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Markets Applaud Draghi’s New, Improved Kick the Can Down the Road Strategy

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On Thursday, ECB chief Mario Draghi announced a bond-buying program that had been largely leaked the day prior, namely that of a new bond buying program, the Outright Monetary Transactions, or OMT. Bond yields in Italy and Spain had already come down on the rumor, and stock markets around the world rallied on the news.

The enthusiasm appears overdone when you look at the sketchy details. Draghi is implementing an improved version of the Securities Market Program, which only temporarily suppressed periphery country bond yields. As hedge fund manager Scott commented via e-mail: I don’t think this is anything but the SMP with more conditionality and pari passu treatment. Markets seem to like it, though.” “Conditionality” is Eurocrat-speak for “debtor countries must agree to wear the particular austerity hair shirt we have designed for them before they get any dough.” Per the ECB’s press release, the new program will be more bloody minded about compliance than the old SMP (which is being terminated). The ECB requires that countries must not only agree to “strict and effective conditionality,” but the central bank also

will consider Outright Monetary Transactions..as long as programme conditionality is fully respected, and terminate them once their objectives are achieved or when there is non-compliance with the macroeconomic adjustment or precautionary programme

While bright lines are useful in theory, in practice, suddenly withdrawing support from a non-complying country is the sort of thing that would provoke the very type of market upset that the central bank seems keen to avoid. So it is not at all clear whether this threat is credible.

Now of course, there were other differences, at least in the mind of Mr. Market. The belief is that the ECB, which is the only actor positioned to buy the eurozone enough time to create a fiscal union and unified bank regulation, has gotten control of the game board. Draghi made clear that only one central bank was opposed to the OMT, which will engage in “unlimited” and sterilized purchases of one to three year government bonds to meet target, but unstated, interest rates. Of course, the Germans central bank was in opposition, and the German media took up the cry:
Financial markets cheer the death of the Bundesbank.”

But what does this mean in practice? Well, first, neither Italy nor Spain have yet formally asked for help (the first step in the dreaded “conditionality” process. Italy does not want to ask before Spain, and Spain has and presumably is continuing to try to get some waivers from the sort of conditions that have been imposed on other borrowers before it requests assistance (the press is now reporting that Spain will submit its petition on September 14).

The second part that is striking is that even though Draghi has used the bold word “unlimited,” he finessed the question of what the rate targets would be. And how aggressive the rate buying needs to be is very much a function of the rate target. In theory, since the ECB would be moving risk onto its balance sheet, it should set the short end rates at the same level as the creditor nations, since more rate relief would help in reducing their debt overhangs. But a move like that could be politically divisive. So not knowing the rate target (or more accurately, finding it out only when the program goes live) is a big gap in assessing whether the program is likely to live up to its promise.

Third, the ECB has had problems sterilizing its debt purchased under the SMP, and it is likely to face this problem on a bigger scale with the presumably much larger OMT. From Colin Lokey:

In any event, the ECB hasn’t always been successful in soaking-up the excess liquidity injected into the system via bond purchases. Notably in June 2010 and in November of 2011, bids for the term deposits came-up short by around 23 billion euros and 9 billion euros respectively. Over all, the ECB has failed to sterilize its purchases on at least six separate occasions. The problem is that banks are the most unwilling to part with their cash when anxiety peaks which of course is likely to coincide with spikes in periphery short-term yields. In other words, the bond buying is likely to coincide with cash hoarding, raising considerable doubts about the ECB’s ability to ‘soak-up’ the liquidity it pumps out. In turn, this raises the possibility that the ECB will fail to soak-up enough of the excess cash to keep inflation expectations in check and to keep its credibility from being questioned

Now in fact, the ECB ought not to care all that much if it can’t sterilize all its purchases, but it is much more hawkish than the Fed, so a certain level of (supposedly) inflationary sterilization fail would give it heartburn. (Inflation fears are overdone is that the European economy has tons of slack and high unemployment).

There is also the pesky question of reality. Per Clusterstock’s write-up of the ECB press conference, the one point where the interaction got testy was when the German reporters pressed Draghi on the legality of the program. Reader Jeremy B highlighted Article 123 of the Consolidated Version of the Treaty of the Functioning of the European Union (boldface his):

Overdraft facilities or any other type of credit facility with the European Central Bank or with the central banks of the Member States (hereinafter referred to as ‘national central banks’) in favour of Union institutions, bodies, offices or agencies, central governments, regional, local or other public authorities, other bodies governed by public law, or public undertakings of Member States shall be prohibited, as shall the purchase directly from them by the European Central Bank or national central banks of debt instruments.

