Christine Lagarde’s “Whatever it Takes… But” Might be a Wet Bullet Against Speculation

Note: this is a rough translation of a piece published on the Italian neswpaper Domani, with a few edits and additions.

On July 21st, the ECB definitively closed the emergency phase that began with Mario Draghi’s whatever it takes in 2012. The Frankfurt institution announced two important decisions. First, it raised interest rates for the first time in eight years, ending the anomaly of negative rates. The increase was more significant than the ECB had previously announced (half a point instead of a quarter). While it is true that a normalisation process had to begin, this acceleration is somewhat puzzling. Christine Lagarde and her colleagues have rushed to explain it by the need to signal to the markets that they are determined to return to 2% inflation in the medium term. However, since the ECB itself recognises that inflation is mainly imported and linked to energy and food prices, the tightening mainly sends a signal that the ECB is prepared to push the eurozone economy into recession in order not to appear weak in its fight against inflation.

Markets are not efficient

The second measure, the real novelty, is the anti-spread shield, on which the ECB has been working for the past few months. The TPI (Transmission Protection Instrument) should keep spreads under control and thus allow the ECB to fight inflation without generating instability on markets: if in the future speculation or markets’ panic movements were to lead to changes in sovereign interest rates that are not linked to the actual public finances’ state of health, the ECB will intervene and with its purchases will ensure that spreads are realigned with the so-called ‘fundamentals’. The anti-spread shield (anti-segmentation, in ECB terminology) should shelter eurozone countries from the speculation that, for example, we observed in the spring of 2012 and which led to Mario Draghi’s famous whatever it takes.
The introduction of the TPI is certainly a positive sign. With it, the ECB officially recognises what all non-ideologised economists have known for a long time: markets are often (too often!) unable to correctly assess the health of public finances. Between 1999 and 2010, for example, in the EMU the risk associated with the behaviour of some governments was not adequately taken into account and markets financed these countries at excessively low interest rates. Then, between 2010 and 2015, they went all the way to the opposite excess, demanding excessive yields that were in no way justified. In short, the introduction of TPI merely certifies the fact that markets cannot be relied upon to discipline eurozone countries’ fiscal policies.

The anti-spread shield is a wet cartridge

However, for the way the instrument is designed, the risk that it ends up being a wet cartridge is quite significant. The shield should mainly function as a mechanism to signal to markets that the central bank is ready to do whatever it takes to prevent speculation from pushing a State whose public finances are fundamentally sustainable into default. Just think of 2012, when Mario Draghi’s whatever it takes speech was enough to immediately calm speculation; those who had been trying to gain by pushing Italy and Spain into default understood that they would not succeed because the ECB was ready to intervene with unlimited purchases, allowing the two countries to continue to finance themselves; a sort of insurance, in short, whose announcement alone rendered speculation vain and quickly brought Spain’s and Italy’s spreads back to acceptable levels.

With the TPI the ECB would like to put in place a similar insurance mechanism, that nevertheless risks not being as effective. Let us see why. The ECB has announced that it will only intervene if the country’s debt is fundamentally sustainable, according to the criteria developed by the IMF and the World Bank in recent years. It could be argued that in certain situations it would also be desirable to intervene to rescue insolvent countries, to secure the system and allow for bankruptcy or debt restructuring under stable conditions. But putting this consideration aside, it is not illogical that the ECB does not want to serve as a backstop for fiscally irresponsible behaviour. However, for reasons probably related to the power struggle between hawks and doves in the bank’s Governing Council, the list of conditionalities is much broader. For instance, the country must comply with European fiscal rules and not be in excessive deficit procedure; or, again, be in compliance with the conditionalities related to the Next Generation EU National Recovery and Resilience Plans (NRRP). It is not clear what is the rationale for these conditions. Why, for example, should a country’s delay in passing a reform scheduled in its NRRP make its debt less sustainable and thus preclude it from accessing the TPI? Or, again, why should excessive private debt deprive the country of the shield, when it is precisely in the case of financial fragility of the country that a speculative attack on its sovereign bonds would be more likely? In short, these conditions seem to invoke the generic notion of a country’s trustworthiness which, in accordance with what Paul Krugman would call zombie ideas, is linked only to fiscal discipline and not to the general conformity of public policies with the objective of balanced and sustainable growth.
The TPI is thus a conditional shield, a sort of ‘whatever it takes… but‘ that might not work to stop speculation, since markets could always decide to test the ECB’s resolve not to intervene to protect a country. A lender of last resort (because this is what we are talking about) is only such if market participants never doubt its intervention. If it only does so under certain (tortuous) conditions, it risks being ineffective as a deterrent to speculation. But there is more: what would happen if a country not fulfilling the conditions were under attack and financial stability were at risk? Of course, the ECB would intervene, thus undermining its own credibility.

