August 9, 2011 8:15 pm
Beware the ECB’s brave new world
By Martin Sandbu
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Jean-Claude Trichet, president of the European Central Bank, has torn up his institution’s implicit rule book by buying Italian and Spanish sovereign debt. Does this make him Europe’s great defender, who has turned back a near-fatal onslaught by market forces? Or is he rather a Molotov cocktail-throwing radical, tearing down the foundations of the eurozone’s social contract by opening the door to monetised public deficits?
He could, of course, be both. It is quite possible, indeed plausible, that the project of monetary union can only survive if some of the premises on which it was founded – such as a ban on using pooled resources to help member states who cannot pay their debts – are jettisoned. If so, Mr Trichet is indeed a revolutionary, but one whose radical measures aim at preserving the established order.
There is a more likely possibility: that for all its radicalism, the ECB’s action will not have much effect at all. Granted, the immediate impact of the governing council meeting on Sunday and the next day’s market intervention was tremendous. Driving down the sovereign yield of a €1,600bn-a-year economy by almost a full percentage point shows that the ECB is no pushover.
The question is not about the force of the ECB’s punch but about its staying power. Its intervention in the sovereign bond markets of Greece, Ireland and Portugal is instructive in this regard. These are much smaller – more cheaply manipulable – than those of Spain and Italy.
The ECB launched its Securities Markets Programme in May 2010, when the first eurozone rescue of Greece was arranged. It later added Irish and Portuguese bonds to its portfolio. Before this week’s intervention, the SMP held €74bn-worth of government securities from these three countries. That is 14 per cent of the around €520bn of bonds they have outstanding, presumably more if counted at face value.
Since Italian and Spanish bonds amount to some €2,250bn, and trade at higher prices than those of the small peripheral countries, the ECB would need to spend well more than €300bn to hold a similar share. If the goal is to induce markets to offer states low-borrowing costs, this amount of bond-buying is clearly far too timid to succeed. Greek 10-year bonds now yield about 15 per cent; Irish and Portuguese ones about 10. Why expect any more success from buying Italian and Spanish bonds?
The answer depends on what precisely the ECB wants to do: make markets lend at reasonable rates, or permanently substitute its own favourable rates for unsustainable market yields? For now, the answer is surely the former: the ECB – and everybody else in their right mind – must hope the intervention will flip market psychology so that investors return at normal prices. This is not a delusional proposition: everywhere except Greece, the biggest cause of rising yields has been self-fulfilling market worries about market access.
But the effect of policy on market psychology is never mechanistic, least of all in times as uncertain as these. The ECB’s action, instead of reassuring investors, could quite possibly make them think that if such a desperate measure is needed, it is better to get out of the market and stay out until things look better. This could accelerate the crisis. More probably, doubts will simply linger until market panic flares up again.
What then? It will be the true test of the ECB’s radicalism. If markets remain unconvinced that Italy’s or Spain’s market access is secure, the ECB has only one tool left. That is to take over the whole market – buy all new or outstanding Italian or Spanish debt at a certain yield – or promise to do so, which it can only credibly do by actually going ahead.
It is inconceivable that the ECB would do this, and there are reasons why it should not. One is efficacy: it is not clear how Italian and Spanish access to private debt markets at reasonable terms would be secured by supplanting those private markets with monetary financing.
Moreover, purely monetary action cannot provide the public sector with real resources on a sustained basis without those resources ultimately being paid for by the private sector. The usual way that this happens is through an inflation tax: net holders of nominal claims see the real value of their assets eroded. In a currency union this would affect all countries and amount to a real transfer from creditor country citizens to debtor states. Transfers can happen in other ways: if bonds were not honoured in full, the entire eurozone must help make the ECB whole for its losses.
Whichever the mechanism, transfers resulting from monetary policy are anathema to the terms Germany thought it secured for the euro.
But this outcome can only be ruled out by finding another solution, and soon. Creditor nations’ taxpayers are already exposed. Politicians must grasp, then explain, that their money is best protected by putting it explicitly behind the commitments made to solvent but illiquid sovereigns. The obvious way to do this is the most impolitic one: boost the eurozone’s rescue facilities – the European Financial Stability Facility and the future European Stability Mechanism – to a level that can cover the entire eurozone’s gross public financing needs for the next couple of years, some €3,000bn.
This would end the crisis. EFSF and ESM bonds, like US ones, will not face buyers’ strikes, regardless of ratings. It would also be profitable – a point missed by politicians who complain about “unjustified” yields. If markets price bonds irrationally, the EFSF can make money for taxpayers by buying them. Sadly, not everyone has Mr Trichet’s capacity for such radical thinking.
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Copyright The Financial Times Limited 2011.
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