Chart of the Day: This is how many periphery bonds the ECB has already bought
This chart from Spiegel shows you that the ECB has been buying a lot of periphery bonds (hat tip Global macro Monitor). But, no matter how much they have bought, their purchases are dwarfed by the absolute magnitude of bonds coming due next year in Italy, over 300 billion euros worth.
Clearly making a credible commitment to unlimited purchases, so called ‘rate-easing’, is going to be a lot less expensive than this – except politically, where it enjoys no support in Germany.
Remember that when discussing QE3 in June I wrote:
My understanding about what [Bill] Gross believes is that the Fed could see QE3 "guaranteeing" a 2 year or 3 year yield at a certain level—say 50 basis points. Moreover, the Fed would not necessarily have to buy any Treasuries to defend this target. Gross understands that the private sector “would do it” for the Fed via the language and confidence in the "guarantee".
When QE3 was a go with the Fed explicitly committing to zero rates for two years, what I call permanent zero, the Fed didn’t have to buy any bonds. The private sector did it for them. Given the size of the Italian market, that’s where the ECB is headed, German political concerns or not. This chart tells you why.
Source: Der Spiegel
Perhaps it will be more expensive in the short term, but the moral hazard introduced by enabling Italy to continue their profligate spending without any spending reforms simply makes the problem bigger over the long term. The only language politicians hear is that of the bond market. It is not a coincidence that after the recent bond market route, the Italian sent moved to rush through a deficit reduction package. Sometimes, it takes a crises to force a change. Let some bankers, shareholders, and bond holders suffer some losses, while politicians need to renege on their bullshit, mathematically untenable promises they made the people. Then perhaps the global economy can return to healthy growth, provided central banks do not induce one more gigantic credit bubble. One that will lead to a tidal wave of currency crashes and hyper inflation.
I agree it is a moral hazard. That said, the Maastricht criteria simply don’t make sense for a union as heterogeneous as the euro zone. Moreover, the central bank should be a lender of last resort. It doesn’t make sense to have a currency without one and this crisis is proof positive that this is true. The euro area is too large and needs to be reduced to only include countries that have converged and are economically compatible.
What I think will happen is that the ECB will be forced to support the government bond markets as all other remedies have failed but because this will be unpalatable, the Europeans will move to closer fiscal union with an escape clause for letting people out of the euro area once this crisis is over. That is the least cost political and economic solution and I believe that is where we are headed since the alternative is a deep Depression.
hey edward i love reading your insight. the ecb backstop proposal you suggest makes perfect sense — almost a silver bullet of sorts.. aside from inducing greater moral hazard, what are the negative consequences of this kind of backstop? it can’t really be that easy can it?
The consequences are that it gives the fiscal agents space to run deficits. Depending on your political/philosophical view, this is negative or positive. The ECB believes this is negative because they associate large deficits with fiscal profligacy, weak currencies and inflation as we saw in Greece and Italy before the euro. However, during a downturn, the budget worsens automatically because of the loss of tax revenue and the increase in spending on automatic stabilisers. Cutting expenditure at this juncture has been shown to deepen the downturn.
So, again this is really a political question. If your primary concern is price stability and deficit reduction, an ECB backstop is bad. If your primary concern is full employment, an ECB backstop is good.
you mentioned previously that the ecb would not even have to buy large quantities of bonds to make italian yields fall, they would merely have to make their intentions known to the market. if this were the case, why would their need to be significant inflation inside the euro area as a result of the policy? also, given the constitutional restrictions imposed against the ecb, would there not have to be fundamental legal changes and amendments before the backstop could even be possible?
Inflation could happen via currency depreciation but it is unclear whether the currency would fall. I am not concerned about inflation in any event, I think we are in the disinflationary phase of the cycle right now, meaning inflation will fall with growth.
As for the constitution, see here: https://pro.creditwritedowns.com/2011/11/the-relevant-articles-of-the-lisbon-treaty-for-the-sovereign-debt-crisis.html
And note that the ECB has already bout nearly $200 billion of periphery sovereign bonds.
https://pro.creditwritedowns.com/2011/11/ecb-bond-purchases-rate-easing-italy.html
The challenge is political, not legal
ok. is there a scenario where the ecb comes in and says we are going to effectively lower italian bond yields to 5% and the market instead moves to call their bluff? what i mean is, if they backstop italian bonds then the entire european debt crisis is over, right? because if they do it for italy they would do it for france, and spain, etc. but when you start talking about backstopping the entire euro area you are talking about trillions and trillions in implied commitments, and maybe this is the hyper debasement theory germany fears? really do appreciate all your insight here, you’re a true wealth of information.
Funny you would ask that because I was talking about it on a different thread. I said that the ECB would probably have to be very aggressive initially. They lack credibility as a lender of last resort, so I think they would be tested at least initially. To beat this back, they could, for example, set a wide range of 50-75 bps the way central banks target policy rates and let the market drift up to the upper end of the range only to bid it down to the lower end again and again. After a few rounds of this, speculators would get the point. I wish I could say I advocate this but it’s more that there is no choice at this point.
The truth is a fiat currency is one that is created and controlled by government and they can dictate terms as they see fit. I think it is preposterous not to have a national lender of last resort but having government dictate price levels is equally preposterous. That’s where we are. The hyperinflation and currency debasement fears are misguided especially if there is no money printing. But even if you saw unsterilised bond purchases, you would need a credit mechanism to transmit it into the economy. In the US we have seen that excess reserves piled up so that transmission mechanism just doesn’t exist because loans create deposits and then reserves, not the other way around.
See here:
https://pro.creditwritedowns.com/2011/04/chart-of-the-day-excess-reserves-2.html
do you think we saw the initial step of the ecb backstop play out in italy last night? there was chatter the ecb played its most aggressive hand yet and yields dropped markedly. definitely a different vibe emerged, i wonder if that will prove to be the ecb sponsored inflection point.
question for you edward.. you hear merkel and bundesbank officials talk about the perils of money printing while at the same time everyone else seems to talk about a need for more printing. as you demonstrated earlier isn’t the ecb already buying bonds and quickly expanding its balance sheet? is the discussion no longer not about whether to print but merely a disagreement on the current scale?