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.