The limits of ECB intervention
This piece was first written and circulated on the 2nd of September and appeared as a comment piece in Le Monde on the 10th of September
The Eurocrisis is on a pause as markets and EU leaders alike wait with bated breath for ECB. President Draghi, who has promised the European Central Bank will not let the Euro fail, to reveal his hand. They are right to think what the ECB will say or do is very important, but it is hard not to feel that too much is being expected of the ECB.
Between the things the ECB cannot do and the things it will not do, its ability to deliver a sustainable ‘big bang’ has been severely curtailed. There are three main reasons to suspect that no matter what the ECB does this week or the next it will not be sufficient to stem the Eurocrisis. Those who have their hopes riding on the ECB are best advised to recognize that while larger scale ECB interventions are necessary, they are simply not sufficient to bring the Eurocrisis under control.
The first is the experience of the SMP, the Securities Market Program of the ECB, under which it bought substantial amounts of sovereign bonds of crisis-ridden countries starting 2010. Under this, the ECB started buying up the government bonds of crisis-ridden countries purportedly to tackle ‘market dysfunction’. This did bring the yields on these bonds down substantially but the effectiveness of the program was severely hampered by its flawed design.
Constructive ambiguity in the form of the possibility of intervention is one of the most potent tools central banks have. With their unlimited power to print money, there is no limit to assets they can purchase, at least in theory. Instead of using this to its advantage, the ECB insisted that its purchases were of a limited and finite nature. This insistence was a sop those such as the Bundesbank, which opposed such purchases as well as a ploy to prevent Euro-area leaders from getting too complacent that the ECB will save their bacon. Both factors remain relevant this time round and are likely to keep the ECB well away from steps such as imposing ‘yield caps’ – not allowing Spanish & Italian borrowing costs to exceed 5% - which could work well.
The ‘limited & finite’ nature of the SMP prompted those who had doubts about the handling of the Eurocrisis to try and sell while the ECB was still buying, hence much of the ECB’s bond purchases ended up financing capital flight. That the ECB’s commitment is not open-ended has been reinforced by the fact that the SMP was effectively shuttered at the beginning of 2012. Any similar limited program announced by the ECB could end up simply funding capital flight once again.
The second is the seed of doubt about the integrity of the Eurozone that was sown by Eurozone leaders when they openly speculated, about whether Greece could stay in the Eurozone at the G-20 summit in Cannes in 2011. In order to reap the benefits of a single currency, the Eurozone needs to be like ‘Hotel California’, where you can come in but never leave. It is only when a currency union is considered irreversible that investors, businesses and citizens would treat the Eurozone as a single currency area and act in a manner that the benefits of an ever closer union can be harnessed.
The minute the possibility of a break-up of the Eurozone became real, no matter how unlikely it still remains, it became rational for consumers, savers, investors, banks and businesses to start acting in a manner that seeks to protect them against such an outcome which would undoubtedly be economically traumatic. So savers started moving their money from less safe countries such as Spain and Greece to safer countries such as Germany and the Netherlands. Investors sold-off Italian government bonds to buy French and German government bonds instead. Banks started reducing cross-border business and exiting markets that are seen to be weak. And businesses have found it rational to stop making investments in countries seen most vulnerable in the event of a break-up. Consumers have gone on strike trying to save up for a rainy day. These actions, which are rational individually, are collectively disastrous and have exacerbated the possibility of exactly the outcome they are seeing to protect against – the break-up of the Euro area.
Under these circumstances, any additional support the ECB provides to the banking system in the form of yet another LTRO (Long Term Refinancing Operation) or to troubled sovereigns through buying their bonds will merely fund the further fragmentation of the financial system and capital flight from Spain and Italy. Only EU leaders can credibly remove a break-up of the Euro from the realm of possibility, not the ECB. The more real this possibility becomes, the less effective any ECB intervention is and the more the ECB can end up as a ‘lame duck’ central bank.
The third reason to be wary of what the ECB alone can do is to look to the UK. The Bank of England has done what the ECB has refused to do and bought substantial amounts of UK government bonds. Most important, markets believe that were borrowing costs to rise, the Bank of England will step in. This has contributed to the UK being able to borrow at record low rates even as the spreads for Spain rise inexorably.
Under a very optimistic scenario, where EU leaders remove any possibility of a Euro break-up and the ECB makes an open-ended commitment to supporting Spain, one can reason that Spanish borrowing costs will come down substantially. It is then relevant to look at how the UK economy has performed, and the answer is very poorly. In the face of an on-going fiscal contraction and a banking system that is still very weak, low borrowing costs can only help so much. For Spain, which faces a fiscal contraction that is even worse and has a banking system that is far more fragile than that in the UK, lower borrowing costs through ECB intervention can only do so much.
It is right to expect, even demand the ECB do much more to stem the Eurocrisis but it would be crazy to think that what it does would be enough. The Eurocrisis is here to stay.