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Is Draghi’s EuroRescue Plan Coming Unglued?

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No sooner had some astute Euro commentators noted that Draghi might have found a path through the Euro mess to keep it patched up long enough for to impose austerity on the periphery and drive all of Europe into a lovely depression, various elements of his plan look as if they were coming unglued.

First, careful readings of the German press suggest, as we had warned, that the commitments he has gotten to bond buying, both from German pols and from northern central banks ex the Bundesbank, are qualified: only near term maturities (less than two years) and only in limited amounts (“limited” has not been translated into a particular number, it appears). Yet the media seems to think quite the reverse, that Draghi is going to engage in unlimited bond buying. A representative quote from the Financial Times:

After denying for months that Spain will require anything resembling a sovereign bailout, Madrid hinted on Friday that it could, after all, take up Mario Draghi’s conditional offer of buying short-term debt.

Unlimited bond buying by the ECB would surely soon follow

Um, no. It appears that anything like that would lead to a revolt by the northern bloc. Absent a September 2008 level meltdown, it does not look like they will give the ECB what it wants quickly or easily.

Second, as the FT piece (and other sources) point out, Spain is now playing coy about asking for funds (the drill is the about-to-be-subject nation has to ask for a rescue, then agree to a Memorandum of Understanding which sets forth the details of the fiscal tortures that will be inflicted on it). Per the FT:

Mariano Rajoy, Spain’s prime minister has insisted on seeing what the ECB has on offer before signing up to a memorandum of understanding. But the ECB is unlikely to reveal more about the details of its new bond buying programme until its September policy vote.

Ironically, Draghi may be a victim of his own success in jawboning. He’s driven down short term yields enough that Spain feels less anxious about access to markets, plus its next bond sale isn’t until October. But Italy has already said (effectively) that it won’t ask for funds before Spain. Now up to a point, that was exactly what Draghi wanted, to keep everything on hold until at least Sept. 12, when the treaty allowing the establishment of the ESM will presumably be signed by the German president, German constitutional court willing. But too much complacency on the part of Spain and Italy is not seen as desirable by the Eurocrats.

Just as a mere ten days ago, reports that German Finance minister Schaeuble had approved ECB bond-buying was followed by a denials, so to do reports that German politicians are moving towards supporting bond buying seem to be less conclusive than the initial news reports suggested. Per Ambrose Evans-Pritchard of the Telegraph:

“We must make it clear to Mr Monti that we Germans will not shut down our democracy to pay Italian debts,” said Alexander Dobrindt, secretary-general of Bavaria’s Social Christians (CSU).

Bundestag president Norbert Lammert said parliament’s integrity cannot be subordinated to the ups and downs of the markets….

“The tone of the debate has turned dangerous. We must be careful that Europe does not rip itself apart,” said German foreign minister, Guido Westerwelle. He himself fanned the flames over the weekend, saying he was “categorically” against further expansion of the EU rescue machinery or bond purchases by the European Central Bank. “I can’t imagine that a majority of the Bundestag will back unlimited debt liabilities,” he said.

The outburst leaves it unclear whether Germany will agree to activate the eurozone rescue fund (EFSF) on acceptable terms if Spain and Italy request bail-outs, the political trigger needed for ECB bond purchases under the “Draghi Plan”. Mrs Merkel and finance minister Wolfgang Schauble back ECB action but revolt within her coalition threatens to spread beyond a hard core.

It also did not help that the Berlusconi paper Il Giornale put a photo of Merkel waving in a way that looks a bit like a Nazi salute with the headline, “Fourth Reich” on its front page.

Yanis Varofakis, correctly recognizing that there is no “unlimited” ECB bond buying program in the wings, explains why the widely heralded Draghi plan won’t deliver the goods even if the other hoped-for device for extending the firepower of the rescue facilities, that of giving the ESM a banking license, is put in effect:

Put simply, the policy of having the EFSF-ESM use its severely circumscribed fire power, in conjunction with a limited bond purchasing program by the ECB, to push Spanish and Italian yields down, will fail as miserably as the combined efforts of the EFSF and the ECB failed in 2010/11 to prevent Portugal and Ireland from following Greece into the mire.

The question now becomes (even if it is an academic one): What would it take to convince investors that the proposed measures will annul the ‘convertibility risk’ that Mr Draghi now acknowledges to be “not insignificant”. Everyone, including Gavyn Davies and Tim Geithner, seems to believe that the answer lies in giving the ESM a banking licence, thus allowing it to use the ECB’s balance sheet as a means of levering up whatever monies it has available (from less than 200 billion to the required 2 trillion!).

