ECB bazooka may be short on credibility ammo

December 6, 2011

By Neil Unmack
The author is a Reuters Breakingviews columnist. The opinions expressed are his own.

The European Central Bank may be readying its bazooka. Euro zone bond markets are rallying amid hopes that an agreement by European governments on fiscal reform may clear the way for the central bank to start massive bond purchases. But bazookas can backfire.

Ideally, an intervention would create a virtuous circle whereby investors were once again willing to hold peripheral debt. That might allow the ECB to calm markets without actually buying that much.

The Swiss central bank’s move to halt the Swiss franc’s runaway rise in September provides some guidance for a successful intervention. The first ingredient is clarity: the central bank set a rate beyond which it would not allow the currency to rise. The ECB could do the same by making it clear that it will not tolerate bond yields above a certain level.

That level should be low enough to help troubled countries, but reflect the fact that their finances are still shaky. Targeting a spread of, say, three percent above German Bunds would mean fixing the yield on Italy’s 10-year bonds at 5.2 percent – still almost 1 percentage point lower than today.

The second ingredient is credibility. The Swiss central bank’s interventions were credible because they enjoyed political and taxpayer support. The ECB does not have the same cover. Germany’s Bundesbank has openly opposed bond purchases because they take the pressure off governments to adjust their deficits, while many Germans fear that printing money will lead to inflation.

The danger is that the intervention would create a vicious circle. Investors may not believe that the ECB is truly willing or able to buy unlimited quantities of debt – and view purchases as an opportunity to sell. The more bonds the ECB buys, the greater the concern that the central bank might rank ahead of private sector creditors – as it appears to in Greece’s proposed restructuring.

The ECB could limit the scale of its purchases by only buying shorter-dated bonds. Though that might disappoint some investors, it would still do some good because longer-dated bonds would increase in value as they drew closer to maturity.

Whatever form the ECB’s intervention takes, its success will depend on the depth of political commitment to greater integration in the euro zone. The weaker the political cover the ECB receives, the more investors will test it.

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Bondholders need to substantially scale back their expectations of a “miracle cure” for the eurozone crisis.

The reality is that:

(1) no eurozone nation or organization has the ability to “buy unlimited quantities of debt”, and

(2) the eurozone cannot become the United States of Europe for a multitude of political and economic reasons.

The sooner bondholders face these two realities, the sooner the crisis can be dealt with in a more constructive manner.

Right now, simply demanding an unlimited supply of (printed) money will not solve anything, and probably worsen the situation by creating more unsustainable debt levels, and may actually bring on the global financial crisis everyone fears.

Forcing nations to reduce their standard of living will only create political tensions on top of the already existing economic problems.

This is a massive financial crisis that was allowed to build up over time when things were going well, but now they aren’t, and it is unrealistic to expect a quick and easy solution.

The reality is this will take years to resolve, if it can be resolved at all.

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