A Tale of Two Marios, Part Deux

I believe that one critical problem at the moment is that financial markets and the political class are still talking past one another. Given the levels at which they are trading, we can assume that financial markets, conditioned, like Pavlov's dog, by 30 years of the Greenspan put, fully expect the ECB to come out with these kind of tough-talking statements, but are convinced that, one policymakers see the gravity of the situation, they will open the spigots and begin financing the Italian state. However, I see the prospect of a much darker scenario emerging - I think there is a very strong possibility that the ECB will refuse to step beyond its mandate to finance Italy (or at least, will refuse to do so until it's too late, which amounts to the same thing). The main reason for this is that the ECB has been trying to tell us, in as plain a way as central bankers can manage, for some time, "our mandate is price stability; we cannot finance government borrowing - it would require treaty change". In short, the ECB, genuinely or not, is arguing that such action would be illegal - it is deliberately painting itself into a corner. Why would it tie itself to the mast like this if it were not serious - it is one thing to say "We won't do this", but quite another to say that "We can't do this, it's illegal". I think the ECB is trying to tie its hands to provide a credible signal to the market, and the politicians, that they had better sort this mess out, because they will see no help from the central bank. The market, however, knowing that the ECB is the Bundesbank in drag, has discounted this, as I said above. The irony of this, of course, is that we are currently in a state where a simple statement by the ECB that they are prepared to spend say, €2 or 3 trillion euros buying peripheral bonds as neccessary would solve the problem, combined with the anticipated supply-side reforms in Italy, and (hopefully) Spain. Italian bond yields would go to 400 bps instantly. Every day that passes, however, brings us closer to that time when the market will simply take borrowing costs out of Italy's reach entirely (and it will happen very quickly, probably sooner than we think). By that time, we may then reach a situation whereby the entire eurozone banking system will be effectively insolvent (already some French banks have difficulty borrowing in dollars). Italy may well be Europe's Lehman - the spark that lights the powder keg to spread contagion across the continent and the world. The problem, then, is that by the time that the ECB realises it is the only institution that can act, and the euro itself is collapsing before its eyes, it may be too late.

A Tale of Two Marios

It seems pretty clear over the past week or so that the fiscal bailout plan for Italy I described in my previous post is dead in the water. Germany and the more fiscally stable northern eurozone members (a shrinking number) will not countenance essentially unlimited aid, even if they could afford it without damaging their own credit rating, which, considering Gavyn Davies estimates Italy will need €750bn in financing over the next 3 years, they likely couldn't anyway. Short of full fiscal union (and with an 85% Eurozone debt/GDP ratio, would even that solve the problem?), there will need to be a monetary solution. Worryingly, however, new Bundesbank President Jens Weidmann re-emphasised in a (rather shocking) interview over the weekend that the ECB could not intervene since monetary financing of governments is prohibited by Article 123 of the Lisbon treaty. The interview betrays a quite spectacular lack of appreciation from the monetary authorities regarding the scope of the crisis. Mr Weidmann appears to believe it is a little local difficulty. He opens the interview by saying that "For me, the eurozone as a whole is not at stake" and that "the seriousness of the (sovereign debt) crisis is apparent, but it is not a crisis of the euro", which is nice - I'm sure we all feel much more reassured now. He goes on to explain that "We need a debate now over the future architecture of the monetary union", which indeed we do, but can I suggest that perhaps the bigger issue, Jens, is that the eurozone economy is trundling toward a catastrophe with our eyes closed because the central bankers and politicians are still being either small-minded or willfully ignorant. But Herr Weidmann goes on to say that , the Greek problem is one of simply implementing the 'adjustment path' (the austerity measures), that have been agreed, and "market turmoil comes from the fact that this implementation has been questioned - and not because the plan is not credible". He is apparently oblivious to the fact that maybe, just maybe, the lack of credibility comes from the fact that no-one with eyes and a brain seriously thinks Greece is going to put up with a decade of vicious austerity measures in order to put themselves in the situation that Italy is now in, with debts that are merely very large rather than totally overwhelming. I think Mr. Weidmann is employing the 'see no evil, hear no evil, speak no evil' model of economics, which involves closing your eyes, sticking your fingers in your ears and repeating ad infinitum "If I don't acknowledge it, it doesn't exist". To address his point about Article 123, however - why, if it is the legality of the situation rather than the fear of inflation that is tying the ECB's hands, is the ECB not being more proactive in looking for ways in which it can help the situation, rather than aggravate it by continually declaring "nuffin' doin', guv". To those who say that the ECB will be preparing, behind the scenes, to do whatever they can if a crisis blows up, but doesn't want to make the situation worse or let spendthrift governments off the hook, I will say this: The crisis is already here - the ECB needs to show it actually has a grip on the situation or the crisis will become a self-fulfilling prophecy - and they are already making the situation worse by acting as if nothing is wrong. There are times to say "don't frighten the horses" and others to say "damn the horses, all hands to the pumps". Everyone apart from the central bank has realised that we are now in the latter situation. Monday's idea from the FT was for the ECB to lend to the IMF, which would then assume the credit risk of lending to European sovereigns, but not a peep has been heard from Brussels, Frankfurt, Paris or Berlin or the matter. Reading Mr. Weidmann's interview, one increasingly appreciates how Alice must have felt when she stepped into Wonderland. I can only think that Mr. Weidmann is the mad hatter...