Edward Harrison and Demetri Kofinas on the Future of the Eurozone
Yesterday I was on RT’s show Capital Account with Demetri Kofinas (@CoveringDelta) talking about the future of the euro zone. Lauren Lyster asked us where this was headed and we both agreed that it really was all about Italy. I just posted on why questioning Italy’s solvency leads inevitably to monetisation. So my answer was that it’s heading toward the ECB buying bonds and acting as a lender of last resort.
By the way, back in July after I wrote why the ECB is the difference, the ECB did in fact step in and start buying bonds. But, disappointed with the progress on reform in Italy, the ECB stopped buying. And yields immediately shot up. Italian yields are now higher than in July. I wrote how I would provide the backstop in that July post and I still think this would be the most effective way to proceed:
The ECB could do rate easing. Frankly, I am uncomfortable with any kind of easing but I certainly see some legitimacy in the ECB acting as a lender of last resort here. The ECB would ‘guarantee’ a rate for Italian bonds that is high enough to be a Bagehot penalty spread to Bunds but low enough that it effectively acts as a lower bound for a positive nominal GDP target. This would be liquidity at a penalty rate, say 200 bps to German Bunds, which would be 4.7% right now [that was in July, now it would be 3.8%].
In practice the ECB would want to step in at unpredictable times and buy up sovereign issues below the guarantee rate to ‘punish’ speculators and police the guarantee this way.
And just as I told you “the Fed would not necessarily have to buy any Treasuries to defend” its target, the same is true here too; after an initial foray in the market and a round of punishing speculators, every speculator would blanch at going up against the ECB’s wall of liquidity for fear of insolvency. The private sector “would do it” for the ECB via the language and confidence in the "guarantee". Even Fannie Mae and Freddie Mac bond yields were still only 1.22% over Treasuries, a ridiculously low spread at the worst moment in the US debt ceiling crisis despite the GSE’s obvious insolvency. That’s the power of a lender of last resort.
Again, there is certainly moral hazard here. But that can only be solved via tighter fiscal union or dissolution.
I thought there was a cliche in economics stating never throw good money after bad money. Seems the EU is still doing that with Greece.
the problem here is not “speculators.” The problem was best illustrated by Italian-American Yogi Berra, who once asked, “If people don’t want to come to the ballpark how are you going to stop ’em?” People don’t want to put their life savings at the disposal of Silvio Berlusconi, and the structure of the Eurozone makes it impossible to stop them.
Given the choice (and they have the choice) they will put them into German banks or German Bunds with zero exchange rate risk.
The ECB will have to simply backstop the Italian Treasury and buy any bonds that go unsold, just as the US Fed does. Or alternatively the Italian government can force its citizens to purchase Italian savings bonds as part of their taxation obligations. That’s it.
The ECB cannot be the lender of last resort it would be illegal.
The German courts have ruled that EMU is ok as long as the ECB follows a like for like swap of the former Bundesbank rules.
To change that would require the Germans to change their constitution.
The ECB is under German jurisdiction and if Mario wants to keep his freedom he better stick to the rules, and he knows it.
I believe these are the issues where some knowledge of historical context comes in. A little personal anecdote of mine… Recently I spoke with a guy who works as an analyst for Raiffeisen bank Austria. He was complaining (in fact he was quite abusive) about Hungarians who have introduced measures allowing their citizens to get rid of Swiss-franc denominated mortgages thus inflicting losses on financial institutions that have made these mortgage loans. He was literally asking “how on earth is this even possible ?” “this is so unfair, who gave them right to do this ?” I told him that if he just looked at the recent Hungarian history when in the 80ties in the final phases of the Communist bloc Hungarians had a tendency to run up debts to purchase merchandise from Western Europe (which was otherwise unavailable in the Communist bloc). And further I told him if he looked even further back into the Hungarian history he would be able to draw some generalizations and conclusions about their tendencies which I would interprete as volatile, wild, prone to jump to quick extreme solutions when in difficulties.
Furthermore I remember the time I was at the student exchange in Madrid – Spain at the beginning of 2000s. I recollect thinking to myself “how in the world can these people afford to spend as much as they do with their income ?” “Wherever I look I see luxury shops, BMW’s, people eat regularly in restaurants, prices of real estate are just crazy…”
I believe this is the sort of “soft knowledge” as opposed to the mechanical economical thinking where the genius mathematicians from LTCM got it wrong with the Russian default which started the chain reaction leading to their spectacular demise…
If you think about this one fact, you will realise that monetisation is sustainable over the medium-term” If a central bank guarantees investors CREDIBLY that you can invest in certain debt instruments and NOT suffer principal or interest repayment risk, but only currency and inflation risk, some are going DEFINITELY going to buy the debt instrument with the greatest yield pick up. The ONLY reason not to buy Italian debt at 2 or 300 basis points over bunds is because they are not credibly backstopped by the ECB. Think about it and you will see that this is true.
You will also get those who are desperate for yields to invest there especially if there is no currency risk. The problem is that the politics will not allow the ECB to act as lender of last resort so the issue then becomes can they exit a market quick enough should it look like a break up is likely. My feelings are that until there is a decision for permanent and substantial fiscal transfers then ultimately the euro looks doomed. Letting Greece fall will mean that the speculators know that there is big money in betting on the failure of Spain or Italy. The real prize will be Germany. CDS spreads there are low, but have been moving upwards. If you can lock in at a low rate on German CDS now, then that could be the biggest prize but will you have any banks left to pay out?
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