Travel day for me -- here's Tim Duy:
Second Policy Failure of the Week, by Tim Duy: This week's policy and communication failures of ECB President Mario Draghi border on epic. It would almost be funny if it wasn't so sad, not just for the ECB, but for the ever-increasing number of unemployed in the Eurozone. Teetering on the abyss with record high unemployment putting the lie to his claims about the strength of the Eurozone, Draghi chooses to play mind games with financial markets. This marks a new low in European crisis management.
Who am I kidding? This doesn't just border on epic. It is epic. And one wonders why I have so little confidence.
As is now widely known, last week, in the midst of surging bond yields in the periphery, Draghi delivered some what now appear to be off-the-cuff remarks signaling the ECB was prepared to do whatever it takes to save the Euro. This was interpretted by market participants as capitulation on the part of the ECB, as it is generally believed that saving the Eurozone, at least with any semblance of economic dignity, requires the ECB to acknowledge its role as lender of last resort for sovereign debt. This follows naturally from the realization that only the ECB has the firepower to snuff out the debt crisis that engulfs one European nation after another.
Draghi, however, did not intend to send such a signal, showing a phenomenal lack of cognizance about the fragile state of financial market confidence in Europe. From the Wall Street Journal live blog:
At the conclusion of their meeting today, the ECB failed to meet the unintentionally ramped-up expectations of financial market participants. Indeed, the ECB did exactly nothing. No new policies, just vague promises about policies that may or may not be implemented in the future. On such policies:
The Governing Council extensively discussed the policy options to address the severe malfunctioning in the price formation process in the bond markets of euro area countries. Exceptionally high risk premia are observed in government bond prices in several countries and financial fragmentation hinders the effective working of monetary policy. Risk premia that are related to fears of the reversibility of the euro are unacceptable, and they need to be addressed in a fundamental manner. The euro is irreversible.
This, I think, is critical to understanding the level of support the ECB is willing to provide. They are not prepared to eliminate default risk by serving as a lender of last resort; they are only willing to eliminate the risk premia associated with a nation's exit from the Euro. I increasingly think that you can't separate the two, that only by serving as a lender of last resort can you eliminate the exit premia. But the ECB doesn't see it that way, and as such I suspect is willing to do much less than needed to resolve their end of the crisis. the more optimisitc interpretation is that Draghi is really just repackaging all the risk premia, default or otherwise, as reversibility risk to limit resistance from the Bundesbank. See Joseoh Cotterill at FT Alphaville.
Then comes the expected push for more sustained fiscal austerity:
In order to create the fundamental conditions for such risk premia to disappear, policy-makers in the euro area need to push ahead with fiscal consolidation, structural reform and European institution-building with great determination. As implementation takes time and financial markets often only adjust once success becomes clearly visible, governments must stand ready to activate the EFSF/ESM in the bond market when exceptional financial market circumstances and risks to financial stability exist – with strict and effective conditionality in line with the established guidelines.
When all you have is a hammer, everything is a nail. The ECB will not do anything until European rescue funds are activated under traditional guidelines. On the role of subsequent role of the ECB:
The adherence of governments to their commitments and the fulfilment by the EFSF/ESM of their role are necessary conditions. The Governing Council, within its mandate to maintain price stability over the medium term and in observance of its independence in determining monetary policy, may undertake outright open market operations of a size adequate to reach its objective. In this context, the concerns of private investors about seniority will be addressed. Furthermore, the Governing Council may consider undertaking further non-standard monetary policy measures according to what is required to repair monetary policy transmission. Over the coming weeks, we will design the appropriate modalities for such policy measures.
Translation, I think: After the rescue fund is activated, and if the risk premia related to reversibility of the Euro remains high, then and only then will the ECB, reluctantly, buy bonds of affected nations. It is interesting that they acknowledge the seniority issue. Here I assume that the ECB intends to signal that they would share in any subsequent debt restructurings. It seems, however, that this might limit their willingness to buy said bonds, implying a less-than-aggressive response.
Relatedly, the IMF lends support, via the FT:
Spain is already doing what the International Monetary Fund would demand in return for a bailout, said Christine Lagarde, IMF managing director, in an endorsement of the country’s economic policy.
Her comments both argue that Spain should not need an IMF rescue but also suggest that it might obtain one without much change to its domestic economic policies.
There is speculation that Spain admitted to Germany last week that Spain would need a formal bailout, which would entail a traditional restructuring program. The IMF is saying that Spain already has such a program in place, and thus could ask for a bailout without fear of embarrassment.
Of course, one might add that if Spain is doing everything they can, why is the economy still sinking? Because they are pretending the the traditional IMF medicine of currency devaluation can be substituted one-for-one with internal deflation. Good luck with that.
Also, if I am reading this correctly, if the ECB will only buy Spanish debt after Spain has asked for and received a EFSF/ESM program, then I think they intend to let the financial crisis engulf Italy until that nation also asks for an EFSF/ESM program. Is this correct? Because if it is, it doesn't sound like much of a firewall. And if they encourage the idea they will only help after the crisis intensifies to the point in which a bailout is necessary, won't such a policy increase the already troublesome financial fragmentation in the Eurozone?
I will let others assess the economic outlook. I will leave the first shot for Joe Gagnon:
Yes, insane indeed.
As for the market fallout, the Euro and European equities were generally stronger as the morning progressed, but then plunged as Draghi started talking and the lack of ECB action became evident. Spanish and Italian equities were particularly hard hit, down more than 5% and 4%, respectively. Bonds were something of a mixed bag. Long bonds were pummeled, especially in Spain:
But 2-year Spanish bond extended gains, although at 4.8% are still well above the the 2.5% range seen earlier this year. I think the message here is that market participants believe Spain can be limped along in the short-run, but there is much less confidence in the long-run. No surprise, given the devastating impacts of fiscal austerity coupled with a ongoing collapse of the financial system.
Bottom Line: An epic policy failure by the ECB. Not only is the ECB willing to let the Eurocrisis simmer for another month, but their communication strategy is abysmal. Draghi very desperately needs to be more aware of the impact of his comments. As for the ECB statement, I think it says that the ECB is a second line of defense, and they will act reluctantly only after the EFSF/ESM fund is activated. This seems to imply to imply a formal bailout request as a precondition to ECB action. We really need to see more clarification in the weeks ahead about what the ECB sees as the ordering of policy actions in the Eurozone. The order implied in this statement seems to me like a commitment to continued economic stagnation.