The Last Man Standing
Which is a greater force driving volatility: uncertainty about whether the U.S. can get its budget act together or Europe’s future? I would argue that Europe poses a much greater risk -- and it is less understood in Canadian and U.S. markets. While it is frustrating that the U.S. is mired in partisan politics -- at least there are only two groups of players, Democrats and Republicans. In contrast, in Europe you have: 17 national governments, the European Central Bank, the European Financial Stability Facility, the Financial Stability Board, the European Council, the EU, the Institute of International Finance, the IMF, BIS, ... get the idea?
Let me try to navigate through the mess in Europe.
The SettingIs the European Central Bank program to buy sovereign debt illegal? What about the idea to leverage the EFSF bailout fund -- or create a Special Purpose Vehicle -- is that legal? How much leeway does the ECB have? What is the endgame?
It is a gross understatement to say the situation is fraught with uncertainty. To understand what is going on, you need to know the minutia of central bank macrofinance -and have legal knowledge of the multilateral treaties (especially the Treaty of Lisbon) and the constitutions of the 17 Eurozone members!
I will walk you through my way of thinking on this. The bottom line is that Germany is likely to be the last man standing. The Euro is important to them and the responsibility for saving it will be decided in Berlin - not Paris, Brussels, or Frankfurt. It will be messy and will involve revamping the main treaty - the Treaty of Lisbon.
The ECB's Securities Market Program (SMP)First, is the European Central Bank program to buy sovereign debt illegal?
The answer is yes and no.
- Yes. The ECB cannot purchase sovereign debt directly from sovereign entities (primary market). Hence, they cannot bailout Greece, Italy or others in buying directly from governments.
- No. The ECB is free to purchase on the secondary market. So for example, if a commercial bank purchased some Greek sovereign debt, the ECB through its Securities Market Program can purchase that debt.
The ECB has been quite active in that market and has purchased €186.848 billion as of November 11, 2011.These are called " Euro outright" operations. You can track the weekly operations here.
A little background. The Governing Council of the ECB established the SMP on May 9, 2010. The formal document is available here and is dated May 14, 2010.
Consider two excerpts from the preamble (my emphasis added throughout):
"...in view of the current exceptional circumstances in financial markets, characterised by severe tensions in certain market segments which are hampering the monetary policy transmission mechanism and thereby the effective conduct of monetary policy oriented towards price stability in the medium term, a temporary securities markets programme (hereinafter the ‘programme’) should be initiated.... The programme’s objective is to address the malfunctioning of securities markets and restore an appropriate monetary policy transmission mechanism."
It is pretty clear to me that the goal here is the conducting of monetary policy. In addition, the sole stated goal of the ECB is "price stability". This is a really important point. The U.S. Federal Reserve has two goals: price stability and full employment. The ECB only has the former goal.
Now consider Article 1.
"Under the terms of this Decision, Eurosystem central banks may purchase the following: (a) on the secondary market, eligible marketable debt instruments issued by the central governments or public entities of the Member States whose currency is the euro; and (b) on the primary and secondary markets, eligible marketable debt instruments issued by private entities incorporated in the euro area."
Now you see the restriction. They can only operate on the secondary market for government debt.
But how binding is this restriction?
Surely a local central bank can pressure one of its commercial banks (which might already be supported or partially owned by the government) to purchase sovereign debt. That debt could be flipped to the ECB through the SMP.
The View from the BundesbankThis is why the Bundesbank is very nervous about the actions of the SMP. Sovereigns can get around the technicalities. It is a stretch to characterize the recent actions of the ECB's SMP as ensuring liquidity and price stability.
There are two key items that any commentator needs to be aware of.
The first is the Treaty of Lisbon and, in particular, Article 123: (my emphasis)
"Overdraft facilities or any other type of credit facility with the European Central Bank or with the central banks of the Member States (hereinafter referred to as ‘national central banks’) in favour of Union institutions, bodies, offices or agencies, central governments, regional, local or other public authorities, other bodies governed by public law, or public undertakings of Member States shall be prohibited, as shall the purchase directly from them by the European Central Bank or national central banks of debt instruments."
The whole Treaty is here.
This is the "no bailout" clause. The Bundesbank sees this as an absolute. In addition, they view gimmicks such as commercial
banks flipping sovereign debt as a violation of Article 123. Indeed, another idea has been floated whereby the ECB lends money
to the IMF and then let the IMF bailout Greece, Italy and company. They view this as a violation of the treaty. Here is what
Jens Weidmann (Bundesbank President) recently said:
"...the crucial point is that the eurosystem is not permitted to lend to eurozone member states – no matter whether this is done directly or indirectly by using the IMF as an intermediary."
This is a must read interview. Read it here [you may need subscription to Financial Times].
