Capitalist banking systems are built on the confidence trick that people can get their money back at any time. Of course, if everyone sought their money at once, no one would get anything because the financial system would collapse.
The eurozone is being held together by a more fragile bluff. This is the European Central Bank’s “outright monetary transactions” scheme, which was announced in September last year. The scheme pledges to buy unlimited amounts of distressed sovereign bonds, a plan enacted by ECB President Mario Draghi to back up his earlier comment that the bank would “do whatever it takes” to save the euro.
Draghi’s scheme is proving to be the masterstroke of the eurozone crisis because it papers over the ECB’s shortcomings as a central bank. It skirts the ban on the ECB acting as a lender of last resort to governments, which means endlessly printing money to fund a government deficit or to repay bonds. Draghi’s scheme sidesteps this prohibition by promising to offset (or sterilise) any bond purchases by selling securities from non-struggling countries to keep the eurozone’s money supply level.
Draghi’s ruse is turning out to be such a successful bluff that no eligible country has called on it. Bond yields on troubled European sovereigns dropped from panic levels when the scheme was announced and have stayed manageable ever since. It’s almost as if bond investors and speculators believe they are powerless against the ECB. But the scheme does have its limits. If investors doubt the ECB’s ability to cap yields on distressed government debt and they baulk at buying these bonds, the scheme will be sunk.
Draghi’s confidence trick has been tested tentatively this year, yet bond investors have exhibited no real signs of doubting his resolve. The worry is whether the scheme can withstand a potentially more bruising encounter in future.
Bailout fatigue
The first test of the scheme occurred when Italy was left without a government for two months after inconclusive elections in February. This political limbo highlighted that Draghi’s scheme can only be enacted if a government agrees to reforms. Whoever thought there’d be no government to deal with?
Portugal exposed another flaw in June when its bond yields soared on political uncertainty, but the ECB was powerless to help because its scheme doesn’t cover EU countries that are unable to sell bonds.
The third (and probably biggest) test of the credibility of Draghi’s scheme occurred earlier in June when Germans launched a legal bid to stop their country from taking part in any eurozone bond buying. The German government opposed and hearings failed to budge bond yields much, even though Jörg Asmussen, Germany’s representative on the ECB executive board and a defender of the scheme, said that the ECB scheme was “effectively limited” in terms of its bond-buying capacity, confessing that the ECB had declared it “unlimited” on its creation “to convince market participants of our seriousness”.
Perhaps investors were reassured by the fact that no verdict is expected until later this year. But the German attack on Draghi’s scheme should have reminded investors that the Bundesbank opposed his ploy from the outset and that the German population, according to opinion polls, is against any ECB-led bond buying. Rising bailout fatigue among Germans is a mounting risk for the euro. It could yet rise to levels that would make Draghi’s scheme stillborn.
Thanks, Ben
Draghi’s ruse could be tested again soon enough. Greece is ever closer to collapse, an event that would trigger bank and bond runs in other troubled countries. Mediobanca, Italy’s second-biggest bank, warned in June that the country might need an EU rescue within six months because the recession and credit crisis for large companies are deepening to the detriment of government finances. Austerity is also boosting government debt-to-GDP ratios in Portugal and Spain to levels that could erode investor confidence.
Another test of the viability of Draghi’s scheme could be a general rise in global bond yields if the US economy improves enough for the Federal Reserve to end, or even reverse, its asset-buying program for US treasuries. US bond yields rose more than 100 basis points in May and June when Fed officials started talking about trimming their support. On August 12, Italian and Spanish 10-year government bonds were trading at about 160 to 200 basis points, respectively, above equivalent US debt. That’s all well and good when US 10-year bonds are trading at 2.6 per cent, as they were on that day. How will the ECB react, though, if US yields jump to 4.5 per cent, to send Italian and Spanish debt into the solvency red zone?
Investors received a clear indication of how panicked the ECB is about the challenge of rising US bond yields when Draghi in July ditched restrictions on the ECB predicting monetary-policy settings. He said the ECB would keep the cash rate at a record low of 0.5 per cent or even lower “for an extended period of time”.
Many analysts took this statement to be another bluff rather than a commitment by the ECB to allow inflation to rise to higher than normal levels before lifting rates. Draghi is a clever man in charge of a pretend-central bank that’s only equipped to fight inflation, not a banking-turned-sovereign-debt-and-unemployment crisis. He must guess that bond investors will soon figure out that a stateless central bank defending a stateless currency is so hamstrung politically that it carries far less firepower than, say, the Federal Reserve has over the US economy and dollar.
If his outright-monetary-transactions bluff collapses, he may well have other tricks ready to suppress yields on struggling sovereign debt and save the euro – without which there is no need for the ECB. If Draghi is out of surprises, he can be thanked for buying time for politicians to come up with durable solutions to the eurozone’s woes. Oh, that’s another flaw with Draghi’s scheme: it removed the pressure for politicians to act decisively, so they haven’t.
Michael Collins is an investment commentator at Fidelity
