The ECB is in a most unenviable position. As the EMU begins to falter they are confronted with few tools with which to fight this battle. The market called their bluff yesterday with the Greek bailout and is clearly looking past Greece at Portugal and Spain while daring the ECB to make a move on either country. The bond “vigilantes” are betting on the fact that the ECB has overplayed their hand with the Greek bailout. At this point, it looks like the vigilantes are correct. The ECB put a gun on the table and it turns out to have been nothing more than a water pistol. Unfortunately for the vigilantes the ECB is not out of tricks. They have a Hank Paulson like bazooka in their option to buy bonds on the secondary market. But can they use it? RBS analysts believe they should not hesitate in acting:
“The ECB should not wait for a renewed deterioration of the periphery before acting. It should regain its leadership in tackling the crisis following a complete communication and coordination failure amongst euro area fiscal authorities around the Greek crisis. Should contagion reappear, there will probably not be enough time to go through a similar backstop facility to that of Greece for the next country. There simply will not be enough time. Better breaking the rule-book than breaking up the euro area!”
Unfortunately, the decision is a bit more complex than the Fed’s decision to buy assets directly from the U.S.banks – what many refer to as “quantitative easing”. As we’ve previously explained, the Euro is flawed primarily because it is one currency housed under several economies with multiple governments. They are not truly unified because their economic strategies differ which make their inherent monetary needs different. Using the same currency for economies as different as Germany and Greece is truly forcing a square peg in a round hole.
Where are the potential roadblocks to QE? First of all, the program would have to be massive. Credit Suisse estimates that the cost to bailout Spain, Portgual and Greece could be as high as $600B. The program would almost certainly have to be as large in order to quell any and all market fears. But the bigger roadblock is the Maastricht treaty. Although the ECB could technically use the loophole of the secondary market the surrounding nations would be hesitant to approve such a program that would be rife with moral hazard and potential inflation. And perhaps the most important roadblock is this: why would Germany ever approve such a measure after nearly balking on what is now viewed as a pitiful $100B package? Marco Annunziata, chief economist at UniCredit told clients:
“(this is a line) the German government would not allow to be crossed. Purchases of government bonds would be a straight monetary financing of excessive fiscal deficits, which is anathema to the Bundesbank and German government.”
In my opinion, the move to bond purchases would be an admittal that the single currency system has failed. If these nations are going to allow such bailouts then you have to wonder why they share a currency and risk not only higher inflation, but future misuse of funds? The Bundesbank would seem to be particularly disgusted by such an option. And even worse, such a measure would almost certainly come attached with very harsh deficit spending restrictions which would ensure continuing economic pain in the region. As we’ve learned here in the states, the banks were never reserve constrained and have not picked up their lending despite the massive Fed programs. Despite claims of victory the Fed is still pushing on a string. As the bank bailouts have done little to relieve Main Street in the United States it’s unlikely that bond purchases in Europe would do anything to help the Main Street citizens of Europe.
The one thing bond purchases would do is prop up a currency system that has been flawed from its inception. And with the purchase of bonds the Germans now have to very seriously consider why they are part of such a misguided union which very seriously risks their much needed price stability? Even worse, the Greeks must ask themselves why they are forcing potential depression on their citizens just so they can appease the needs of their surrounding “union” – a “union” which appears increasingly less likely to support them following yesterday’s market action.
It now looks like the ECB has no choice but to go nuclear. After all, we live in a bailout world where failure is truly not an option and government intervention is the savior of the “free market”. With this intervention I believe the Euro currency will officially take its first step into the grave. The member nations are now realizing that there is little benefit to being in such a “union” when all it does is impose potentially catastrophic risks on each of their citizens.
Surely the Germans must be asking themselves how the Brits could have been so wise to sidestep this whole disaster. And if they are wise, they will either put their foot down on any bond purchases or begin the process of leaving the union as soon as possible.
Mr. Roche is the Founder and Chief Investment Officer of Discipline Funds.Discipline Funds is a low fee financial advisory firm with a focus on helping people be more disciplined with their finances.
He is also the author of Pragmatic Capitalism: What Every Investor Needs to Understand About Money and Finance, Understanding the Modern Monetary System and Understanding Modern Portfolio Construction.