Drahgi has taken the position that these short term bond purchases are monetary operations and hence permissible, and claims they were contemplated in the ECB’s charter. But it is awfully hard to see a purchase of sovereign bonds in the context of a bailout as a monetary activity, as opposed to using monetary tools for other ends.

Finally, one might regard this move as a breakthrough if there were reason to think the eurocrats would make good use of the time that this sort of program will buy. But the eurozone leadership seems no closet to resolving its basic impasse than it was in May 2010, the first acute eurocrisis episode. Germany is still unwilling to give up running surpluses, yet Germany and its fellow creditor nations are unwilling to fund the deficit countries who are Germany’s and their customers. And as we are seeing in Greece, the austerity hairshirt only makes matters worse. The resulting deflationary spiral alone makes debt to GDP ratios worse. And as conditions worsen, the institutional and social fabric starts to decay, which makes recovery even more unlikely. As Costas Lapavitsas writes in the Guardian:

Last week I was in Athens and took the metro to Syntagma Square. Like many northern Greeks, I have mixed feelings towards the capital. Northerners do not like to admit it, but we secretly enjoy the smell of jasmine – the true scent of Athens. But this time the air smelt of cordite.

Syntagma was abnormally quiet: shops shut, people halfheartedly shopping, riot police everywhere. The atmosphere crackled with the expectation of something sinister about to happen. And lo, in Monastiraki Square, afew hundred yards away, agroup of young men attacked a shop owner; just another violent episode in a city resembling a tinderbox…

Today, ECB president Mario Draghi tried to stop the rot by promising to buy unlimited amounts of short-term public debt from states that accepted austerity programmes. His aim was to compress interest rates and reverse the fragmentation of banking, but it will be a short-term palliative at most. Banks need restructuring, and peripheral competitiveness needs to be restored through an investment programme to raise the productivity of labour. Instead, the EU has opted for the blunderbuss of cuts to labour costs. For the periphery this means high unemployment and low growth; for the eurozone it means a break-up is more likely.

The eurozone mess is the classic illustration of a saying attributed to Herbert Stein, “Economists are very good at saying that something cannot go on forever, but not so good at saying when it will stop.” But while it once looked like market pressures would force a change in policy, it now looks like the shift will come as a result of punitive austerity, either open revolt or widespread disobedience. And they can be as abrupt as market events.

So while Draghi may have achieved what many commentators see as a firm defense, what he has constructed is the economic equivalent of a Maginot line. While it could be an effective bulwark against financial market attacks, it remains vulnerable to political and legal outflanking.

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33 comments

  1. 4D

    Yves, I like your “mMginot line” conclusion, but I was just wondering, how much “attacking” has there really been?

    Anyone know how much was genuine investors bailing out of bonds with appalling fundamentals and how much was short selling bonds? Is shorting bonds the same mechanics as shorting stocks, easier or harder?

    1. BertS

      They have been banning short sales of bank stocks and sovereign bonds whenever they see fit since 2008.

      I think what they are really doing is going long on every “we fixed the eurozone” rumor of the last 2 years, then selling the bad news that they really didn’t.

      Someone is getting rich off this.

    2. Milton Arbogast

      It’s the run on the banks. In the game of depository musical chairs, no one in their right mind wants to hold deposits in a Greek, Spanish, Italian, or Portuguese bank. Period. I frankly believe that extends to French banks.

  2. OMFT!

    Step 1 ECB – liquefy investments by fin institutions
    Step 2 Bank of Spain – play around with local banking system for 4 years
    Step 3 Bank of Spain – liquefy investments by fin institutions
    Step 4 ECB – liquefy investments by fin institutions
    Step 5 -Bank of Spain – allow local depositors to be ripped off by a supervised bank
    Step 6 ECB- talk about redenomination risk
    Step 7 ECB – back to step 1

  3. jake chase

    Another opaque discussion of what the ECB is really doing. The central bank is buying bonds from whom? From market participants or issuer countries? What does ‘sterilization’ really amount to? How exacty does this buy time and for whom? As for the reaction of Mr. Market, yesterday was short covering. As for today and next week, we’ll see.

    Kicking the can is the only thing any central bank can ever do. It has been going on in the US since at least 1970. The alternative to continued kicking is collapse. No central bank is ever going to alter class relations since the purpose of all central banks is to maintain them. The footwork possibilities are essentially endless, which is the reason gloom and doomers are nearly always wrong. Every twenty years or so one of them is right (briefly), and he feeds on the publicity for the next ten.

    1. craazyman

      Ur crackin me up, man. so true. so true indeed.

      Amazing how far they can kick that can. They can kick it into a low-earth orbit and when it flies overhead you don’t even know what it is anymore. It’s like the Neanderthals looking at the stars.

