits in Europe – and fiscal deficits are the presumed root of the crisis. High interest rates driven by nervous bond markets has stunted economic growth and therefore reduced tax collections in all European countries. It has also driven up debt service costs. If the ECB had put a ceiling on rates in sovereign bond markets by announcing its intention to intervene without limitation, the damage done by high interest rates, unreliable liquidity and the uncertainty regarding sources of financing would have been eliminated long ago.
ECB officials don’t want to do QE. Their reticence can be understood, from a certain point of view. However, by their inaction, they are allowing needless economic and financial damage to be done.
In the end, all of this show of “discipline” on the part of the ECB will be for naught. It will be remembered in history as just so much bloodletting.
At the end of the day, the market will force the issue, and the ECB will have little choice but to engage in open-ended sovereign bond purchases. I derive this supposition from the law of self-preservation. Unfortunately, due to ideological and political reasons, equity and bond markets will have to needlessly suffer substantially more carnage before ECB officials finally spring into action and institute large and open-ended bond sovereign bond purchases.
But when the ECB finally does spring into action, the euro crisis will be over.
A little inflation, or even a great deal of it, does not and will not threaten the euro. Defaults threaten the existence of the euro. For this reason, the stewards of the euro will ultimately save it by purchasing as many sovereign bonds as is necessary to put an end to this crisis that has already been allowed to drag on far too long.
The virtual certainty that the ECB will -- if push comes to shove -- place a backstop behind all euro area sovereign debt, is an important reason to not get to carried away with bearishness on US stocks and ETFs such as AAPL, MSFT, CSCO, SPY, DIA and QQQ.
Disclosure: I am long SPX puts.