I have no doubt that an announcement along these lines would cause a frenzy of enthusiasm in the money markets, and that spreads throughout the Eurozone will collapse. But I also have no doubt that this would be another temporary measure. The reason? The toxicity of the EFSF-ESM funding structure. Toxicity? Yes, toxicity. As I have explained a long time ago, the bonds issued by the EFSF (which will have the same structure with those that the ESM will issue, assuming the German constitutional court gives the green light in September) are structured very much like the awful CDOs that brought the house of cards down in 2008. If this analysis was correct last summer, then levering the EFSF-ESM up, by granting it a banking licence, would be tantamount to creating a CDO mountain on steroids and planting it in the heart of the Eurozone. It may work for a while (just like the CDO market was buoyant for a while) but in the end that new, Eurozone-constructed, house of cards will come crashing down. And if investors have learnt anything from the recent past, they should see thins coming fairly early on, which means that the half life of a new ba king-licence-carrying ESM will cause more problems than it will solve very, very soon.

So? What policy can address ‘convertibility risk” effectively? The answer is: Nothing short of proper mutualisation of the Maastricht Compliant Debt. And since we do not have a Federal Treasury to do this (and won’t get one before the ‘convertibility risk’ turns into ‘convertibility reality’), the only tool that I think can do the trick is ECB-bonds as per Policy 2 of our Modest Proposal. That this is not on the cards is as evident as it is indicative of the low probability that the Eurozone will survive.

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32 comments

  1. Foppe

    I never see this being mentioned in any of the Draghi posts, but how does this relate to the plan to give the ESM a bank licence? The austrian CB president, and more recently the PM, have suggested that ‘germany will have to come around’ (presumably austria is worried because of their outsized banking sector) on this topic; and it seems to me that giving it a banking licence (combined with the liberal approach to risk accountancy that is still so much in vogue) could ‘solve’ a lot of problems. So am I missing something, or?

      1. Foppe

        Having said that, I don’t really see why, if it is indeed “liquidity” (nudge-nudge, wink-wink) backstopped by the ECB, while having either Eurostat or one of the corrupt 4 as its accountant, it could not basically buy everything and “hold to maturity” or whatever.

        1. Robin Hood

          I think they want it because it would create what Europe desperately wants – a (brand new) dumb bank. One that can buy new shaky sovereign debt directly, and probably any toxic waste anywhere (or wherever they think is neccesary), and be legally “backstopped” by the ECB rather than taxpayers or the borrowing power of the dwindling group of “rich” nations.

          I’ve always wanted one of those too, but I gave up believing in Genies long ago.

  2. mmckinl

    It is called “The Long Emergency”. Despite the entire world GDP shrinking Brent crude is now, once again above $110. Ant resuscitation of the world economy would once again cause Brent to sky rocket killing any sort of recovery.

    There is only one way out of the financial crisis and that is nationalizing all banks and huge debt write-offs. How many times must it be said: You can’t cure utter insolvency with more debt.

    What we will probably see is more war to obfuscate the complete and utter implosion of the world economy. At this point it is just about the only card left for bankster-plutocrat class. Since they own the Main Stream Media and every government in the Western World it’s clearly on the table. They’ve been champing at the bit for years over Iran.

        1. F. Beard

          What Professor Keen calls a “A Modern Debt Jubilee” is a actually a universal bailout of the population with new reserves.

          1. mmckinl

            New reserves from where and to what end? Unless and until massive actual debt write offs take place there is no jubilee!

  3. Jose Guilherme

    I’ve been trying to get the following point through – without success up to now – so I’ll give it another try in the following lines.

    Italy (or Spain, for that matter – I’ll use Italy as the base country because it is a large economy, not easily intimidated) does not need to ask for aid, if she decides to use Target 2 rules in order to regain monetary sovereignty, neatly and nicely, inside the eurozone.

    The steps to take would be the following.

    1. Italy finds a state-owned commercial bank (if there isn’t one available, it does nationalization on a private bank) to buy all newly-issued public debt securities at par and with a low coupon.

    2. The Italian government uses the proceeds to redeem all maturing bonds held abroad (say, in Germany). The Bank of Italy lends funds to the commercial bank (taking as collateral the government bond, a practice allowed by the ECB under current rules) at the prevailing eurosystem rate of less than 1%; the funds replace the government deposits transfered abroad to redeem the bonds.

