Despite the high expectations, nay, demands of the Bond Gods, ECB chief Mario Draghi, who had promised to part the seas and deliver investors to a promised land of Eurotranquility, which these days means at least a few weeks of relief, instead resorted to more brave-sounding talk. Today his message was he and his fellow Eurocrats were still working on a plan to do something really big, not to worry. Markets “recoiled,” in the words of the Financial Times. Spain’s 10 year bond yields rose to over 7%; the increase in short-term yields, which had been particularly alarming prior to Draghi’s bazooka talk of last week, didn’t blow out as badly due to his contention that buying short-term debt would be part of “classical monetary policy,” meaning the Bundesbank couldn’t throw a hissy fit over that. The Spanish stock index fell over 5% and the Italian, 4.6%.
From Draghi’s statement, one can infer what the plan is likely to look like. The ECB will not buy bonds in isolation, save maybe on the short end, and even then, one suspects not too much. However, it will buy bonds alongside the EFSF/ESM facilities (something Ambrose Evans-Pritchard has suggested might happen for some time). This is the operative section:
As implementation takes time and financial markets often only adjust once success becomes clearly visible, governments must stand ready to activate the EFSF/ESM in the bond market when exceptional financial market circumstances and risks to financial stability exist – with strict and effective conditionality in line with the established guidelines.
The adherence of governments to their commitments and the fulfillment by the EFSF/ESM of their role are necessary conditions – not sufficient, necessary conditions. The Governing Council, within its mandate to maintain price stability over the medium term and in observance of its independence in determining monetary policy, may undertake outright open market operations of a size adequate to reach its objective.
In this context, the concerns of private investors about seniority will be addressed. Furthermore, the Governing Council may consider undertaking further non-standard monetary policy measures according to what is required to repair monetary policy transmission. Over the coming weeks, we will design the appropriate modalities for such policy measures.
The problem is that Draghi has to keep the markets appeased until September 12, when the German Constitutional Court will presumably lift the injunction against having the German president sign the treaty that creates the permanent rescue fund, the ESM (my connected German buddies believe the judges are just about certain to lift the injuction, even if it were to take some tortured reasoning to get there). The second obstacle that has to be overcome is that Spain and Italy have to ask for aid. Why is that necessary? Because formal aid comes with strings attached. The about-to-become subject nation signs a Memorandum of Understanding and gives up fiscal sovereignity to get the dough. As Ed Harrison pointed out via e-mail, Germany wants to see the periphery countries capitulate and slash pensions, cut wages, and gut social programs. Spain’s Rajoy and Italy’s Monti are neoliberals and believe in this sort of thing. The odds favor that they’ll put up a show of holding out for a bit and then relent. But as Ambrose Evans-Pritchard describes, they are putting up a good show for now:
The eurozone is now in limbo, with intense pressure building on Spain’s premier, Mariano Rajoy, to fall on his sword and request the EFSF package needed to set the Draghi plan in motion. Mr Rajoy said the proposals had “positive aspects” but deflected further questions.
Italy’s leader, Mario Monti – forging a Rome/Madrid axis as part of his efforts to give the Latin bloc a full voice in the eurozone drama – said the two leaders “will have to study” whether or not to activate the mechanism.
Hours earlier he warned that Italy could not wait forever for Europe to put real muscle behind its rhetoric. “I can assure you that if the bond spreads stay at these levels for some time, you are going to see a eurosceptic government take power in Italy.”
But even if the Germans prevail, their diktat is no solution. This is the path of at best bringing deflation to the northern countries, and Japan style outcomes, and the worst is a full bore Depression.
And the severity of the stress is not well recognized in the US. There is an accelerating bank run underway now, as lenders and investors that fear suffering losses if the Eurozone breaks up and they are left with deposits in countries that redenominate them in a new, lower value currency, move their money to banks in the core. As Marshall Auerback has stressed, interventions now have such a short half life that it is unlikely anything will arrest the bank run until the Eurozone has deposit insurance. So his challenge is not how to patch things up until September 12, but until a deposit insurance scheme is in place. Whether he can do so is very much an open question.