23 August 2012

Yanis Varoufakis: The three conditions for the ECB to cap spreads successfully - and why they will not be met

That the ECB can, if it wishes, impose a ceiling on interest rates and/or spreads, there is no doubt. Just as the Central Bank of Switzerland imposed a cap on the franc’s exchange rate, in relation to the euro, so can the ECB implement an automated system that activates ‘buy’ orders for eurozone government bonds whose yields climb above a certain level. For this to work, however, three are the conditions:

1. First, it must be common knowledge that the ‘buy’ orders will not be discontinued before the cap threshold is attained. (Otherwise, speculators are offered a golden opportunity to beat the ECB at a game of its own design.)
2. Secondly, the threshold for each Member State must be common knowledge. (Otherwise, much speculation and many financial resources will be wasted while the asymmetric information is turned symmetric.)
3. Thirdly, there must be no conditionality. (Otherwise, speculators will place bets against the ECB’s automated purchasing strategy which will pay off if the said Member State fails to meet its ‘conditions’).

Summary

Markets are buoyant these days. This is so because of a powerful rumour that the ECB is about to cap Italy’s and Spain’s spreads. Such optimism is, tragically, unfounded on the facts and guaranteed to yield disappointment very soon. The three conditions outlined above, without which the thresholds will fail, cannot be met in a manner that is consistent with the currently prevailing paradigm...

Where does this leave us? The answer is: In a world where the ECB Council continue to dither, dawdle and evade. What will this mean in practice? At best, the ECB will step into the eurozone short-term debt market suppressing the spreads in three month T-bills. At most, it will cap one-year bonds too, but in a manner that lacks transparency and long-term legitimacy. By enabling Italy and Spain to roll over their short-term debt, the ECB will buy Berlin and Brussels another six months or so. Just like it did with the LTRO. The difference, however, this time is the mountain of great expectations that Mr Draghi has created. When the markets realise how far short the deeds fall vis-à-vis the words, the ECB will discover that the eurozone’s yields (which it wants to contain) have become more twisted than our politicians nickers. While ECB action will keep short-term borrowing costs relatively tight, 10 year bonds will diverge more than ever. In short, Mr Draghi’s “and believe me, it will be enough” is more likely than not to come to the same grief that M Trichet’s “place no bets on a Greek debt restructure” did a year ago. Make no mistake: The Euro Crisis will not be resolved through the actions or decisions of the current ECB Council.

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© Yanis Varoufakis