    3. These amounts will necessarily show up at the end of the process (Target 2) as a debit position towards the eurosystem on the Bank of Italy´s books and a credit position towards the eurosystem on the books of the Bundesbank.

    In practice, the eurosystem (ECB) will end up replacing the previous external creditors of Italy and this process may continue indefinitely, again according to Target 2 rules.

    Just check out the latest figures: Italy already has over 200 billion euros of negative claims on the eurosystem (Target 2), mainly from capital flight out of Italy. Build up a few hundred billion more of negative balances as a result of public debt and I’m sure you’ll hear the screams of pain coming from the EU.

    More practical results:

    a) the state-owned commercial bank gets a profit from the spread.

    b) default risk on Italian bonds is eliminated.

    c) Italy will never need to ask for aid packages and will thus be liberated from the threat of foreign-imposed austerity.

    This may seem all too complex but, hey, Target 2 rules are complex.

    IMO, it should be the duty of both Italy’s and Spain’s governments to defend their countries against foreign-imposed austerity.

    And it can be done right now.

    All it takes is a good look at Target 2 mechanisms and the decision to apply them without being intimidated by the fear of a putative reaction from EU authorities who would be, in any case, quite impotent to do anything about it – aside from screaming, that is.

    One final point: the mechanisms of Target 2 are clearly (and thoroughly) explained by the following authors, particularly: Garber, Whittaker, Lavoie. Perhaps Italian and Spanish leaders (or their advisers, at any rate) should simply read them before deciding on how to deal with the EU.

    1. Tiger

      Interesting but isn’t what you described a de facto euro breakup? By eliminating cross debt holdings and negotiations about austerity Italy would thus be laying the ground for disunion and breakup and the rise in Germany’s target2 balance would be the cost of breakup (plus other stuff). Others chime in?

      1. Jose

        You may have a point – it’s an possible interpretation, at any rate.

        And it would be achieved using only legal, existing and well-established rules…

    2. Jim

      Interesting, Jose.

      But what happens if, after two more years of stagnant or negative growth, Italy decides to leave the Euro?

      1. Jose Guilherme

        That´s my point, precisely.

        Italy can escape austerity right now, while staying in the euro, just by appropriately using the mechanisms of Target 2.

        And in a couple of years time (if not before) I believe the pressure building against the eurosystem will just be too much to bear.

        My favourite outcome would be an orderly dismantling of the EMU, by agreement among all parties concerned, while preserving the essential parts of the European single market.

        1. Jim

          Preserving the free trade union components of the EZ, after a dissolution, would be ideal.

          But I have to return to the Target2 “debt” Italy would owe. Would Italy have to repay it? In Liras? In Euros?

          What if a few “core” countries in the North wanted to preserve the Euro. Would the Italian central bank have to declare bankruptcy and repay the North at 5 cents on the Euro?

          Good comment, Jose.

          1. Jose Guilherme

            Thanks.

            I think this quote from Peter Garber (from Deutsche bank, one of the top experts on Target 2) may help to analyse the present situation:

            “There is no limit to the extent of…liabilities…that a NCB (read: Italy´s central bank)can incur; and these liabilities can be carried indefinitely as there is no time prescribed for settlement of balances”.

            As for what would happen to the credits in case of collapse of the euro, we might imagine the following.

            I am an Italian citizen, transferring today one million euros from a deposit I have at an Italian commercial bank to a new deposit of mine at Deutsche Bank. I’m afraid Italy will abandon the euro and devaluate, so I want to preserve the purchasing power of my wealth by sending my hard-earned money to safe and secure Germany

            Say tomorrow Italy exits the euro with a parity of the new lira to the euro of one:one initially, depreciating after a couple of seconds of forex trading to 2:1.

            On day zero, one million euros are worth either a Ferrari or a top of the line BMW.

            On day one, a BMW is still worth a million euros, whereas the Ferrari sells for one million lire, now worth only 1/2 million euros, however.

            Let’s say the exchange rate 2:1 reflects the true value of goods and services in Italy, as compared to Germany.

            Then I, the Italian depositor who fled with my capital to Germany, have a net gain of half a million euros.I can still order the BMW model to be shipped to Italy at the price of my original deposit.

            The Bundesbank, however, has got a credit balance of a million euros on the eurosystem, as a result of my transfer. Will it be able to claim as credit over Italy (at the end of the line) two million lire or less than that? Two Ferraris for one BMW, in terms of real goods?

