“ECB bailout or bust.” So says Paul Krugman and he’s one of many.Outside of Germany, a consensus among economists has emerged that the European Central Bank is the only body capable of arresting the debt crisis coursing through the region’s veins. With the European Financial Stability Facility (EFSF) widely viewed as dead on arrival, the printing press is now regarded as the last remaining hope. Of course, it’s possible another solution will emerge. But for the moment, bets are being placed with ECB or bust in mind.
Investors have a curious take on this apparently binary situation. Given that the market has actually held up as the debt crisis has materially worsened, they are betting that when push comes to shove, it’s out with the bust and in with the ECB.
This mimics the way stock market participants now tend to behave. If “Possible Outcome A” is frightening yet potentially solvable by government action, and the market reckons that the government really doesn’t want to see said outcome, then investors think there is no need to significantly discount the possibility of the terrifying event actually happening. What traders are doing is playing a high stakes financial game of chicken.
The U.S. debt ceiling saga over the summer illustrates this complacency. While a last-minute deal was struck, it certainly was not inevitable. But you wouldn’t have known this by looking at the stock market. Only in the days before the debt ceiling deadline did investors start to act less sanguine.
Expecting the government to ride to the rescue isn’t a new phenomenon. After the Long Term Capital Management crisis, talk of a “Greenspan put” permeated the markets. In technical terms, traders sensed that the Federal Reserve was so worried about a stock market decline that it was implicitly guaranteeing them against loss. So in market parlance, investors believed the Fed had given them a put option: the right to sell back to the central bank their stocks, which in practice just meant protection against market declines.
The beauty of this put was three-fold: it was free, it did not expire, and most importantly, the presumed guarantee (or “strike price” in options terminology) sat very close to the prevailing level of the market. It was the ultimate giveaway, privatizing the gains and socializing the losses.
Notwithstanding the fact that the market crashed despite a supposed Greenspan put, investors now arguably place more faith in his successor, Ben Bernanke (even though the market has also crashed on his watch).
This is not totally irrational. Back in June 2003, according to an FOMC transcript, then-governor Bernanke did not hide his desire to protect the market. In pressing for the earlier release of FOMC economic forecasts, Bernanke opined:
“It occurs to me that the numbers that we see here would be quite useful to release to the public in two senses. One, this combination of unusually high growth and low inflation would make very clear on what we base our balanced risks for growth going forward combined with our downward risks to inflation. Second, I think it would support the financial market configuration that we’re looking for, which is a strong stock market and a strong bond market.“
In January 2011, CNBC quizzed traders about the absence of a correction in equity prices. After listing other possible explanations, the big one came at the end:
“Finally — and this is likely the most important reason: the Fed QE2 continues to the end. Traders are buying the slightest dip because they still believe the Fed is behind them — and when you have Ben Bernanke specifically saying his policies are helping the stock market, who can blame them?”
Stock market investors are counting on massive ECB intervention to bring down sovereign bond yields. But relying on the ECB seems to require believing that Angela Merkel is on board with the bailout. The nominally independent central bank is clearly wary of a German backlash should it engage in full-scale sovereign debt purchases. Thus, until Merkel gives her approval, it is unlikely the ECB will go all in. This explains why so much pressure is being brought to bear on the German Chancellor, revealing for all to see that the ECB is very much a political institution.
Why might the Merkel put be more unforgiving to financial markets than the Bernanke equivalent? In the case of the European debt crisis, it boils down to legal and political issues. Influential Germans, from the President, to the head of the Bundesbank, assert that debt monetization by the ECB is prohibited by European treaties. (Indeed, as market analyst Doug Huggins argues, even the central bank appears to deem such lender of last resort financing beyond its mandate). Merkel herself has repeatedly opposed an ECB bailout on these grounds, and yet it’s as if equity markets just blithely assume she’s posturing.
Legalities aside, Merkel must contend with German domestic politics in deciding whether to support the ECB in this matter. This is a Chancellor whose party does not have a majority in the Bundestag, and whose coalition partner, the Free Democratic Party, has spoken out against ECB bond market purchases.
Last but not least is the electorate. Stemming from the Weimar hyperinflation, it is well-known that Germans have historically been averse to a central bank printing money. Politically it will be hard for Merkel to sanction a massive ECB intervention unless Germans believe they will be better off with an easy money policy. Otherwise it will be seen as a stealth bailout of countries that did not keep their fiscal houses in order, paid for by a stealth tax, i.e. inflation, on hard working Germans.
Merkel may only relent and endorse an ECB rescue if events really start to get out of control, with Germany acutely feeling economic pain. This would presumably alleviate much of the domestic opposition to the ECB printing press.
The mistake investors are making is assuming that the Merkel put, if it exists, sits where the Bernanke put does. Think of it like an insurance policy where the holder pays the deductible. Investors may not realise that they are responsible for the first 20-30% loss, after which Merkel may act to set a floor under the market. Only as stocks fall from current levels and she does not immediately appear as saviour will this reality set in, further accentuating the decline, and ironically, bringing forward the day at which Germany ceases to say nein and starts to say print.