The big rumor driving markets in the last 24 hours is the idea that the ECB will step in as the lender of last resort in Italy once the austerity bill is officially passed. It’s a hilarious quid pro quo – you crush your economy through austerity and we’ll buy a few bonds to ease market fears. Danske Bank has some details on the timeline here:
“The development in Italy will continue to be focal in the coming week. It is key that the austerity bill (EUR60bn) will pass in the lower house. The vote is set to take place on Sunday. We expect the ECB to step up its buying on Monday, once Italy has done its part. It is possible that the ECB will send out a statement on Sunday evening in which it recognises Italy’s last move, as was also the case in August. Back then, when Italy and Spain were included in the Securities Markets Programme (SMP), the ECB successfully pushed 10-year yields from around 6.5% to under 5%. The purchases were massive in the first 7-day period (EUR22.5bn). However, this time the purchases are likely to be even bigger, say +EUR30bn in the first 7-day period. It is essential that the ECB sends a clear signal that it is committed, as it will be tested by the market repeatedly. PM Berlusconi is expected to step down once the bill has passed. We still don’t know whether Italy will go for a general election or whether a national unity government will be formed. This week President Napolitano announced that Mario Monti (former EU commissioner) has been named senator for life, which would make it easier for him to lead a “technocrat” unity government. If this gets broad support it would be the ideal solution from a market point of view.”
Will this work? It depends. If the ECB came out and said: “we are a buyer of Italian bonds at 6%”, then yes, this will work. But they won’t do that. Instead, they’ll likely repeat what they did in August where they buy EUR20B+ bonds, yields sink and then EMU leaders crawl back into their corner where they can watch everything start to meltdown again. As we now know, austerity and tepid bond buying is not the fix. Austerity without growth improvements leads to a worsening budget situation. Have we learned nothing from recent experience? And Italy’s growth prospects are particularly atrocious (see here). The odds of them growing their way out of this catastrophe is practically nil. So, the only real fix here is for the ECB to step in as THE buyer. That or a Euro bond/central treasury solution. In other words, you have to eliminate the solvency issue in Italy. I don’t think the Germans are willing to unleash the bazooka that is required here. Jurgen Stark made that VERY clear earlier this week. Their long standing fears of inflation override all of this.
So, we’ll wait and see what happens in the coming week, but I am fairly certain that nothing has been resolved and nothing will be resolved. The Europeans are in denial over what is required here and their inability to work together is now on full display for the world to see. I believe they should move towards fiscal union, but I don’t for a second underestimate the potential risk of a dissolution of some sort. At times I claim to be able to predict the madness of crowds, but I would never pretend to be able to predict the madness of politicians.
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.