Further to my previous post on Mr Draghi’s recent undermining of the Office of ECB President, Gavyn Davies of the FT penned the following line: “It is risky for a central banker to acknowledge that the payments system on which the currency stands may not be fully credible. Mr Draghi could simply have repeated the old line that the operation of the Target 2 system is enough to ensure that the euro can never fall apart. By admitting the reality that the system is no longer 100 per cent credible in the eyes of the market, the ECB president has invited investors to ask whether his proposed interventions are powerful enough to deal with problem he has raised.” And, as I have argued, investors will inevitably come to the conclusion that they are nowhere near powerful enough. Put simply, the policy of having the EFSF-ESM use its severely circumscribed fire power, in conjunction with a limited bond purchasing program by the ECB, to push Spanish and Italian yields down, will fail as miserably as the combined efforts of the EFSF and the ECB failed in 2010/11 to prevent Portugal and Ireland from following Greece into the mire.
The question now becomes (even if it is an academic one): What would it take to convince investors that the proposed measures will annul the ‘convertibility risk’ that Mr Draghi now acknowledges to be “not insignificant”. Everyone, including Gavyn Davies and Tim Geithner, seems to believe that the answer lies in giving the ESM a banking licence, thus allowing it to use the ECB’s balance sheet as a means of levering up whatever monies it has available (from less than 200 billion to the required 2 trillion!).
I have no doubt that an announcement along these lines would cause a frenzy of enthusiasm in the money markets, and that spreads throughout the Eurozone will collapse. But I also have no doubt that this would be another temporary measure. The reason? The toxicity of the EFSF-ESM funding structure. Toxicity? Yes, toxicity. As I have explained a long time ago, the bonds issued by the EFSF (which will have the same structure with those that the ESM will issue, assuming the German constitutional court gives the green light in September) are structured very much like the awful CDOs that brought the house of cards down in 2008. If this analysis was correct last summer, then levering the EFSF-ESM up, by granting it a banking licence, would be tantamount to creating a CDO mountain on steroids and planting it in the heart of the Eurozone. It may work for a while (just like the CDO market was buoyant for a while) but in the end that new, Eurozone-constructed, house of cards will come crashing down. And if investors have learnt anything from the recent past, they should see thins coming fairly early on, which means that the half life of a new ba king-licence-carrying ESM will cause more problems than it will solve very, very soon.
So? What policy can address ‘convertibility risk” effectively? The answer is: Nothing short of proper mutualisation of the Maastricht Compliant Debt. And since we do not have a Federal Treasury to do this (and won’t get one before the ‘convertibility risk’ turns into ‘convertibility reality’), the only tool that I think can do the trick is ECB-bonds as per Policy 2 of our Modest Proposal. That this is not on the cards is as evident as it is indicative of the low probability that the Eurozone will survive.