Waiting for deus ex ECB
James Saft is a Reuters columnist. The opinions expressed are his own.
It looks as if we will need to see some kind of miracle intervention from the European Central Bank — a Deus ex ECB — or the euro zone is heading for a nasty divorce.
Either the ECB comes across with a mandate-busting rescue, probably involving direct lending to Italy and rolling the currency printing presses, or the forces aligned against currency union will roll over Italy and into France.
Italian political chaos and a move by some clearing houses to demand more margin on Italian debt helped to drive 10-year yields of the troubled sovereign borrower to a euro-era record of 7.5 percent on Wednesday. The market appears to doubt that the EFSF rescue fund will be big enough and operative enough to back Italy effectively.
The sheer size of what would be required to backstop Italy, which has the world’s third-largest bond market, throws doubt in turn on support for Spain, whose bonds are also selling off, and the ability of France to maintain its AAA rating, without which Germany is left alone as the bulwark against a gigantic bank run.
The ECB has been buying Italian bonds in the secondary market but still sees itself as only providing transitional support until other European rescue initiatives can take its place.
There is no time for that, and the ECB, and the nations which ultimately govern it, must decide if they are going to stick to their stated principles or preserve the euro.
“What is needed is a clear statement from the ECB that it would act as the lender of last resort for a sovereign that meets explicit and tough conditions and can thus safely be deemed to be solvent,” Holger Schmieding, economist at Berenberg Bank wrote in a note to clients.
“We still believe that the ECB would step in to save the euro and itself in the end, and that the Bundesbank may even acquiesce to that once all other alternatives to keep the euro together have been exhausted.”
To save the euro the ECB must declare that it will act as a lender of last resort for euro zone sovereigns, wade into primary bond markets in huge size, effectively monetizing government debt by printing money to fund borrowing. To work, this has to be accompanied by believable pledges not just of economic reform, but to bring on fiscal integration and to change forever the role of the ECB.
Doesn’t sound very likely, does it, especially in the next week or two.
A SMALL MATTER OF THE LAW
Not only is this anathema to many within the ECB, it is expressly against the treaty which describe what it may and may not do. Article 101 of the European Treaty expressly forbids the ECB from lending to governments and Article 103 prohibits the euro zone from becoming liable for the debts of member states. That means that either the ECB has to in essence go rogue, violating its founding principles, or the mechanisms of structural change have to pull off a miracle in the next week to change its mandate.
The amount of debt the ECB would take on to its balance sheet might also eventually require a recapitalization of the central bank itself, no small matter.
If that all somehow comes to pass, then the rest of ailing Europe, seeing how Italy was bailed out solely because it is big, will immediately try to reopen the terms of their own bailouts. Not to mention the fact that these actions would almost certainly face enormous political and legal challenges in Germany and elsewhere.
Not only does this all seem far-fetched, it is far from clear that it is a good idea. As soon as the ECB starts printing money the euro will tumble, and the Federal Reserve will be under pressure to engage in its own round of quantitative easing to counter the drag on its own economy that a newly strong dollar represents, raising the specter of hot currency wars.
One alternative is an IMF-led bailout of Italy, perhaps supported by some cash from the EFSF. This too may be too big a task for the IMF to garner sufficient support from its own funders. Imagine the election year challenge the Obama administration would face in explaining why it provided hundreds of millions in support to Europe via the IMF.
The other choices are equally unpalatable. Simply letting Greece go, which might have worked several months ago, is now not enough. The consequences to the global banking system and economy if Italy and perhaps others left at the same time are mind-boggling.
Why equities have traded as well as they have given these risks is a mystery. Perhaps massive money printing will be good for riskier assets; a euro break-up surely will not.
One way or another, it is looking as if we are going to find out.
(At the time of publication James Saft did not own any direct investments in securities mentioned in this article. He may be an owner indirectly as an investor in a fund. You can email him at firstname.lastname@example.org)