Draghi’s comments about the ECB doing “whatever it takes” are irrelevant

By Edward Harrison On Aug 3, 2012

Everyone seems to be talking about Mario Draghi these days. They think his comments about the ECB doing "whatever it takes" are important. They’re not. They are meaningless. Here’s why.

The flaw in the euro zone’s construction is that no entity can prevent solvency crises for national governments. The way the eurozone is set up means that it is very easy for a liquidity crisis to become a solvency crisis. The ECB’s willingness to buy peripheral sovereign debt on the secondary market doesn’t change that. It is a form of extend and pretend.

See, credit risk is the defining element of all bond analysis. Bond investors are risk averse coupon clippers. They are loaning money to someone in expectation that they will get their money back in full. The interest rate compensates the investor for the risk that this won’t happen. So, what you want to know as an investor in debt markets is that you will be repaid in full plus interest.

In Japan, in Australia, in the United States, in the UK, if you go to the government with any government paper IOU to claim your money, the government can always hand you another paper IOU of the exact same amount. They create the currency. There is no risk of involuntary default. That’s not the case in Euroland. Italy can default on euro obligations. Spain can default. And Germany can default too.

The ECB’s willingness to work in concert with a bailout fund of limited financial resources like the EFSF or the ESM to buy peripheral debt changes none of that. Unless the ECB is willing to buy unlimited amounts of debt at specific yields or spreads, solvency will always be an issue. And that’s how many in Euroland want it.

There is only one issue here: how many reforms the periphery will undertake. There will be no support unless we see reforms. If the periphery capitulates and slashes government jobs, raises pension ages, and makes it easy to fire people, Germany and the ECB will give them anything they want. Until they go whole hog, they won’t get full support.

This is blackmail, of course. But Monti, Samaras, and Rajoy are neoliberal reformers. So they want this too, just not the domestic political loss that goes along with it. Germany is obliging them by playing the fall guy for their domestic cutting agendas.

But, in my view, Europe is screwed. Eventually the neoliberals will have to cave and try to reflate in order to save their own hides when the debt deflation moves to the core or the Great Depression begins. They think they can extract the reforms they want before depression becomes firmly entrenched. I think they’re wrong.

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