      New theories of money and reality are emerging from the bus rides and they are amazing me. I’m almost at the point of admitting what is now obvious even to me — even though it is not ethically satisfying — that as long as society cooperates, there’s no end to the crap the ECB can buy and replace with new money. The money never existed in the first place. It isn’t real and never was real. The only thing that’s real is the cooperation.

  4. Bam_Man

    And so far I have not seen anybody comment on what impact “sterilization” will have on the QUALITY of the ECB’s balance sheet.

    The ECB will be buying garbage bonds at prices nobody else will offer, and then “sterilizing” by presumably selling assets that there is a market. What does this leave the ECB with at the end of the day?

    1. banger

      Do you really want to know? The ECB and the international financial community seems to want to create a mysterious black box where water is turned into wine.

      1. Bam_Man

        The problem is that when a Central Bank’s balance sheet becomes a garbage can, it greatly decreases their ability to conduct open market operations.

        What happens if/when a serious inflation problem develops in Europe and/or the ECB has to step in and defend the Euro from speculative attack? How will they do this if their balance sheet contains nothing but garbage?

        1. F. Beard

          If inflation takes off then they raise reserve requirements. Ya don’t need a good balance sheet to do that.

          1. Bam_Man

            Good luck trying to stop a run on your currency if “raising reserve requirements” is all you can do.

            It is getting easier and easier to see exactly how these fiat currencies will eventually die.

    2. BertS

      The ECB may not have any quality short term bonds left at the beginning of the day. They have been buying crap bonds for a while now. Even trichet did it.

      I think they have and will continue to try and sterilize by paying interest on banks reserves. Whether that works or not will depend on how long the “liquidity trap” lasts. As soon as they need to sterilize to control inflation – they won’t be able to.

      My other suspicion is that this “liquidity” follows the bank runs to Germany. Next thing you know DB will be swimming in cash and the a-holes will buy a London bank for Germany to backstop.

      1. Bam_Man

        My thoughts exactly. There can never be an “exit strategy” because they will never be able to raise interest rates. Given the composition of the balance sheet, it will be impossible. Looking at the Gold price the last couple of days, it appears that this thought has also occurred to others.

          1. Bam_Man

            True. They can just “re-capitalize” themselves via the printing press. That will do wonders for the value of the currency.

  5. banger

    The European financial community, with the cooperation of the international financial community appears to want the kick-the-can-down-the-road policy for rational reasons. The only way this can all work is to create a series of black boxes that transform toxic assets to easily negotiable financial instruments. Given that we live in a world of fiat currencies it would be logical to fix those currencies into a stable system where value can be created by decree. To do this, major market actors must cooperate. In exchange these actors will be given immunity for prosecution for past and current criminal activity. In exchange these institutions must agree to take only a fixed rate of return as a kind of international tax on all financial exchangess. Policy-making will be done by virtual committee based on emergent properties of the developing network that is already in place. The finance oligarchs need time to put the system in place so thus the delaying tactic.

    We all have to agree that a new system must be put in place. And we all know that we can’t just regulate the financial industry through democratic means since the major actors that profit from current arrangements can game the system with ease and virtually run at least the governments of the U.S. and Britain. So those major actors along with the major industrialized central banks must set policy through give and take that is a win-win for everyone but, of course, the populations as a whole–though, in the end I think a stable system would help us all even if we have to pay a substantial tax to the oligarchs. The question is: will that be enough for them? I’m counting on the answer being “yes.”

    1. BertS

      You must think they have nice oligarchs in Europe.

      Ours have been behaving more like the Terminator – they never stop coming at you.

      1. Jim

        I’d rather have US oligarchs than the ones in the continent of Europe.

        Those effectivey told the German voter that they don’t care aobut German democracy, about the promise never to monetize the debt of the Eurozone countries.

        Frankly, I’m amazed that so many progressives who were critical of Bernanke/Geithner/Bush/Obama are so complimentary with Draghi and the ECB.

        You can’t have it both ways.

        Either you believe that a central bank, wherever it’s located, can do as it pleases to save an economy, even if this means usurping democracy, or it can’t.

  6. TC

    How does sentiment to leave the EMU in Germany not grow even among those who, knowing the “heads I win, tails you lose” dynamic they’re trapped in, would better be dealt with triaging losses entirely within Germany’s sovereign domain to address following its exit? So far, Germany’s effort to force the EMU’s demise (or its restructuring) without being assigned the blame for ensuing chaos, this with its insane insistence on an austerity regime imposed on so-called profligate euro-zone member states, has failed. Talk of the death of the Bundesbank might be just silly, yet if it’s meant to be a slap at Germany’s sovereignty, those laughing today seem only the more set up to be weeping tomorrow.

