We take a break from China and iron ore today and turn our gaze to Europe. Last night, European Central Bank chief Mario Draghi announced what the market pretty much already knew. That is, the ECB will engage in ‘Outright Monetary Transactions‘ (OMTs) to help bring borrowing costs down in Spain and Italy, although these countries were not explicitly named.
The pretence for the decision was that the high borrowing costs in these two large Eurozone economies threatened the stability and the future of the euro project. The ECB had to do something that ensured the long term future of the euro — the ‘irreversible’ project.
Whatever. Mario simply came to a fork in the road and chose the path most travelled. That is, he chose the easy path, the road to debt monetisation.
Before we get into why the world is on the road to ruin, let’s back up a bit. What exactly did the ECB announce, and did it justify the surge in global markets?
Basically, the ECB pledged to purchase the sovereign bonds in the secondary market with the purpose of pushing bond yields lower. Here’s an excerpt of Draghi’s speech:
‘As we said a month ago, we need to be in the position to safeguard the monetary policy transmission mechanism in all countries of the euro area. We aim to preserve the singleness of our monetary policy and to ensure the proper transmission of our policy stance to the real economy throughout the area.
‘OMTs will enable us to address severe distortions in government bond markets which originate from, in particular, unfounded fears on the part of investors of the reversibility of the euro.
‘Hence, under appropriate conditions, we will have a fully effective backstop to avoid destructive scenarios with potentially severe challenges for price stability in the euro area.’
That’s the spin. The ECB wants everyone to think that high interest rates in some markets (Spain and Italy) are due to ‘unfounded fears on the part of investors of the reversibility of the euro’. That’s one interpretation. The other is that high sovereign interest rates are the markets’ way of saying that some countries have debt levels way above their ability to service and/or repay. The market is telling these countries to get their houses in order.
The ECB thinks that it has come up with a clever carrot and stick plan. The carrot is the OMT program, which pushes yields down and finances government spending where the market wouldn’t. This is the debt monetisation part. The stick is the conditionality of the bond buying. That is, if you want the ECB to monetise your debt, then you have to agree to austerity measures.
And assisting with the justification of the OMT program, the ECB reckons it will ‘sterilise’ any debt purchases it makes. That is, when it injects cash into, say, Spain’s economy, by buying Spanish government bonds
, it will remove the cash from elsewhere by issuing notes.
Now this all sounds pretty smart. The equity market loved it…although these days the market is happy to rally on the breath of a rumour, so we’re not too moved by the reaction.
The issue is that, once again, you have a bunch of bureaucrats/technocrats who think they are smarter than everyone else. They think they can re-jig the system to suit their needs. When something doesn’t work because of the pesky functioning of the market, they change the rules.
This provides a short term boost to confidence and asset markets. The announced policy seems so obvious and clever that you wonder why it took so long to announce. Formally insurmountable problems appear solved.
But are they really? Or does it once again push the problems down the road?
The Dallas Fed recently published a paper by former Bank of International Settlements bigwig William White, titled ‘Ultra Easy Monetary Policy and the Law of Unintended Consequences’. The paper begins with two quotes that seem very apt considering the recent events in Europe.
‘This long run is a misleading guide to current affairs. In the long run we are all dead. Economists set themselves too easy, too useless a task if in tempestuous seasons they can only tell that when the storm is long past the sea is flat again.’– John Maynard Keynes
‘No very deep knowledge of economics is usually needed for grasping the immediate effects of a measure; but the task of economics is to foretell the remoter effects, and so to allow us to avoid such acts as attempt to remedy a present ill by sowing the seeds of a much greater ill for the future.’– Ludwig von Mises
Central bankers and politicians believe wholeheartedly in Keynes’ quote. In the long run, before they are dead they are retired on full pension and benefits. Of far greater importance to them are the short term effects of their policies.
Take Alan Greenspan. He took Keynes‘ words to heart. He slavishly focused on the short run. He retired from the Fed Chairmanship in 2006, just a few years before the long run hit. He wasn’t dead at that stage, but he was busy disavowing himself of any responsibility for the global meltdown and making good money in the process. What a worm.
For Draghi, the long term is for losers. It’s all about the now. What will be the unintended consequences of the ECB’s latest measures? Who knows…but there will be some.
For one thing, it will probably lead to increased uncertainty and volatility as the carrot and stick program goes back and forth. How much austerity is required to qualify for bond purchases? What is the incentive for governments to lie about and fudge their reform programs, knowing the ECB will always be there as an emergency backstop?
Giving money to the profligates and taking it from the thrifty (via the sterilisation measure) is just another example of authorities distorting the market mechanism.
Ever since the 2008 crisis, the distortions have grown worse. The constant focus on the short term — to the next month, the next summit or the next election — clouds the fact that the long term looms. It is out there, and it will arrive.
The only one who will get out of this with any semblance of credibility is the head of the Bundesbank, Jens Weidmann. Following Draghi’s speech, the Bundesbank issued a statement.
‘He (Weidmann) regards such purchases as being tantamount to financing governments by printing banknotes. Monetary policy risks being subjugated to fiscal policy. The intervention purchases must not be permitted to jeopardise the capability of monetary policy to safeguard price stability in the euro area.
‘If the adopted bond-purchasing programme leads to member states postponing the necessary reforms, this will further undermine confidence in the political leaders’ crisis-resolution capability. This underscores the crucial importance of ensuring both credibility in the promised conditionality and the resolute determination to immediately terminate intervention purchases if the underlying conditionality is no longer assured.
‘The announced interventions in the government bond market carry the additional danger that the central bank may ultimately redistribute considerable risks among various countries’ taxpayers. Such risk-sharing, however, can be legitimately authorised solely by democratically elected parliaments and governments.’
Weidmann knows that debt monetisation, whether under the cloak of ‘conditionality’ or not, is going down the path of destabilising inflation. Because once you go down that path, there is no turning back.
Draghi has certainly won this round and Weidmann is most definitely ‘isolated’. Draghi took pleasure in making this quite clear at the press conference. He said the decision ‘was not unanimous … there was one dissenting view. I will leave you to guess who that was.’
Gracious in victory Draghi is not. But now it’s back to the Germans to respond. Germany’s Constitutional Court votes next week on the legality of the European Stability Mechanism. They’re expected to give it the tick, and Draghi will continue walking down the path most travelled.
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From the Archives…
The Pin-Up Stock of the Iron Ore Boom
31-08-2012 – Greg Canavan
How Australia Grew Fat and Lazy Off the China Boom
30-08-2012 – Greg Canavan
Why You’ll Never Change Our Mind About Inflation
29-08-2012 – Nick Hubble
The Make Believe World of Economists, Continued…
28-08-2012 – Bill Bonner
Iron Ore, a Love Story
27-08-2012 – Dan Denning