The ECB gives a tiny glimmer of hope, not more!

Following Mario Draghi’s remarks last week in London, wherein he promised that the ECB stood ready to do ‘whatever it takes’ to save the Euro, as long as it was ‘within its mandate’, the markets were flooded with a wave of optimism. This optimism took on frenzied proportions as the head of the Austrian central bank, one of 23 members of the ECB’s governing council, evidenced support for the idea of the ESM getting a banking license. Much of this optimism has vanished in the face of the reality that confronted markets at the ECB’s press conference today. That is not to say that there has been no progress, only that what has been announced is not a game-changer.

We were sceptical at that time and said so. It turns out we were justified in our scepticism. The ECB did not intend to, nor was capable at this point of delivering a 'bazooka'. It has outright rejected the idea of the ESM getting a banking licence, once again. It has however held out a promise to reactivate the defunct Securities Markets Program (SMP) albeit with some important modifications. This note discusses what this means and what impact this may have on the progression of the Eurocrisis.

Spiking Skywards? Tackling rising yields in the Eurozone

Spiking skywards? Tackling rising yields in the Eurozone

The Eurocrisis is once again dominating the headlines. Renewed talk of a Greek exit, record yields for Spanish bonds and rising Italian borrowing costs have been splashed all over newspaper headlines. This week Spanish bond yields reached new record highs breaching the 7% level for maturities of two years and above. Italian yields too were trying new highs.

Then the president of the ECB spoke saying that the ECB would do "whatever it takes" to save the Euro. The markets reacted positively and yields fell. There is an expectation in the markets that policy makers may come up with some new measures to address the spiking yields soon. We are much more sceptical both of their immediate intentions to enact more measures and their ability to bring the yields down sustainably. One could hardly expect the president of the ECB to not say that he would do whatever it takes to save the Euro. This Policy Brief addresses two questions 1) why are spiking yields a problem? and 2) what are the near-term options for bringing these down.

The Spanish Donkey

The Spanish Donkey, a feared torture device from the middle ages, consisted of a wedge on which the victim was seated with weights tied to his or her legs so that with enough weight, the wedge could even slice though the victim’s entire body. Arguably, the Spanish economy now sits atop such a wedge weighed down by deep austerity measures and unprecedented unemployment on the one side and by large unknown losses in the banking system brought about by a real-estate bubble that has burst on the other.

What is worse is that these two aspects weighing the economy down reinforce each other in a manner that is clearly not understood that well by EU policy makers. The Spanish economy today is at a point where every bit of austerity, measured in percentage points of GDP, leads to a reduction in demand that is even larger. So a 1% cut in government spending is likely to lead to a fall in GDP that is larger than 1%. This is because the uncertainty over the future of Spain and the fact that tomorrow, at this point, looks worse than today mean that neither consumers nor businesses are spending so a reduction in government spending translates directly into lost demand in the economy. What’s worse is that the expectation of falling GDP that accompanies such austerity means that both consumers and firms will make further cutbacks to their consumption and investment plans.

The Italian Conundrum

After Spain, it’s Italy’s turn in the Eurocrisis spotlight. The immediate cause for this spotlight is a two notch downgrade of the Italian sovereign by Moody’s, a rating agency from A3 to Baa2, just two notches above the dreaded junk status. Despite the downgrade, Italy is not Spain and the fact that the downgrade had a rather limited impact on the pricing of Italian bonds issued in its immediate aftermath reflects some of its fundamental strengths.

Nevertheless, expect this to generate a barrage of strongly worded public criticisms from European leaders, but the truth is that they only have themselves to blame. The single biggest factor weighing on the Italian economy at present is the uncertainty about whether or not the Eurocrisis will be resolved. And it is this, rather than Italy’s own domestic situation (which is also complicated), that is the most serious problem.

The Good and Bad of Spain's Bank Bailout!

The terms of Spain's bank bailout are being finalized and this draft memorandum is a near final verison that lists the timeline and details of how this bailout would be conducted. While the draft looks rather comprehensive on first glance and does have several positive elements, it is also afflicted by a number of glaring omissions. 

The first of these is that the memorandum fails to understand or acknowledge the link between the macroeconomic policies being pursued by Spain, for example on cutting its fiscal deficit, and the stability of the financial sector. In fact, many of the new austerity measures adopted by Spain will undermine the objectives of its bank bailout program. It also fails on take note of the social and political realities. Crucially, it makes no reference whatsover to the direct injection of equity by the European crisis funds, now or in the future. 

Pages