Draghi Disappoints, But Look Beyond The Headlines

by: Martin Lowy

Today (Thursday, August 2), the ECB and its President Mario Draghi have disappointed the financial markets. The ECB plans that Mr. Draghi disclosed at his press conference are by no means final, and they are expressly contingent on the EFSF/ESM, the multi-country rescue funds, being asked for help by a government and that government agreeing to the conditions imposed. Thus, any market expectation that the ECB would take immediate action to bring down Spanish and Italian bond yields has been dashed.

Markets do not like subtle, long-term plans that have many conditions before they can be implemented or that have unspecified details. The ECB disappointed on both counts.

No one should blame the markets or their participants for this negative reaction. Nevertheless, if we analyze Mr. Draghi's remarks carefully, we might change our pessimism about the long-term future of the euro as the currency of Spain and Italy. "You don't go back to the drachma or the lira or whatever," Mr. Draghi said. "It is pointless to bet otherwise." I realize that many European politicians have said many optimistic things that proved not to be true. But so far, Mr. Draghi has a better record.

The ECB Will Do Whatever It Takes

Mr. Draghi confirmed that the ECB Governing Council, with one dissent (almost certainly, Bundesbank President Jens Weidmann), affirmed that the ECB will do "whatever it takes" to defend the euro. Mr. Draghi also said, however, that the ECB could not defend the euro by itself. He said that the governments had to take steps to cure the imbalances within the Eurozone. And he said that the EFSF/ESM would have to act before the ECB would implement its proposed plan to purchase bonds of specified countries in the open market. My interpretation of these conditions to ECB action are that they are of two types. The first type is the broader fiscal integration of the countries that will be designed to prevent large differences in competitiveness from occurring in the future. The planned fiscal consolidation is going forward and will not be completed for many months. I infer that the ECB cannot mean that the process of fiscal consolidation must be completed before the ECB will take action. This condition is what I would call a "soft" condition.

The EFSF/ESM Must Act First

The second type of condition is much firmer condition: The EFSF/ESM have to take action to support the target country first. What action the EFSF/ESM are required to take as a condition of ECB action is not specified. Only the imposition of conditions by the EFSF/ESM is specified; that is, as a condition of its assistance, the EFSF'ESM must specify conditions that the assisted country must meet. This "conditionality" has been a requirement of all European and IMF assistance to Greece, Ireland and Portugal. Imposing it on Italy and Spain, countries that already have governments that are taking responsible steps to make their economies more competitive, may be window dressing, but my guess is that it is window dressing that is important to a number of the members of the Governing Council. It also may be important politically in countries such as Germany and Finland, and it may reinforce the domestic political efforts of the governments of Spain and Italy.

From where I sit, EFSF/ESM direct loans to Italy and Spain would not be effective to change the market's view of their solvency and therefore would be unlikely to affect interest rates more than temporarily. Open market purchases of Italian and Spanish bonds are likely to be more effective to bring interest rates down, since they operate directly on the market and support it. In light of the potential ECB program that Mr. Draghi outlined and that I will try to explain below, I think the EFSF/ESM are likely to adopt a program to buy longer-term debt in the open market. I think that would make the biggest market impact within the confines of the EFSF/ESM's limited resources.

Cross-Border European Money Markets

Such EFSF/ESM actions would provide the ECB with the cover that it needs to go ahead with an ambitious program to resuscitate the cross-border short-term money markets in Europe. I found this part of Mr. Draghi's answers to reporters' questions the most interesting. The predicate for ECB action will be that the money markets have become increasingly national rather than integrated throughout the zone. This fragmentation has made the transmission of monetary policy ineffective. Examples of fragmentation are the gradual reduction in cross-border deposits and money market loans in the last two years, as well as the reduction in cross-border collateral being offered to the ECB. The consequences of such fragmentation, which has contributed to the significant interest rate differentials among the nations at the short end of the yield curve, are serious for the exercise of monetary policy, which is the ECB's mandate. Therefore the ECB's program, a program that has been approved in principle by the Governing Council, will be, if implemented, to make open market purchases of specified countries' bonds at the short end of the yield curve.

We can see here the somewhat convoluted structure that the ECB has to adopt in order to do "whatever it takes" while remaining within its mandate as interpreted by the variety of interests represented on the Governing Council. Nevertheless, Mr. Draghi said that, if the program is implemented, the Council will authorize an amount of firepower that will be sufficient to defend the euro. He would not elaborate on what that might mean. But he did say that the countries and the amounts would be specific and that the program would be transparent. And although many politicians use the word "transparency" loosely, so far Mr. Draghi has made full disclosure of the programs that his ECB has provided, including unconventional programs. Mr. Draghi also said that the issue of ECB preference over the market will be dealt with in the context of announcing the program's specifics. One presumes that this means the ECB will give up its preference, but Mr. Draghi refused to say more than that the issue will be addressed.

