Setting a European time bomb

Published in Business Spectator (Melbourne), 10 August 2011

The announcement by Standard & Poor’s to downgrade US government debt may have been historic but largely inconsequential, as Alan Kohler pointed out (Wall Street calls a code blue, August 9 2011). In contrast, the European Central Bank’s (ECB) decision to purchase Italian and Spanish government bonds is both historic and hugely significant. It’s a real game changer. Last weekend, the eurozone finally morphed into a giant, undemocratic and unaccountable transfer union. The ECB has turned itself into a financial time bomb, which will eventually wreck the continent.

The move to purchase Italian and Spanish paper is not without precedent. In May 2010, coinciding with the first Greek bailout package, the ECB started its Securities Markets Programme. This soaked up Greek, Irish and Portuguese debt – and thus debt from smaller, seemingly more manageable economies. But even back then the move was controversial and ultimately resulted in the resignation of the German Bundesbank President, who had publicly opposed the programme since its inception (Farewell to Europe’s old guard, February 17 2011).

The new move to extend the intervention in sovereign debt markets to the much bigger economies of Spain and Italy is of a completely new quality than previous ECB efforts. Initial purchases of Italian and Spanish debt may have been timid, perhaps as little as €5 billion. In the coming weeks, however, markets are surely going to test the ECB’s resolve to keep yields on Italian and Spanish bonds low. This could see a rapid expansion of the programme.

Already economists like Nouriel Roubini are calling on the ECB ‘to go nuclear’ and soak up half of Italy’s and Spain’s public debt – an operation that would cost just under €1 trillion. It’s money that would have to be created out of thin air because there are no such reserves at the ECB.

If the experience of previous ECB interventions is anything to go by it is only a matter of time until we see larger-scale ECB operations, potentially accompanied by a European Financial Stability Facility (and later European Stability Mechanism) bailout. This is how it happened in the cases of Ireland and Portugal. ECB measures have always been announced as ways to prevent further, more costly rescue packages. The strategy never worked because in the end we got both. It won’t work this time, either.

It is remarkable how far the ECB has now moved from its initial Bundesbank-like philosophy of independence and monetary stability. These were not just soap-box oratories but supposedly law. The EU Treaty defines the ECB’s role very clearly: “The primary objective of the European System of Central Banks [the ECB and eurozone central banks] shall be to maintain price stability.” And the ECB “shall be independent in the exercise of its powers and in the management of its finances. Union institutions, bodies, offices and agencies and the governments of the Member States shall respect that independence.” If only!

Maybe the ECB somehow manages to conform to the letter of the law. It certainly doesn’t to its spirit. They are trying hard to keep up appearances though. In Sunday’s press release the ECB seriously claims that buying Italian and Spanish government bonds was required for “restoring a better transmission of our monetary policy decisions” in order to – wait for it – “ensure price stability in the euro area”. Printing money has never sounded more prudent.

What is also new about the ECB’s policies is that divisions within its Governing Council have never been as visible. The first public departure from ECB unanimity was when then Bundesbank chief Axel Weber voiced his dissent over the purchase of Greek debt in May last year. Today, however, there are deep divisions between the different nations represented on the Council. The fault line runs between countries currently or potentially in need of help (the majority) and those having to provide that help (a small minority led by the Germans). It is not difficult to guess which side always has its way. The Germans must have been stupid to subject themselves to such decision-making that makes them the default losers.

Markets were quick to understand who were the winners and who were the losers of Sunday night’s ECB announcement. On Monday morning, the German stock market crashed – while the bourses in Milan and Madrid were celebrating big gains. Market participants knew that Italy and Spain could now look forward to future transfers; and they also knew where these payments would come from.

It is remarkable how such huge shifts in public policy could have been achieved without a single member of any European parliament ever voting for it. As it appears, some conversations between ECB officials and heads of government suffice for the biggest change in the shape of the EU. While small policy amendments can take years in Europe, revolutionary moves are always presented as a fait accompli.

Worst of all, not even the ECB’s coming interventions will solve any of Europe’s problems. It is just another way to postpone the inevitable and kick the can down the road, as Thilo Sarrazin warned last week (Hitting pause on the eurozone crisis, August 4 2011). Italian and Spanish competitiveness will not improve simply by passing on their debt to the ECB. In fact, the lower yields will undermine efforts to restore their public finances. It is hard to understand in any case why Italy is seemingly unable to refinance itself at 6.2 per cent yields as reached last Friday when Italian yields before the introduction of the Euro were regularly above 7 per cent.

The ECB’s move is just an exercise in buying time. In doing so, it will turn the ECB, already over-loaded with potentially toxic paper, into a massive bad bank. Sooner or later, it will require to be recapitalised by those European governments that still manage to remain solvent in the coming economic crisis. Unfortunately, by then the liabilities on the ECB’s book may already be too large to be borne by anyone.

Not that voters in potential donor countries like Germany, the Netherlands and Finland would be ready for this. What they had been promised was an independent central bank committed to price stability; no trans-European bailouts; and no monetisation of government debt. What they got in each case is the precise opposite. It is inconceivable that, say, German voters will let measures pass which would cost them tens of billions each year in perpetuity for the benefit of the eurozone fringe.

Europe has arrived at the crossroads. It can either go down the path to full-blown fiscal union – and the ECB is clearly ready for it. Or, preferably, it must end the Euro experiment now before any further damage is done. The Germans should leave the fringe countries with the carcass of the Euro – and reintroduce the Deutschmark. It’s the only chance to avert an even greater European debt disaster further down the track.