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Could there actually be a working policy to save the euro zone?

December 17th, 2011 · No Comments

After all, there seems to be some modicum of market optimism, with peripheral yields going down..


We wrote about a bank funded solution here a couple of days ago, now read this one:

The Eurozone’s policy breakthrough?

Today’s money quote, obviously, is this, from Fitch:

a ‘comprehensive solution’ to the eurozone crisis is technically and politically beyond reach.

Fitch’s view reflects the clear consensus of Anglo-American commentators. But Anglo-American commentators aren’t always right. Ezra Klein writes that the German policy establishment “remain[s] serenely confident that they will save [the Eurozone].” Note that Klein attributes this to no one in particular. He characterizes it as a view drawn from “members of Angela Merkel’s government, members of the opposition Social Democrats, industrialists, and bankers.” In other words, Klein heard this in private conversations, not market-moving public statements. Jean-Claude Junker’s famous when-it-becomes-serious-you-have-to-lie rule doesn’t apply. These are smart people who know everything we know, and they think they’ve got the situation covered.

Tyler Cowen has been emphasizing the possibility that the ECB will quietly fund sovereigns via the banking system. The ECB would lend to banks at very low rates, accepting sovereign debt as collateral. Banks would earn the spread between the yield on sovereign debt (which is currently distressed and very yieldy) and the sliver of interest demanded by the ECB. As a matter of mechanics, this plan could work. It’s the same as direct ECB lending to sovereigns, except ECB gets added security (in theory) by interposing banks as guarantors, and pays a fee for the privilege.

The Anglo-American punditosphere is unimpressed. After all, European banks are already in deep trouble because of their sovereign holdings. An article by Gareth Gore (ht Felix Salmon) quotes a senior banker:

“When investors are constantly asking what you have on your books and the board is asking you to reduce your exposure, it doesn’t really matter about the economics of the trade,” said the treasurer of one of Europe’s biggest banks. “Am I going to buy Italian bonds? No.”

That view echoes comments from UniCredit chief executive Federico Ghizzoni, who this week told reporters at a banking conference that using ECB money to buy government debt “wouldn’t be logical”. The bank had traditionally been one of the biggest buyers of Italian government bonds, with almost €50bn on its books.

Cowen responds

My view is not that banks will find the arbitrage opportunity overwhelming (that is unclear), rather my view is that public choice mechanisms will operate so that desperate governments commandeer their banks to make this move, whether the banks ideally would wish to or not.

I’m not sure that bank-mediated ECB finance is the plan, but if there is any plan at all, it is the only one I can find. And, as Cowen points out, markets seem to perceive some cause for optimism. But if this is the plan, I think Cowen is a shade off on the politics. Desperate governments can commandeer domestic banks all they want, but it is the ECB who decides to whom it will lend and against what collateral. Further, bankers’ objections are entirely irrelevant. That major banks may be, from an admittedly archaic perspective, “insolvent” is an argument for rather than against the practicality of the plan.

European banks, especially in the troubled periphery, are mortally dependent upon the ECB for liquidity and finance. These banks will acquire whatever collateral the ECB prefers to lend against. It is not a matter of trying to profit from a spread. A spread would be nice for banks, a subsidy that will help them recapitalize over time. But holding collateral the ECB wants is a matter of life-or-death for them, every day. If the ECB wants Italian bonds, they will be supplied. If the ECB prefers that Italy “face market discipline”, it can quietly hint its concern and steepen the haircuts it imposes when the country’s bonds are offered as collateral. Banks will start to divest, replacing them with whatever the ECB favors.

A lot of commentators have derided Europe’s “policy breakthrough” as just a restatement of the old stability and growth pact with some institutional changes at the margin. Talk of automatic consequences and qualified majorities may just be blah blah blah. But if European states become dependent on bank finance, they become dependent on ECB finance. The ECB would have the power to manufacture fiscal crises for a misbehaving state at will, and with marvelous deniability. Laundered through banks and then through capital markets, ECB actions would be attributed to nameless bond vigilantes rather than unelected technocrats. ECB haircuts would very quickly be self-justifying, and disentangling cause from effect would be nearly impossible as officials might privately telegraph changes before anything is put in writing. Control would be hidden as a market outcome, a fact of nature.

Operationally, I don’t see why the plan can’t work. I dislike it, both because I dislike the policies I suspect ECB would enforce (austerity and internal devaluation) and because it is profoundly undemocratic. Democracy is really the main obstacle, though the plan gains some immunity from the fact that politicians who try to call it out would quickly be labeled conspiracy nuts.


p.s. If you haven’t seen Ashwin Parameswaran’s democratic twist on the putative Euroarbitrage, do check that out.

Tags: Sovereign debt crisis