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It’s been darkly amusing watching European leaders continue to increase the size of their “bazooka” over the past two years, only to see the markets return fire, and render it useless.First they thought they could solve the problem with a few hundred billion euros. Then they had to double that. Then they had to leverage what they doubled. And now there are calls for even more money.
Not only hasn’t it worked, each time, everything’s just gotten worse.
But there is a solution. The markets seem to think we’re about to see the ECB enter into the fray as a lender of last resort to troubled countries. The ECB already nibbles in the secondary bond market, but at such low volumes, and such random intervals, it doesn’t mean anything.
The solution: The ECB needs to declare an interest rate cap for various countries, and tell the market that if X-country’s bonds hit X-rate it will intervene.
Goldman Sachs made this point this week, drawing on the Swiss example. In Switzerland’s case, it wasn’t about debt, but about the value of the Franc. It tried for a long time to strengthen the euro against the Franc, spending billions to no avail. Then it just came out and said: This is it, we’re going to put a floor under the euro (against the Franc) and that was that.
The success so far in the SNB strategy indicates that credible commitments backed up with the threat of unlimited action are likely in general to be much more effective, and cheaper, than vaguer intervention strategies. This lesson is one that is familiar from economic theory (a fully credible commitment will not in fact be tested) but the recent Swiss experience is a clean reminder.
The key point: Not only has the strategy been more effective for Switzerland, it’s been cheaper!
Edward Harrison at Credit Writedowns has been making this point for a while now, and does think that ultimately the ECB will monetise Italian debt this way.
The ECB would ‘guarantee’ a rate for Italian bonds that is high enough to be a penalty spread to Bunds – liquidity at a penalty rate – say 200 bps to German Bunds, which would be 3.8% on 10-year money. The ECB would not necessarily have to buy any BTPs to defend its target. The private sector “would do it” for the ECB via the language and confidence in the “guarantee”. That’s how it works at the short end of the curve with the policy rate by the way and it is also exactly what the Fed did during the 1940s and 1950s; so we know ‘financial repression’ works. After an initial foray in the market to prove the credibility of the backstop and to ‘punish’ speculators, every speculator would blanch at going up against the ECB’s wall of liquidity for fear of insolvency. I added the part about speculators because that’s how policy makers in Europe think about this crisis.
The point is that this is a moral hazard. The only way to credibly force countries within the euro zone to get onboard with fiscal tightening is fiscal integration. That’s why a future rump Euro will have it or be comprised of more similar national economies. In the absence of fiscal integration, you have these makeshift policies of moral suasion and empty threats. In Ireland, Portugal and Greece’s cases, the threats are more real because those economies are small. The ECB would not risk its anti-inflationary credibility to monetise the debt of smaller euro zone countries like Greece, Portugal or Ireland. However, Italy and Spain are too large to believe this threat is credible.
So the ECB is solution is not 100% perfect because of this moral hazard bit, and the fact that it would immediately take the pressure off of Italy to go ahead with reforms. It’s a bit of a chicken and egg thing.
But remember, if the ECB does go in soon, its success will depend on the approach it takes. As Cullen Roche points out, if it just comes in and buys a ton of debt, it will fail and will have spent a lot of money. However, if it says, “we will not let Italian yields rise above 4.5%” then it will succeed on the cheap.