Can the European Central Bank solve the eurozone crisis on its own? The answer is clearly no. But without ECB intervention, the crisis is insoluble. So what should the goals of such an operation be? And how should this be accomplished?
I would consider three goals, subject to two constraints. The first and most important is to get rid of market expectations of a eurozone break-up. Whatever the ECB’s governing council decides on September 6, it must be big enough to squash expectations that Spain or Italy will leave the eurozone. A Greek departure is different. This program is not about Greece.
Second, it must be part of an overall resolution strategy. Mario Draghi is right to say that ECB support should depend on an official application for support. But this is when it gets tricky. How will the president of the ECB adjust his program if a country fails to meet the criteria? And who decides?
Third, he has to address the issue of investor subordination. If the ECB’s holdings are considered senior to those of other investors, it may never be possible to get private investors back into those countries.
But would an announcement that the ECB accepts equal rank, also known as pari passu, be credible? The ECB rejected participating in the Greek debt restructuring because it constituted a monetary financing of debt. This is illegal under European law. It is easy for the ECB to state that it ranks pari passu, but is it really prepared to take a hit in the event of a debt restructuring?
The European Stability Mechanism cannot indemnify the ECB for any losses. I would suspect that ECB legal constraints will ultimately outweigh the credibility of an informal pari passu pledge. There is a law against monetary financing of sovereign debt. There is, however, no law against lying.
Of the constraints, the first is political. If you push this too far, you may simply replace a southern European debt crisis with a northern European political crisis. The German establishment is already howling.
The second constraint is legal. A legal dispute, especially in Germany, could endanger the credibility of the operation. It is one thing for the Bundesbank to disagree with an ECB policy. It is quite another for it to say publicly that Draghi is breaking the law.
On Sunday, Jens Weidmann, the Bundesbank president, issued the sternest warning yet that he opposed large scale bond purchases. He said they came close to outright debt monetisation.
With those goals and constraints, what can and what cannot be done? I do not expect to see any explicit targets for interest rates, or for spreads, as some media reports have suggested. The markets would test any published target.
Also, what would they do if German interest rates rise? What if the guaranteed interest rate for a program country ends up being lower than the market interest rates of a non-program country?
A guarantee may also be too blunt an instrument to manage a conditional program. If a country fails to meet the condition, the only real sanction available would be to drop the guarantee and cause a massive financial and political crisis. A simple bond purchasing program may be easier to fine tune.
I suspect the ECB will endorse a conditional purchasing program, targeted at Treasury bills, perhaps also at bonds with a short maturity. There will be no explicit or implicit interest rate targets, but a promise of unlimited intervention. There will be a pari passu pledge of uncertain credibility. Unless I have misjudged the ECB’s room for manoeuvre, the program is going to be more modest than markets had hoped for.
Since the ECB is rightly concerned about the eurozone’s broken monetary transmission mechanisms, it might also consider the purchase of other debt instruments, including corporate bonds. A broadening of the program would have two advantages: it would help parts of the private sector directly and it would be less suspect legally. A broad-based program of quantitative easing would also be warranted because the economy has fallen back into recession.
Angela Merkel, the German chancellor, is on the side of Draghi in this debate. But if the German public reaction to ECB bond purchases is negative, the political support for this action might change.
An ECB bond purchasing program would form an important staging post in the resolution of this crisis, but it would be wrong to regard it as a magic bullet.
The eurozone crisis may look less acute once the bond purchases start but we have been through phases in the past where the crisis appeared to be receding, only to come back a few weeks later. Unless the program is accompanied by a swift move towards banking and fiscal union, it will not make a difference.
And that means it probably won’t.
Copyright The Financial Times Limited 2012.