            My bet would be that Italy would not accept to convert Target 2 balances at market exchange rates. There would be a negotiation to decide on the “proper” equivalence. Maybe the Germans would get only one Italian Ferrari for their newly-made BMW, after all.

            Conclusion: wise Italian investors should put their capital in Germany (and they’re doing that right now, voting with their purse at the rate of hundreds of billions of euros per semester). And once (if) Italy drops out of the euro the German Target 2 claims on her will likely be settled at much less than their current book value.

            No wonder Germany is scared of facing such a scenario..

  4. jake chase

    Be careful drinking the legality-democracy kool aid. When the jig is up and the elite have no choice but to print money they will print money and legality and democracy be damned. Of course all the “northern” politicians are talking down the scheme, but talk is cheap.

  5. Hugh

    Who could have predicted that the 25th euro-deal would come unglued, just like the previous 24? It seems almost like piling on to note, as Varoufakis does, that even if the Draghi plan had been put into effect it would not have fixed what is broken in Europe.

    1. Robin Hood

      I suspect the press may be overlooking the simple answer to this latest oratory from one of our CB saviors. On the day he first made his “do anything” statement the Spanish bond market was unravelling and I think it is possible anyway that he may have been trying to focus his CB Jawboning powers on the Spanish bond market. He then found himself smack dab in the world spotlight and then had to re-spin a bit with more jaw-boning, so as not to blow his job, as it were.

  6. gerold k.b. weber

    I am surprised that you and usually competent economists blogging on this site still don’t discriminate enough on Eurozone periphery countries. Also the commentariat is startingly uninformed when it comes to studying ‘European Sector accounts’ (I challenge you to find them on Eurostat).

    If you would use this relevant source, you should know that Italy is a wealthy country which could very well save itself by wealth transfer from households to the government.
    All the more as the Italian median household is nearly three times as rich as the German one (just have a look at Credit Suisse’s ‘Global Wealth Databook 2011′).

    This is by far not the case for Spain, and therefore Spain and Italy have to be discussed differently. Spain has low household wealth and ‘rest of the world’ holds a lot of financial assets.

    This is also true for Portugal, which has higher household wealth, but highly indebted non-financial corporations.

    To sum it up, all the periphery countries are quite different. While there is not much reason to be concerned on Italy (with the exception of market psychology and Italy’s wrong approach to solve its problems), Spain and Portugal definitely need help.

    And of course Greece has anemic money supply in its depressed system, and we should think hard on additional currencies for this lovely country, or an Euro exit.

    As nakedcapitalism is one of the best economic sites in the global brain called Internet, I appeal for more quality in discussing Eurozone matters.

    1. Jose Guilherme

      Well, it so happens that I have worked for extended periods of time – and I mean years, not weeks – in all the 3 countries you mention so I’m not sure your indiscriminate criticism of NC readers applies :)

      You also confuse stocks (wealth) with flows (GDP, contracting in the 3 countries concerned) which certainly does not help our analysis.

      And contrary to what you say there is reason for deep concern about Italy. Not only is she entering a recession – there is the added risk of her being submitted to foreign-imposed austerity because of the pressure on her public debt’s yields.

      Under the present conditions, austerity would have catastrophic consequences for Italy’s economy, similar to the ones we’re now observing in Spain.

      1. Jim

        Jose, very few “solutions” consider the flows component.

        Even if you wrote off 90% of Greek’s debt, you still have a country burdened with a currency that renders it far too uncompetitive to grow.

        1. Jose

          I agree.

          The solution should thus include two steps:

          1. Greece gets a 90% writedown on her bonds (quite feasible and by agreement with the EU: no less a player than Germany has recently imposed a 70% haircut on Greece’s old bonds. Greece might easily get a further write-off down the road).

          2. Greece leaves the euro, 90% free of foreign debt, devalues and funds deficits freely. In a couple of years she will be the star performer for economic growth in southern Europe (see Argentina’s case as the closest example).

      2. gerold k.b. weber

        Jose,
        For sure it is possible than one has worked in multiple Eurozone countries and nonetheless misunderstands the Eurozone crisis.

        From stock-flow consistent approaches like MMT we should have learned until now that both flows and stocks are relevant. Usually neoclassical and neokeynesian economists don’t look at stocks too much, as they are addicted to marginalism.

        And looking at financial balances of sectors in Eurozone countries is important to understand the problem and possible solutions.

        If we do that, we recognize that Italy has it in her own power to reduce government debt significantly without imposing austerity, if it taxes her rich households.

