The three conditions for the ECB to cap spreads successfully: and why they will not be met

Adam Smith believed that it was part of human nature to truck, barter and exchange. I am not so sure that he is quite right. What I do observe, however, is that it is in the ‘nature’ of the ECB Council to dither, dawdle and evade.

Ever since this crisis began, the ECB has never lost an opportunity to be part of the problem. In July 2008, they… raised interest rates. A year later they sat idly by while Greece began the long walk up its own Golgotha, only to enter the fray in a half-hearted way when Portugal and Ireland seemed on the brink too. Their pathetic, heavily circumscribed, intervention in the secondary market of the fiscally stressed states’ government bonds was an example of how not to repress ballooning spreads within a currency union. In 2011 the ECB was the first of the major Central Banks to raise interest rates, after the loosening up that followed Lehman’s collapse. It proved, yet again, a particularly silly move. As if to add insult to injury, in July 2011 the then President of the ECB, the hapless M. Trichet, demolished the notion that it pays not to wager against the ECB by warning investors that bets on a Greek debt restructure will lose them money – a few weeks before Greece’s debt was restructured!

In view of this hideous track record, many rejoiced when Mr Draghi replaced M. Trichet, especially after the new ECB President famously unleashed his two-stage 1 trillion euro LTRO with which he bought 6 months or so of tranquility for the Eurozone’s politicians. Alas, the Eurozone was at an advanced stage of disintegration and throwing a wad of fresh loans at the insolvent banks could only go so far. Before long, Spain was in the mire and Italy began to feel the heat of insolvency. As the paroxysm of pessimism took hold once more, Mr Draghi made his famous declaration: “The ECB will do what it takes to save the euro. And, believe me, it will be enough.” While the markets reacted with restrained enthusiasm, everyone is now speculating as to what Mr Draghi is up to.

Der Spiegel seems to know what Mr Draghi is planning: a cap on the interest rates at which Eurozone member-states borrow or, at least, a cap on the spreads (vis-à-vis Germany’s bunds). If this is accurate, it constitutes a major step in the right direction, at least in terms of containing the debt crisis and buying time during which Europe’s leadership can, at long last, engineer a systematic solution to our systemic crisis. While I would be delighted if Der Spiegel’s story is born out by developments, I very much doubt that it will be. Here are some reasons.

That the ECB can, if it wishes, impose a ceiling on interest rates and/or spreads, there is no doubt. Just as the Central Bank of Switzerland imposed a cap on the franc’s exchange rate, in relation to the euro, so can the ECB implement an automated system that activates ‘buy’ orders for Eurozone government bonds whose yields climb above a certain level. For this to work, however, three are the conditions:

  1. First, it must be common knowledge that the ‘buy’ orders will not be discontinued before the cap threshold is attained. (Otherwise, speculators are offered a golden opportunity to beat the ECB at a game of its own design.)
  2. Secondly, the threshold for each member-state must be common knowledge. (Otherwise, much speculation and many financial resources will be wasted while the asymmetric information is turned symmetric.)
  3. Thirdly, there must be no conditionality. (Otherwise, speculators will place bets against the ECB’s automated purchasing strategy which will pay off if the said member-state fails to meet its ‘conditions’).

Since the crisis erupted, the first condition has never come even close to being met. ‘No Monetisation’ was, and remains, the crying call of surplus countries for whom the ECB’s greatest potential sin is to meddle with member-state interest rates (by employing its figurative printing presses). Let’s assume that the recent near-death experience of the Eurozone, following Spain’s and Italy’s travails, has changed the mind of the majority in the ECB’s Council, and possibly of some central characters in Berlin. I am not suggesting that this is what has happened. I am only prepared to go with this as a working hypothesis. Do the other two conditions apply?

Let’s cast an eye upon the second one: Is it possible to imagine that thresholds (and caps) are determined and made common knowledge by the ECB, in conjunction perhaps with the Eurogroup? To begin with, there is the question of whether the threshold will be the same across the Eurozone. Can we envisage an announcement such as: “From tomorrow, the ECB will ensure that no Eurozone member-state’s yields will exceed those of the German bunds by 3%”?

