We at Argonaut have consistently argued that the Euro-zone was uniquely vulnerable to a sovereign debt crisis – not because of high levels of debt and fiscal deficits – but because there was no central bank buyer of sovereign debt as a last resort. No sovereign should ever default on debt denominated in a currency which its central bank can print. But within the Eurosystem it is the ECB which controls the printing presses, not the national central banks. As a result, Euro-zone sovereign debt has credit risk which simply does not exist in for example the UK or the US. Euro-zone countries could default because they borrowed in a currency they could not print. Denied access to the printing presses the Euro could be seen as the modern day equivalent of the 1930s gold standard: ultimately condemning all of its members to a deflationary bust.
Since the Euro-zone sovereign crisis began its politicians have been painfully slow in grasping this fundamental flaw in the Euro. Summit after summit focused on the building of “firewalls” none of which would ever have sufficient “firepower” to impress markets. The latest attempt, the European Stability Mechanism (ESM), with a theoretical capacity of €500 billion compares to current peripheral debt outstanding of €3.5 trillion. The alternative solution of “Eurobonds” was equally flawed. Had Germany been prepared to accept the unlimited liabilities of her Euro-zone partners, this massive additional credit risk would soon be priced into bunds. In other words, instead of lowering overall borrowing costs, Eurobonds would likely to have the opposite effect, with the periphery infecting the core. Only the ECB, with its ability to create new money, could possibly have the firepower to save the Euro.
Hitherto the ECB has been reticent about buying Euro-zone sovereign debt. There are good reasons for this. If the ECB was seen to finance the fiscal policy of individual Eurozone countries then there would be little incentive for sinning countries to reform and balance their books, or indeed for the non-sinning countries not to sin. This however did not stop the ECB introducing its Securities Markets Programme (SMP) in May 2010 which has to date purchased €211bn of Greek, Portuguese, Irish, Spanish and Italian government bonds. The SMP was always a controversial policy tool within the ECB, leading to the resignation of Bundesbank representatives Axel Weber (February 2011) and Juergen Stark (September 2011). As a result ECB sovereign bond purchases have been small in comparison to the size of the Euro-zone economy (2% GDP) and the amount of peripheral debt outstanding (6%), particularly when compared to the size of the purchases made by the Federal Reserve (16% of US GDP) and the Bank of England (25% of UK GDP) (see Figure 1). Although the SMP has never officially been deactivated, since Draghi took over as ECB President, it is yet to make any purchases.
N.b. ECB’s bond purchases were sterilised so were not technically full QE
Source: Argonaut, IMF
Draghi’s comments last week that the ECB would be prepared to resume government bond purchases in the secondary market was therefore a welcome development. In addition, he promised that bonds bought by the ECB would not rank senior to those privately held (a key flaw in the failure of the original SMP to comfort private creditors); that bond purchases need not be sterilised (i.e. they could be funded by new money created rather than by excess bank liquidity); and that they could be theoretically unlimited. Furthermore, by making ECB purchases conditional on governments having previously requested EFSF/ESM assistance and willing to undergo fiscal reform programmes and by focusing purchases on shorter duration maturities, moral hazard concerns could also be legitimately addressed. In short, the ECB would seem to have finally accepted that QE is the solution to the Euro-zone sovereign crisis, albeit within a sensible framework of conditionality.
It is of course not yet clear whether Spanish and Italian governments are prepared to request EFSF/ESM aid and agree to more austerity under fiscal reform programmes. Such programmes would probably in the short term result in deeper recessions which their electorates may not tolerate. Moreover, with the exception of objections by Bundesbank President and ECB member Jens Weidmann, dissent from Draghi’s new plans seems surprisingly muted so far. Without unity in the ECB and across the Euro-zone’s governments, financial markets may doubt the willingness of the ECB’s to sustain unlimited purchases of peripheral sovereign bonds. It is also not clear how any losses from bond purchases would ultimately be funded. For now the Euro-zone finally has a plan which can prevent a deflationary bust. The crisis cannot be said to be “solved”, but taking the Euro-zone off the modern day gold standard would be a good start.
Founding Partner & Fund Manager