A European Debt Agency to control spreads

The TPI wet cartridge is further proof that one cannot continue to rely on the ECB to ensure at the same time the traditional tasks of monetary policy and the financial stability of a sovereign debt market that is segmented by its very nature (remember that as long as there is no real federal budget, fiscal policies will remain the almost exclusive competence of the member states). I have several times discussed the creation of a European Debt Agency that could protect member states from the mood of the markets while keeping them responsible for their fiscal policy choices. A debt agency (or a similar institution) would achieve the goals the ECB set itself with the TPI more efficiently, freeing the central bank itself from having to deal with spreads on top of everything else.

A Lender of Last Resort for the EMU

Update: The Court ruled the OMT “Legal in Principle“. The final ruling will be later this year, but it is safe to assume that it will confirm the preliminary one.

Today is an important day for the ECB, as the European Court of Justice will issue an interim ruling on the Outright Monetary Transactions program launched in the fall of 2012. The Court needs to rule, upon demand by the German Constitutional Court, whether the program overstepped the boundaries set by the Treaties to ECB action. The ruling of course may have an impact on furture action by the ECB, notably the decision to launch a round of QE.

I think it is important to clarify once more that QE and the OMT (welcome to the wonderful world of EU acronyms) are not the same thing. If Mario Draghi manages to rally the Governing Council behind him, QE will consist of a vast program of sovereign bond purchases, in order to try to lift the European economy out of deflation. A European version in short, of what was done three years ago by the Fed and other major central banks in the world.

The OMT responded to a very different need, notably the need to defuse speculation on sovereign debt markets and to protect peripheral countries (at the time Spain and Italy) from the risk of default. The summer of 2012 was very difficult, as economic and political problems in Greece caused investors to flee from peripheral countries and spreads on sovereign bonds to increase at unprecedented levels. After the “whatever it takes”  speech in July (But there is another message I want to tell you. Within our mandate, the ECB is ready to do whatever it takes to preserve the euro. And believe me, it will be enough), the ECB in September engaged almost unanimously to step in the market for sovereign bonds and, if necessary, to stretch its mandate by acting as a lender/buyer of last resort for countries in trouble.
With the OMT program, the ECB commits to buy unlimited amounts of sovereign bonds of countries in trouble that request assistance, thus de facto transforming itself into a lender of last resort. In exchange for ECB protection countries need to engage in a program of fiscal austerity and structural reforms. In other words with the OMT program the ECB offered insurance in exchange for reforms and austerity. A deal that would entail the loss of a good deal of sovereignty. It is not by chance that Spain always refused to apply for the program, in spite of heavy pressure, and that as of today no country ever used it. At the time the OMT program was wrongly interpreted as a clumsy attempt to implement quantitative easing in the Eurozone. It was instead clear, since the beginning that, as with any insurance scheme, its success would be measured precisely by the fact that the ECB would not have to intervene on bond markets.

So we need to be clear here. The European Court of Justice today and in the next months will not be deciding on QE and macroeconomic management. It will be deciding whether the EMU has the right to rely on an insurance mechanism that all countries have . It will be deciding whether EMU governments borrow in their own currency, or in a foreign one. A major decision indeed.

Would Eurobonds be Enough?

George Soros writes a piece on Project Syndicate, that is both pedagogical and very clear in outlining a possible answer to the current EMU crisis. He starts with a diagnosis of the EMU imbalances that rejects the “Berlin View”, and argues for the existence of structural imbalances

Normally, developed countries never default, because they can always print money. But, by ceding that authority to an independent central bank, the eurozone’s members put themselves in the position of a developing country that has borrowed in foreign currency. Neither the authorities nor the markets recognized this prior to the crisis, attesting to the fallibility of both.