One has to state it to realise the kind of verbal storm that will hit Europe when arguments and counter-arguments start flying on how inappropriate it is to have the same cap for Greece and, say, Italy – or Ireland for that matter. It is a fair assumption, I submit, that if the ECB moves in this direction it will employ differential thresholds/caps. But, if so, who determines the differential between the thresholds? Will the ECB do this? Will the Eurogroup? Will the EU Council, at its monthly meetings, determine these numbers?

It is clear that neither Ecofin nor the Council can do this at the regular basis at which it will have to be made. And besides the fact that they cannot be counted upon to do this properly, our politicians do not have the remit to instruct the ECB on which threshold it should choose per member-state. After all, the ECB is supposed to be… independent. On the other hand, the ECB could certainly do this (from a technical point of view). But, if the ECB adopts this role, then it will have become the political overlord of the Eurozone, while lacking any semblance of democratic legitimacy.

It is clear that these thoughts are, indeed, exercising the mind of Mr Draghi and his minions. The result is confusion, dithering and a sad degree of inconsistency in their dealings. On the one hand, they tell us that it is up to Spain whether it wants help from the EFSF and the ECB. On the other hand, it is clear that the ECB has a track record of imposing (see Ireland) an acceptance of an EFSF program. It was, after all, only recently that the ECB told Italy that a series of austerity measures were the condition for LTRO help via Italian banks.

The ECB, in short, wants its cake and to eat it. It is jealous of its independence, pretends it is not in its remit to tell governments what to do and yet, in the same breath, selects measures that tie its monetary policy on the EU’s austerian mindset while dictating to governments fiscal terms and conditions before it flexes its monetary muscles in their favour.

Which brings us to condition 3: Suppose that the ECB commits to keeping Italy’s spreads to 3% or less. Suppose also that, as part of today’s dominant (austerian) paradigm, the ECB makes this commitment conditional on Italy respecting a (Greek-style) memorandum of understanding on government expenditure cuts and labour market reforms (to be assessed by the EU, the IMF, whomever). Suppose, lastly, that you are a speculator considering a wager against the ECB’s 3% spread threshold for Italian government debt. You know that if the ECB was unconditionally committed to the 3% spread target, it would be suicidal to bet against the ECB. However, if there is a significant probability that Italy will not meet the conditions that are part of its agreement with the EU-IMF-ECB, there is room for profitable speculation against the ECB’s 3% threshold. Which means that the ECB must choose between credibility toward speculators and credible conditionality of its threshold/caps. It is pure fantasy that the ECB can have both.

Summary

Markets are buoyant these days. This is so because of a powerful rumour that the ECB is about to cap Italy’s and Spain’s spreads. Such optimism is, tragically, unfounded on the facts and guaranteed to yield disappointment very soon. The three conditions that I outlined above, without which the thresholds will fail, cannot be met in a manner that is consistent with the currently prevailing paradigm. I wish they were. But they are most definitely not. Where does this leave us? The answer is: In a world where the ECB Council continue to dither, dawdle and evade. What will this mean in practice? At best, the ECB will step into the Eurozone short-term debt market suppressing the spreads in three month T-bills. At most, it will cap one-year bonds too, but in a manner that lacks transparency and long-term legitimacy. By enabling Italy and Spain to roll over their short-term debt, the ECB will buy Berlin and Brussels another six months or so. Just like it did with the LTRO. The difference, however, this time is the mountain of great expectations that Mr Draghi has created. When the markets realise how far short the deeds fall vis-à-vis the words, the ECB will discover that the Eurozone’s yields (which it wants to contain) have become more twisted than our politicians nickers. While ECB action will keep short-term borrowing costs relatively tight, 10 year bonds will diverge more than ever. In short, Mr Draghi’s “and believe me, it will be enough” is more likely than not to come to the same grief that M. Trichet’s “place no bets on a Greek debt restructure” did a year ago. Make no mistake: The Euro Crisis will not be resolved through the actions or decisions of the current ECB Council.