In the same FT interview, Weidmann categorically ruled out interest rate targetting of sovereign spreads. He said:
"Fixing an interest rate for a country is certainly not compatible with our mandate. You would guarantee a certain refinancing cost for a government and you could not argue that this was not monetary financing.
The stated purpose of the SMP is to cope with dysfunctional markets and it’s not to ensure a specific spread for a specific country."
While I am citing Weidmann, another important read is his very revealing speech at a November 8, 2011 Deutsche Bundesbank conference. I refer to this as the
"sweet poison" speech. Consider the following excerpt: [the full text is available here]
"In conjunction with central banks’ independence, the prohibition of monetary financing, which is set forth in Article 123 of the EU Treaty, is one of the most important achievements in central banking. Specifically for Germany, it is also a key lesson from the experience of the hyperinflation after World War I. This prohibition takes account of the fact that governments may have a short-sighted incentive to use monetary policy to finance public debt, despite the substantial risk it entails. It undermines the incentives for sound public finances, creates appetite for ever more of that sweet poison and harms the credibility of the central bank in its quest for price stability."
The key points are:
- No "monetary financing" aka bailouts invoking Article 123
- This is a big deal if it is considered "one of the most important achievements".
- The specter of the Weimar Republic's hyperinflation is still fresh.
- The "sweet poison" is the belief that bailing out creates the wrong incentives.
There are some other interesting quotes. When talking about "leveraging" the EFSF by creating a Special Purpose Vehicle to invest in sovereign debt, Weidmann says: "an SPV buying government bonds – would be a clear violation of this prohibition" [i.e. the prohibition on monetary financing].
Finally, the endgame has two possibilities:
"While the first would be a return to the founding principles of the system, but with an enhanced framework that really ensures sufficient incentives for sound public finances, the second way would imply a major shift entailing a fundamental change in the federal structure of the EU and involving a transfer of national responsibilities, particularly for borrowing and incurring debt, to the EU."
The possibilities are:
- Get back to where we started (all countries on side with debt to GDP and deficits to GDP - Note Greece was never on side because the data they submitted in their application was bogus). However, change the system to provide "sufficient incentives" aka non-negotiable sanctions to keep the system in equilibrium.
- Major change in the structure such as an outright fiscal union.
Wiggle Room at the ECB?Gavyn Davies' excellent blog at FT argues that there is wiggle room (my words not his). You can read it here. He cites the Protocols in the Treaty of Lisbon. In particular, Protocol 4, article 20 which reads:
"Other instruments of monetary control The Governing Council may, by a majority of two thirds of the votes cast, decide upon the use of such other operational methods of monetary control as it sees fit, respecting Article 2. The Council shall, in accordance with the procedure laid down in Article 41, define the scope of such methods if they impose obligations on third parties."
The full text of the Protocols is here.
This seems to imply that by a two thirds vote of the Governing Council the ECB could do just about anything as long as it was consistent with price stability. It is a substantial loophole. In addition, Davies points out that there are no mandated "limits" to the buying and selling of securities. However, I am convinced the Bundesbank would not see it as a loophole.
However, I think there is an even more substantial loophole. Consider this one:
...the primary objective of the ESCB shall be to maintain price stability. Without prejudice to the objective of price stability, it shall support the general economic policies in the Union with a view to contributing to the achievement of the objectives of the Union as laid down in Article 3 of the Treaty on European Union.
- Price stability is the "primary" objective - but not the only objective.
- Notice the words "shall support the general economic policies"
Again, I don't think the Bundesbank would agree with this interpretation. Nevertheless, some could make the case for the support of general economic objectives - as long as it was not inconsistent with price stability.
The Federal Constitutional CourtIt is reasonable to think that there are differences of opinion between the President of the Bundesbank, the Chancellor and others in Germany. However, it is very important to understand that Germany is bound by its own constitution.
A key guidepost is the Federal Constitutional Court's decision of September 7, 2011. In this case, arguments were made that aid to Greece and the Eurozone's rescue package (EFSF which will become the ESM in 2013) were constitutionally illegal. The argument was rejected and the rejection got the press. It was characterized as a victory for Chancellor Merkel. However, you need to read the fine print.
While the complaints were rejected, the Constitutional Court laid out a list of what was unconstitutional. I will quote the English translation of the press release which is available here.
First, you cannot decrease the current or future power of the Bundestag. The Court said: "Article 38.1 GG protects competences of the present or of a future Bundestag from being undermined." In other words, it is a problem to enter into an agreement that fundamentally diminishes the power of the Bundestag, either today or in the future. The Court also reiterates Articles 20.1 and 20.2, Article 79.3 GG which make it clear that decisions on revenue and expenditure of the public sector remain in the hands of the Bundestag. This is so important that the Court uses the words " fundamental part of the ability of a constitutional state to democratically shape itself."