        40% of GDP transferred from wealthy Italian housholds to the government, trust of market restored. Slump terminated as taxes can be phased out. No austerity, case closed. Italian households still considerably richer than Germany’s.

        No need to tax poor German households for ESFS or ESM to buy Italian government debt.

    2. Darias

      Now I figured it out.

      If a family member is a drug addict (gov), let’s go out of our way and give them a few more shots of heroin. The addict is sure to get better as the dose go higher.

      What happens when we all run out of doses? Well, nobody knows and nobody cares. The important thing is that our addicts are still high and happy.

      It’s also worth noting that it’s more productive for the economy to take from the hard working family members or even retirees to give the addicts that next shot. Very interesting solution to say the least.

      Jose,
      How does the national bank find their accounts to find the bond buying program? Let me remind you that taking 20 from your left pocket and putting it in the right does not change the 20.

      1. Jim

        Darisas, what you’re describing are permanent fiscal transfers, and they do take place within countries due to solidarity and a common project rooted in history. They take place in the USA, UK, Germany, Italy and Spain. And in every country.

        But should they take place within a continent. Does a German retiree have an obligation to assist a Greek student?

      2. Jose

        I liked the drug addict image – Ii think it explains a lot about what’s happening right now.

        As for the question you raise about how Italy would find the necessary funds for selling her bonds: at the end of the process those funds show up as credits of the eurosystem on the Italian NCB.

        In practice, since said credit balances can accumulate until eternity with no upper bound this means Italy has regained monetary sovereignty under the euro. She is creating “money” at the stroke of a pen (in fact, a computer keyboard) by selling her Treasury’s bonds to a state-owned commercial bank. The sale creates a deposit that is transferred to a German bank to pay off an old bond. The Bundesbank gets a receivable at the end of the process – with an unspecified date for payment.

        (This is already the case, btw, for payment of net imports within the eurozone).

        Voilá: the magic of money creation at work – for Italy’s benefit – within the eurozone.

      3. gerold k.b. weber

        Darias,
        capitalism as a system is addicted to debt, just read Steve Keen or Michael Hudson on it. And the creation of debt needs agreements between debtors AND rent-seeking creditors, last time I looked.

  7. Hubert

    Why the fuss about banking license ?
    Think EFSF-ESM as Hedge Fund and ECB as prime broker.
    Does a Hedge Fund need a banking license ?
    The ECB prepares to inflate. If the market believes in the Draghi Put, the Put will not have to be enshrined. If the market doubts the Draghi Put, the Put will come into reality in due time.

  8. john bougearel

    Yves,

    Thanks for this follow-on post to “Will Draghi Outmaneuver the Bundesbank.” These two posts should be read in conjuction by investors and traders and parsed through very carefully.

    The key takeaways from these two important posts were the following:

    1) The ECB’s determined guidance to push its agenda to preserve the euro fx forward has been a primary consideration to the recent surge in investor optimism. But, as Yves and IMF Director Nicolas Eyzaguirre point out, the required adjustment of structural reforms and austerity reforms will create a needlessly large output loss in the eurozone that could linger on for years and years to come. A Great Depression comes readily to mind, and Greece and Spain are already there with their 20% plus unemployment. While equity markets did exceedingly well on balance during the last Great Depression, equities were recovering from significantly lower valuation levels. (See case shiller long term price earnings ratio). This latest equity rally driven by hopes the ECB, acting like one of the Three Musketeers (all for one, one for all), should be viewed with a healthy dose of skepticism.

    Investors also have to consider that there “is no unlimited ECB bond-buying in the wings.” ECB bond-buying is going to be limited in both quantity and duration (2 years). This, Yanis Varofakis underscores, is quite problematic and likely to fail miserably as it has before. What then is the alternative? Granting the ESM a banking license? Yes, that trial balloon was floated yet again by the ECB’s Nowotny last week. Yes, that might prove a viable short term solution. But a banking license is politically not feasible in the short term. Moreover, as Varofakis points out, a banking license is fraught with grave difficulties as the bond issuance from the EFSF/ESM are structured too similarly to the CDO’s that blew up the financial system in 2008.

    So, even if Draghi and company can politically square this “fiscal compact” circle as Pritchard suggests is happening, it will square nothing for the economic well-being of Europe, or the rest of the world, other than guaranteeing an increase in the world-wide misery index.

  9. Unconverted

    If “convertibility” risk is driving, would we not expect a see some signs of greater Euro exit rather than bidding the core below zero??

    2 types of liquidity preference…

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