Here are my first quick reactions to the ECB’s new monetisation scheme. They have decided to buy bonds on the secondary market in potentially unlimited quantities up to three-year maturities for countries that submit to a Troika program. The bonds they buy will be pari passu with bonds held by private investors. And the purchases will supposedly be sterilised.
Everything that has happened was pretty much telegraphed right from the start. As I told members in late July:
Mario Draghi has a specific plan in mind for how the ECB will be able to arrest the sovereign debt crisis. Two Bloomberg central bank sources told the news agency that ECB President Draghi will have talks with Bundesbank President Jens Weidmann in coming days as the Bundesbank is the “biggest stumbling block” to Draghi’s bond purchase plan. Under that plan, the European rescue funds EFSF and ESM would be permitted to buy European sovereign debt of issuers like Spain and Italy at auction. The ECB would then also be permitted to purchase those bonds on the secondary market, effectively monetising sovereign debt. ECB rate cuts and more LTRO loans to banks are also potential actions the ECB would take according to one of the Bloomberg sources.
Wedmann did not get onboard. Weidmann was the lone dissenter – and so Draghi rode roughshod over him. That is significant because it tells you that the Bundesbank has now lost power at the ECB. In retrospect, you can say that the Stark and Weber resignations made the BuBa weaker, just as a Weidmann one will do.
Further, as I wrote last month, this is the end of European bailouts and the beginning of monetisation:
In the German press, there have been a number of stories recently that indicate that the German government will not commit any more money to bailouts in the euro zone. Specifically, the reports of greatest interest have to do with Germany’s neither funding a new Greece or topping up the EFSF/ESM bailout facilities. I think these reports are credible and I am writing this note as to what I believe they mean for European economic and monetary policy.
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The basic dilemma here is that almost all of the eurozone governments including Germany carry high debt burdens in excess of the Maastricht Treaty. For example, Germany has been in breach of Maastricht Treaty in 8 of 10 years since 2002, has been over the Maastricht 60% hurdle in each of those ten years, and now carries a debt to GDP burden above 80%. The ratings agencies are onto this and Moody’s has recently downgraded all of the remaining AAA credits in the euro zone except Finland (whose fiscal health is buoyed artificially by a property bubble, I might add). If you look at the contributions to the ESM then, you can see that it cannot be a AAA-rated facility.
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The bottom line here is that the ESM is both underfunded and backed by weak fiscal agents. It cannot possibly withstand a crisis in Italy or Spain.
The obvious conclusion, one I made in January, is that the ECB would decide to monetize. And they have done.
In the end, however, this is really about the German, Dutch and French banks. If you think of OMT as a bank bailout instead of a sovereign one, the ECB’s new OMT scheme is really very much equivalent to the Fed’s QE1 scheme of buying mortgage bonds. I told members two weeks ago:
The problem here is that this is just a Super SMP. It has the ECB buying in unlimited quantities for countries that are making fiscal and structural adjustments instead of the ECB making ad-hoc commitments to purchases that are not credible backstops. Now I realize that this is what Joerg Asmussen meant when this exchange occurred:
There are to be bond purchases once more. What makes you think the new programme will be more successful than the first two programmes, which only reduced rates in the short term?
Because it will be better conceived than the old bond-buying programme, the SMP.
But the Super SMP is a moral hazard for banks instead of the reputed moral hazard for sovereigns that a rate target would be. Instead of potentially giving sovereigns an open ended rate target commitment, you are giving banks an open-ended quantity commitment. And they will use it. The Super SMP will work just like QE1 did in the US except instead of the Fed buying toxic MBS indiscriminately and at inflated prices, it’s the ECB buying distressed sovereign debt indiscriminately and at inflated prices. The whole premise of the ECB’s buying again is to have some sort of Bagehot rule that it applies in providing liquidity as a bank lender of last resort. But yet again we see there’s nothing like that going on. Instead, the ECB plans to give one and all comers liquidity and allow them to dump their distressed debt onto the ECB at inflated prices. The result will be an instant improvement in bank balance sheets, all without private money recapitalization. Sounds like a bailout to me.
That’s very euro bank bullish. Not for Spanish and Italian banks, mind you, because their domestic economies are in a world of hurt. But German, French and Dutch banks just got a Draghi put on their sovereign bond assets – and that’s bullish.
That’s it for now. More for subscribers later