Second, and this is the key passage:
"When establishing mechanisms of considerable financial importance which can lead to incalculable burdens on the budget, the German Bundestag must therefore ensure that later on, mandatory approval by the Bundestag is always obtained again. In this context, the Bundestag, as the legislature, is also prohibited from establishing permanent mechanisms under the law of international agreements which result in an assumption of liability for other states’ voluntary decisions, especially if they have consequences whose impact is difficult to calculate."
This says that any agreement that has large fiscal implications must go back to the Bundestag.
It is unconstitutional to impose permanent facilities to bailout states that are in trouble because of their own actions. Here it is important to draw the distinction between "voluntary decisions" (Greece spending too much) and other circumstances, like a natural disaster.
So the EFSF is OK because the liability to Germany is limited by the amount of their contribution. This also explains why the Bundesbank President said that targeting a yield spread was illegal. It is hard to determine how much funding it would require to maintain that target.
Again, the EFSF and ESM are OK because there is clear limit on the amount committed and the limit is feasible for Germany. Most of the press reports focused on the fact that the Court mandated that the Budget Committee of the Bundestag needed to approve new committments.The Court said that section 1.4 of the Euro Stabilization Mechanism Act was unconstitutional because it said that government only needed to "strive to reach an agreement" with the Budget Committee. The Court said agreement was manditory.
My point here is that the German Constitution substantially restricts the types of actions that the ECB, EFSF or ESM can take. In addition, it seems extremely unlikely that a constitutional amendment could be passed that effectively allows Germany to bailout failed states by monetizing their debts.
One Last Big One Under the Radar ScreenFrankfurter Allgemeine had a fascinating story last week on the TARGET system. TARGET is the short form for the Trans-European Automated Real-time Gross Settlement Express Transfer System. I did not see this picked up in the North American press. To read the story, you will need to translate the page here.
TARGET is the system that is used for payments among banks. The latest version of this system went live in November 2007 and is called TARGET2. This is a European system rather than a Eurozone system.[Note that Sweden and the UK do not participate]. An overview can be found here. The system is very similar to the FEDWIRE system in the U.S. In the U.S., the members (regional Federal Reserve Banks) settle twice a year.
All this is routine -- except Germany has racked up a €465 billion balance - they are essentially providing massive credit to Ireland, Greece, Spain, Portugal and Italy -- this is backdoor funding of these troubled countries. For an interesting analysis of TARGET2, read John Wittaker's paper here. There is also a good FT piece here.
In my opinion, it is up to Germany to save the Euro. Unclear is the way that it will unfold. The EFSF does not have the firepower - even with leverage - to deal with the fallout. It is also case that the ECB is severely constrained. It is unrealistic to think that they can act like the U.S. Federal Reserve did during the 2008-2009 financial crisis.
In addition, with the problems spreading all over Europe, the credit worthiness of the EFSF is questionable. Frankly, who is going to be contributing among the big four? Not Spain. Not Italy. Maybe France but they would surely lose their AAA status as a result (though they will likely lose it anyways).
It really comes down to Germany. In particular, bilateral actions. Forget the multilateral actions that take over a year to be approved by 17 national legislatures.
However, bilateral assistance will come at a cost. I believe that the first option mentioned by the Bundesbank president is the most viable. A revamp of the Treaty of Lisbon to give it some teeth. I have said in previous blog postings that there must clear penalties, including possible expulsion from the Eurozone, for violators of the Treaty. There can be no exceptions.
Indeed, there is a logic to excluding Greece. They will be the example of what could happen.
There will be no more kicking the can down the road. You will notice fewer consultations between Merkel and Sarkozy. It will be Merkel calling all the shots.
The changes in the Treaty would be very controversial under usual circumstances. However, in a time of crisis, they are easier to push through.
This will be a meaningful step towards a fiscal union - but a full fiscal union will have to wait.
Can Germany afford it? German debt/GDP is forecast to be 81.7% of GDP in 2011 -- not much different from France's 85.4%. [See page 36 here.]
German GDP is €2.5 trillion [data here]. Importantly, almost half is due to exports. If the Euro falls apart, a new German currency would substantially appreciate. This could put half of the exports at risk. So a ball park (one year) cost of lost exports might be about €600 billion (in today's currency terms). You might argue that this barely covers Italy's rollover next year. However, it is naive to think that all of the Italy debt has zero value. That is, €600 billion can go a long way.
German decision makers need to weigh the cost of a broken Eurozone versus the cost of keeping it together. Importantly, keeping it together cannot not mean more of the same. A new Eurozone model must be shaped by lessons from the current debacle.
p.s. The coin featured at the beginning is a Roman "Drachma".