  7. pebird

    The irony is that without unlimited purchases, the ECB will not be able to sterilize the bond purchases. The point is to make the government paper equivalent to currency with the addition of a short time preference.

    As long as the ECB hesitates on unlimited purchases, eventually the markets will sense that some country’s bonds will not be purchased, and then auctions will fail. Hard to have no risk assets when the damn government auction fails.

    Unless the ECB has some other external source of financing, they need the market to swap the currency spent for the bonds, and the markets need to know they can circulate those bonds.

    Instead we get these statements that sound bold, but on further review are just restatements of kick-the-can policy.

  8. Jim Haygood

    ‘While bright lines are useful in theory, in practice, suddenly withdrawing support from a non-complying country is the sort of thing that would provoke the very type of market upset that the central bank seems keen to avoid. So it is not at all clear whether this threat is credible.’

    My, yes, don’t we all recall those sober and sensible Maastricht rules, which to this day stipulate that members which run deficits exceeding 3% of GDP, or debt greater than 60% of GDP, shall be fined.

    Not a single fine has ever been levied, even though every large member of the euro zone has violated the Maastricht criteria multiple times. Like politicians everywhere, eurocrats exempt themselves from their own rules — even the ones that have nothing to do with little people.

    In his press conference, Draghi commented that ‘yields in Europe are distorted in all directions,’ suggesting that rates are too low in the core and too high in the periphery. Yet it is entirely rational for depositors in the periphery to move deposits to the core. They can’t lose — if the euro survives, it costs them nothing. If it doesn’t, their deposits get redenominated into strong northern euros or D-marks.

    It’s a one-way bet, and Draghi can’t change that.

    Discretionary tampering with bond yields via OMT (Outright Moonbat Transactions) simply demonstrates the enormous paternalism, egotism and narcissism of central bankers. Abolish the Fed and all its harelipped little brothers.

  9. Gerald Muller

    The troubles in Spain and Italy come essentially from the euro. Do you think anyone would have built those houses, mansions and city gigantic dreams of concrete if they still had the peseta? No way.
    Draghi, ex-Goldman Sachs (never forget), is trying to cram down the throats of the Spanish people a Greek-like program. My guess is that the Spaniards will tell Draghi and his cohort to bugger off.
    And, if they are sensible, they should leave the eurozone. That would lead to a terrible year but with hope at the end of the tunnel, while in Greece, the end is nowhere in sight after 4 years of terrible austerity.

    1. Eric377

      The terrible austerity can be thought of like this: Greece has defaulted on a major portion of its debt and has gotten very large loans and remains unwilling to fund the public sector that they currently enjoy, let alone the one of their dreams. In aggregate, they are getting exactly what they “worked” hard to achieve over several decades…national insolvency. There is real and severe human suffering, however, so simply saying that they deserve the current situation and doing nothing based on that understanding is inhumane. Pratical help, yes; sympathy, not so much.

    1. Valissa

      Yup, both neolibs and neocons have a great love for authoritarianism, they just wear slightly different suits.

      1. Valissa

        They love to use the word technocrat for the neoliberal European politcal aristocracy. And of course, as the story goes, the technocrats aren’t political… HAHAHAHAHA…

        1. Valissa

          Don’t pin much faith to the Draghi plan – The technocrat has spoken. Now it’s up to the politicians to act. The latter doesn’t necessarily follow the former. http://www.telegraph.co.uk/finance/comment/9526928/Dont-pin-much-faith-to-the-Draghi-plan.html

          OK, let’s see if I have this straight. Draghi is a technocrat not a politician… yeah, right… just because it’s an appointed position doesn’t mean it’s not highly political. Draghi’s background is as an economist and banker, a prior VIP at Goldman Sachs. Technocrat = neo-aristocrat, and naturally much superior to mere politicians.

  10. Schofield

    You can’t keep a good Neo-Liberal (Neo-Conservative) from forcing economies into death spirals with their austerity programs.

  11. Susan the other

    The ECB might be planning to sterilize bonds like a good laundry. Things in the news: Did Angela do some deal, the details unknown, with China having to do with Germany’s short term bonds of Greek debt? Which do nothing for Germany but tread water unless Germany can sell them to, say, China. China loves Germany and trusts Germany and Germany’s bonds. And both Germany and China know that Greece has enormous oil and gas reserves. What’s not to invest in? And if the ECB (aka the Bundesbank) is allieviated of this asset isn’t the money sterilized and available for more sovereign bond purchases in Spain and Italy? And maybe France.

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