31st July 2012
Last Thursday the head of the European Central Bank Mario Draghi raised the stakes in the Euro crisis by making this statement.
"Within our mandate, the ECB is ready to do whatever it takes to preserve the euro. And believe me, it will be enough."
So a promise backed up with some hyperbole, and it was followed by this.
"To the extent that the size of these sovereign premia hampers the functioning of the monetary policy transmission channel, they come within our mandate."
This speech made an obvious immediate impact as the Euro surged higher against the US Dollar eventually reaching US $1.24 before falling back and a sustained rise in Spanish and Italy government bond prices.
However less well reported was this bit:
"progress has been extraordinary in the last six months"
After all if this was true then he did not need to make what are rather wild promises did he?
However we are approaching crunch day for these promises as on Thursday the governing council of the European Central Bank meets and we will see if they are minded to back up what has been said.
The European Central Bank is extended anyway
One issue to be faced here is that the ECB is already involved on an extraordinary scale with a balance sheet of approximately three trillion Euros. Much of this is because monetary transmission mechanisms in Europe are failing and rather than deposit funds with each other banks now prefer to deposit at the ECB. This is in spite of the fact that its interest-rate is now 0% for such money. It is true that deposits at the ECB have dropped (336 billion Euros) but money held in its current account has surged (515 billion Euros). So the money in essence just went from one to the other and thus even reducing the interest-rate to zero did not end the desire to hold funds at the ECB.
What could be done about this?
The ECB could reduce its headline interest-rate to 0.5% which if it maintained the normal relationships would take the deposit rate into negative territory at -0.25%. This might incentivise banks to take money away from the ECB. However there is a possible chilling alternative, what if they did not? A so called solution would then be declaring that Europe's monetary system is in such a dreadful state that even negative interest-rates will not jump start it. So this could make things worse as fear is an intangible factor.
An interest-rate cut would have other effects but as we approach zero my argument is that the effects get weaker and weaker. I recall for example the Bank of Spain stating that in spite of the last ECB interest-rate cut (to 0.75%) borrowing rates for Spanish businesses had risen rather than fallen.
Buy Spanish and Italian government bonds
Some parts of the media seem to treat this option as some form of a holy grail. If only the ECB would sanction this option then all would be saved appears to be the mantra. However it seems to have slipped their mind that this option has been tried already. And the inevitable cries of "More,more,more" forget that it was tried on a large scale when we consider that its main operation was in the relatively small Greek economy. They also seem to have forgotten that it did not work and that Greek debt looks as though it will need yet another restructuring.
So we see that a policy which caused a lot of problems for the ECB (two German members resigned) and did not work in a country with 280 billion Euros of government debt (Greece) will work in one with 775 billion Euros (Spain). Even more bizarre are the claims that it might work in Italy with its 1946 billion Euros of debt. We are back to PM Dawn.
"Reality used to be a friend of mine.
Reality used to be a friend of mine
I lost touch with reality……… I just chose to laugh at her"
Some of the hopes/fantasies for action also seem to have focused on the ECB indulging in some Quantitative Easing. If we put aside for one moment the fact that there is no evidence that QE has ever actually worked anywhere there are other problems. The Euro area has 17 sovereign bond markets so which ones do you buy? The answer seems obvious right now in that it would be Italy and Spain but there is a clear moral hazard in that. And how do you know that the money created would remain in Italy and Spain? As it could join the existing deposit flight and go for example to Germany and the Netherlands. You would then be enhancing the imbalances.
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