Easing Europe’s woes after failed Bund auction
Does a failed Bund auction last month reveal serious investor concerns about Germany’s credit fundamentals if treaty changes lead to closer fiscal union and put it on the hook for the periphery’s debts?
Perhaps that’s reading too much into it. Had yields, driven down by Bunds trading for so long as the eurozone’s last safe haven, been just a few basis points higher, investor interest might have been much stronger.
Yet after weeks of outspoken opposition to more aggressive ECB intervention in troubled government bond markets, policymakers at the Bundesbank and in the German government now see a clear warning sign. The Bundesbank had to buy bonds to prevent an outright auction failure. Last month, contagion spread from the periphery to the core of Europe, as not just French and Italian but even Dutch and German bond markets weakened.
Mario Draghi has called for urgent action by politicians to restore market confidence and to encourage other investors to buy government bonds. However, by emphasizing repeatedly that the ECB’s own buying under the Securities Markets Programme is temporary and limited, he and his predecessor as ECB president have limited its effectiveness.
Maybe the ECB thinks this policy is working well. Government bond yields have risen to the point where politicians finally realize the seriousness of the situation. New governments in Italy, Greece and Spain are making early efforts to consolidate public finances and will, hopefully, follow these up with credible structural reforms to improve competitiveness. The ECB might be congratulating itself that its bond buying through the SMP has been just sufficient to prevent outright financial catastrophe but limited enough to avoid moral hazard. This is a very narrow glide path to success.
And what happens next, if eurozone governments take what the ECB considers the correct steps and yet investors continue to abandon the government bond markets? Banks and fixed-income fund managers are working down exposures and won’t easily be tempted back; market makers are withdrawing, leaving bid-offer spreads to widen and markets to gap up and down in price.
Next year, governments have big volumes of financing to do on the primary markets and might lock themselves into an inescapable debt trap if they have to complete it at very high spreads. Italy might have passed the point of no return already.
One answer might be for the ECB to begin quantitative easing in the name of monetary policy transmission to stave off deflation, rather than of capping government bond yields or anything else that smacks of financing governments.
After all, the traditional offset for tightening fiscal policy, which is what the ECB wants, is looser monetary policy, and ECB policy rates are low already. Moreover, the transmission mechanism through government bond markets is even more broken this month than when the ECB first began buying government bonds in May 2010. Extraordinary measures are called for.
Presentation is important to the ECB, which fears legal challenges – as well as lost credibility over inflation fighting – to any action that smacks of funding governments directly. The ECB could change tack and intervene in government bond markets if a majority on the governing council votes in favour. The votes of the Bundesbank and its Dutch and Luxembourg allies carry no extra weight to block this. However, the question has been asked whether individual national central banks might even refuse to implement ECB decisions that appear unlawful under the founding treaty. QE offers a way past this.
Rather than just targeting the periphery under quantitative easing, the ECB would probably have to buy across a representative sample of the eurozone government bond markets, perhaps based on its own capital key, which heavily weights Germany and France. If it was feeling a little cheekier, it might propose buying according to a European government bond index that would give greater weight to Italy.
For the ECB to enact a policy of quantitative easing, the economic outlook would have to appear grave indeed. The central bank would also require abundant political cover, including an undertaking by the council of ministers to indemnify it against losses born when undertaking extraordinary monetary policy measures.
It would also help if national governments were locked, either by new treaty obligations or, more likely, by memoranda of understanding with the IMF, into budgetary discipline.
The experience of the Bank of England suggests that if the policy of quantitative easing works and if it restores market confidence – even as debtor governments consolidate finances and enact structural reforms to boost growth in the longer term – then the ECB might even make a profit.