The ECB May Yet Save Europe!
Hat’s off to Mario Draghi, who may actually be the smartest man in Europe.
As a result of today's ECB board meeting, I now assign a higher probability to eurozone survival than I have since the crisis began in early 2010. For the first time, the cup is half-full. Europe has finally abandoned its hopeless strategy of mutual eurobonds backed by fiscal union (piling debt upon debt), and is moving toward the only possible solution: full-scale monetary rescue by the ECB.
The entire governing council (minus one, Weidmann of the Bundesbank) voted for Draghi’s bond-buying program (“outright monetary transactions”). Under this program, the ECB will spend an “unlimited” amount of euros to buy medium term government bonds in the secondary market. To be eligible for the OMT, governments will have to apply to the EFSF/ESM and submit to a comprehensive reform plan including both micro reforms and a path to budgetary balance. (This is a big mistake.)
But before I discuss the plan’s drawbacks, let me explain its good parts. First of all, this action embodies my fondest hope, which was that the ECB would finally ignore Weidmann and get on with rescuing the eurozone. Poor Mr. Draghi was forced to cook up an elaborate rationale explaining why buying peripheral bonds is in keeping with the ECB’s charter, which explicitly forbids exactly it. He knows that his rationale is completely bogus but he needs it to help the Northern governments sell it to their people. (Note that both the Finnish and Dutch central banks went along with the plan, which may not please their governments, especially Finland. We haven’t heard from any governments yet.)
This announcement effectively means that the South (or should I say Europe?) has hijacked the ECB and left the Bundesbank in the dust, which was absolutely necessary. Weidmann will now have to resign or shut up. Merkel certainly wants him to shut up. (Germany’s other board member voted for the plan, which further isolates Weidmann.)
The ECB staff was unable to come up with a transparent formula for deciding how to target bond yields for each country, which is perhaps understandable given the political sensitivity. However, without an announced target, the markets can only flounder around trying to figure out what the ECB’s secret target really is. This will cost the ECB a lot of money that it wouldn’t have had to spend defending an announced target.
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There will be a lot of commotion in the bond market for a while. The key numbers to watch will be Spanish 3-year and 10-year yields. The 3-year maturity would fall within the OMT program, and the 10-year will signal the market’s unmanipulated opinion of the program.
This program could contain the seeds for a complete monetary rescue of the eurozone, maybe including even Greece (which Draghi never mentioned and which no reporter asked about). Greece is now chump change. Once the ECB starts in on this, it is literally in a fight for its life. It will have to spend whatever it takes, or it will lose. I don’t know if Merkel fully understands what has just happened, but it really does mean the Italianization of the ECB. It may still be located in Frankfurt, but it’s now the Banca Centrale Europea. Some Germans besides Weidmann may not like this.
Now, the problems. As I indicated yesterday, it takes two to play the conditionality game and, for now, Spain isn’t playing. Rajoy’s position is that Spain has already launched a reform program and doesn’t need a new one imposed by the Troika. Draghi (meaning Merkel) left no room for compromise on this, so Rajoy will have to blink. When and how will he do so? He has run out of money except for the round-trip through his central bank. The ECB abandoned all collateral standards today, so in theory the Spanish banks can now pledge their paper clips and furniture, but I expect that Draghi will start closing the spigot. Rajoy will be forced to lose face or default. (This is not your father’s central bank!)
As I said earlier, the austerity requirement is a big mistake, since it leads inexorably to depression. These economies need growth, not asphyxiation. I’m sure Draghi knows this, but is an incrementalist. An even bigger mistake is the ECB’s ongoing monetary nonfeasance.
Turning to the monetary analysis, the underlying pace of monetary expansion remained subdued. The annual growth rate of M3 increased to 3.8 percent in July 2012, up from 3.2 percent in June. Economic growth in the euro area is expected to remain weak.
Euro area real GDP contracted by 0.2 percent, quarter on quarter, in the second quarter of 2012, following zero growth in the previous quarter. Economic indicators point to a continued weak economic activity in the remainder of 2012 in an environment of heightened uncertainty.
Looking beyond the short term, we expect the euro area economy to recover only very gradually. The growth momentum is expected to remain dampened by the necessary process of balance sheet adjustment in the financial and nonfinancial sectors, by the existence of high unemployment, and by an uneven global recovery.
In plain English: “We don’t know when we will arrive at our destination because we are driving as slowly as we can and are taking frequent rest stops. Also, the motor may be broken."
You might ask: won’t unlimited bond purchases stimulate monetary growth? Not for these scientists. Draghi made clear that all such purchases will be fully sterilized and that the notion of not sterilizing wasn’t even discussed (!).
The ECB is apparently quite happy with zero real growth and negligible nominal growth. And one of the excuses Draghi gives for low growth is high unemployment! Maybe he isn’t the smartest man in Europe, or maybe he is playing the long game. After all, if he plans to monetize the entire debt of Spain and Italy, that will ultimately require a bigger balance sheet. I hope that’s what he’s thinking. In for a penny, in for three trillion euros.
As long as the ECB continues to deliver zero growth, nothing can save the periphery because only growth can grow government revenue and shrink relative debt. The ideal policy would be unlimited spending in support of across-the-board yield ceilings, no austerity, and massive monetary stimulus in order to achieve 5-6% nominal growth. We are nowhere near that plan, which is why I am not yet converted to the bull case for Europe.
Going forward, we will have to see what Rajoy says, what Monti says, what Merkel says, what happens to Spanish yields and--yes--what happens with Greece. But Spain is the crisis du jour.