The ECB's September Meeting

Over the next few weeks - I assume between now and the September meeting of the ECB - the various internal committees of the ECB will flesh out the proposed program. I assume that in the same timeframe, Italy and Spain both will talk with the EFSF/ESM about how to design a program that will be least onerous but still meet the ECB's conditions for action.

Immediately after today's press conference, Mario Monti, prime minister of Italy, and Mariano Rajoy, prime minister of Spain, were asked by the FT whether their countries would apply to the EFSF for assistance. Neither committed to doing so, but both professed satisfaction with Mr. Draghi's plan. Therefore, when Mr. Draghi holds his press conference on September 6, he should have a more concrete program to announce, and I would be most surprised if it did not include agreements between the EFSF/ESM and both Spain and Italy. The "conditionality," I predict, will require little or nothing in addition to what Mr. Monti and Mr. Rajoy already are trying to accomplish; the conditions will be designed to strengthen their hands in their domestic political markets as well as to assuage critics in Germany, Holland and Finland.

Timing of ECB Action

Although the crisis continues - and continues to be a crisis - it is easy to overestimate the urgency with which action must be taken. For example, although 7% may be too high an interest rate for Spain to pay on all its long-term debt, it does not pay the current market rate on a high percentage of its outstanding debt. To pay 7% on a few billion euros of debt is quite sustainable, and that is all that Spain has to raise in the long-term market in the near future. Thus, although 7% grabs the headlines, it does not mean that immediate action is required.

Solvency Distinguished from Liquidity and from Competitiveness

Regardless of whether Mr. Draghi's program is a success from a monetary policy point of view, it will not answer the question of whether Spain and Italy are "solvent." There is no good test of solvency for a country. A country does not have a balance sheet; therefore we cannot talk about balance sheet solvency, as we could with a company. We can create balance sheets for a country's consumer, business and public sectors, as well as projected income and taxing ability. But I do not think there is sufficient experience with that kind of analysis to conclude with confidence whether a nation is solvent in the sense that, at a specified interest rate, it can or cannot meet its debt obligations. In the absence of established solvency tests, it is tempting to focus on liquidity as the best test of solvency. I do not embraced the liquidity test because, on one side, markets are not perfect; they may not provide liquidity in a mistaken belief about the country's ability to repay its debt. On the other side, official liquidity assistance, such as from the EFSF/ESM, the ECB or the IMF, may mask a country's underlying inability to pay its debts.

Thus, over the long term, it is not possible to tell whether a country can pay its debts, so long as the EFSF/ESM, ECB and IMF continue to provide liquidity. In this case, in my view, the question is whether Spain and Italy can attain sufficient competiveness and the European economy as a whole can regain sufficient strength that Spain and Italy will be solvent in the longer term. I do not think that is knowable at this time. When I look at the numbers, I am not optimistic. But I also do not underestimate the determination of the Europeans. My best guess is that somehow Spain and Italy will end up forcing their creditors to take a haircut but that by that time, the ECB will be a substantial creditor of both, as will the EFSF/ESM. Thus, the supporting arrangements will accomplish what economists believe is the necessary outcome: a transfer of wealth from north to south to counteract the south's lack of competitiveness. That is what the American states do, with rather less fanfare, as New Yorkers, for example, are taxed to support Mississippians. The euro will go on, I think, just as the dollar does, except that Mississippi does not have to default in order to receive the assistance.

One reporter asked Mr. Draghi whether he would estimate the amount of the interest rate differential between the northern and the southern countries was due to currency fears - that is, fear of Spain declaring a new peseta or Italy declaring a new lira to replace the euro - and, implicitly, how much was due to solvency fears. Mr. Draghi refused to speculate. The ECB has a mandate, as I understand it, to counteract fears of a change in currency; it does not have a mandate to counteract fears of a government's insolvency. Mr. Draghi knows quite well that the solvency conundrum is not immediately answerable. But he will do whatever it takes to make sure that the euro remains a viable currency for the nations of Europe.

Market Implications

The implications of today's press conference and actions/non-actions are (1) uncertainty will continue to prevail. (2) It is likely that insolvency of Spain or Italy is a good way down the track, perhaps-maybe even probably-years down the track. (3) Freeing up the European money markets, if it happens, will be good for European banks, though poor earnings reports from Deutsche Bank (DB) and Societe Generale (OTCPK:SCGLY), among others, have caused European bank stocks to decline in value today. (Yes, a few months ago I suggested Deutsche and SG, as well as Credit Agricole (OTCPK:CRARY) as risky but potentially good long-term investments. I wish I had not done so because they all have significantly lost value over the months since my recommendation. But if I am correct about point number (3) above, perhaps they will come back.)

In my judgment, Mario Draghi continues to be the man for the job. Even if he does not succeed, he will remain an economic hero to me.

Disclosure: I am long DB, OTCPK:CRARY, OTCPK:SCGLY.