The Ancient Roots of EU Problems

Il Sole 24 Ore just published an editorial I wrote with Jean-Luc Gaffard, on the structural problems facing the EU. Here is an English (slightly longer and different) version of the piece:

It is hard not to rejoice at the ECB announcement that it would buy, if necessary, an unlimited amount of government bonds. The Outright Monetary Transactions (OMT) program is meant to protect from speculation countries that would otherwise have no choice but to abandon the euro zone, causing the implosion of the single currency. As had to be expected, the mere announcement that the ECB was willing to act (at least partially) as a lender of last resort calmed speculation and spreads came down to more reasonable levels.

Quantitative Easing and Lender of Last Resort: Lots of Confusion under the Sky

I have read an interesting article by Wolfgang Münchau, on the Financial Times.  To summarize, Münchau argues that because of politician’s complacency, there is a chance that the new OMTs program launched by the ECB will never be used, and hence prove ineffective in boosting the economy. He therefore argues that the ECB should have done like the Fed, and announce an unconditional bond purchase program (private and public alike).

The piece is interesting because Münchau is at the same time  right, and off the target. It is worth trying to clarify.

A Question is Bothering Me…

A few weeks ago, speaking before  the European Parliament, Mario Draghi stressed once again the ECB committal to provide the financial sector with all the liquidity it needs.

Much Ado About Nothing

There was a lot of noise, yesterday, about the main central banks’  decision to coordinate in maximizing liquidity provision (in dollars) to households and firms. An excellent and clear explanation of what they exactly did can be found here.

Are we effectively at a turning point? I am afraid not, for essentially two reasons:

• The first is that, after an initial moment of euphoria, markets may realize what really happened, i.e. that central banks are preparing for a major Lehman-like event: If the euro breaks down, and if investors flee from it, central banks are ready to act to avoid contagion. This is reassuring, but it also informs us that the main monetary authorities of the planet are seriously considering the possibility of such an event occurring.
• Second, this move, per se,  does nothing to address the main source of the problem: the lack of  proper Eurozone governance, and the unwillingness of the ECB to act as a lender/buyer of last resort. Major changes on these issues would be a turning point, reducing the risk of a euro crisis, and hence making liquidity in dollars unnecessary.

A safe bet: Financial market euphoria will be short-lived.

(Bad) Arguments Against Debt Monetization

I think it is useful to list, and assess, the main arguments advanced against an enhanced role of the ECB as a lender/buyer of last resort. I can think of four of them: credibility, inflation, irrelevance, ineffectiveness.

It’s the Eurozone, Stupid!

There are two interesting developments in the eurozone crisis.

• The first is that there seems to be no discrimination coming from financial markets anymore. The French (and Dutch, and Belgian, and counting…) spreads are dangerously increasing, not for objective reasons, but rather because France (and then Belgium, and the Netherlands, and counting…) is perceived as the next country in line after Italy. It is clear that the process will not stop, and that today the only investment that is considered safe is German bunds.
• The second development is that besides the German government, the  Bundesbank president, and of course the ECB, there is increasing consensus that only a radical shift in monetary policy can stop contagion, building a firewall around eurozone sovereign debt. It is impossible to have well functioning bonds markets with 17 governments de facto borrowing in foreign currencies, and without a lender of last resort.

The two developments are of course related. It becomes increasingly clear that national government, independently of their past wrongdoings or virtuous behavior, are less and less responsible for speculative attacks, that seem to be fueled by the perceived flaws in the EMU governance design: countries with very limited fiscal space and even more limited fiscal pooling, borrowing in a foreign currency without a Lender of last resort umbrella, and experiencing increasing external imbalances.

As somebody would have said some time ago, “it’s the eurozone, stupid!“

The EMU Problem is North vs. South. But not the Way Mrs Merkel Thinks

For observers of EMU woes, it came as no surprise that Wednesday’s summit in Brussels ended in a low-key compromise that leaves the eurozone fragility untouched.

In part this is due to the decision making process in the EU, intrinsically incapable of reaching quick and bold decisions. But there are more substantial reasons that lie in the interpretation of the crisis, the “blame game”; a blame game that has no particular interest, were it not that understanding what went wrong should constitute a guide for designing a durable and effective solution.