Among the questions still remaining since last week's summit of European leaders is whether the new measures will stabilise government bond markets. This column's answer is 'no'.
The focus of this column... is on the new role that is given to the European Stability Mechanism (ESM), otherwise known as its bailout fund, that should start its operations very soon. In addition to its conditional financial assistance to member countries, the ESM was given two new tasks.
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The first one... is that it will be able to recapitalise troubled banks directly.
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The second one is that it will be allowed to buy government bonds in the secondary markets so as to prevent further destabilising surges in bond rates.
These are eminently important objectives.
Surely something must be done about the inexorable rise in the sovereign bond rates of a number of southern European countries? These surges in the interest rates are only partly the result of bad fundamentals. For countries like Spain and Italy, a significant part of the increases in the spreads is the result of fear and panic in the markets that have the potential of driving countries into bankruptcy in a self-fulfilling way.
The question then is whether the
ESM will be able to stabilise the government bond markets. My answer is ‘no’.
Why the ESM will fail to stabilise government debt markets
The
ESM has financial resources amounting to €500 billion. Compare this with the total government bonds outstanding of close to €2,000 billion in Italy and of about €800 billion in Spain and it is immediately evident that the
ESM will be unable to stem a crisis involving one of these two countries, let alone the two countries together. In fact it is worse. As soon as the
ESM starts intervening, it will quickly destabilise the government bond markets in these two countries. The reason is the following.
Suppose a new movement of fear and panic, triggered for example by the deepening recession in Spain, pushes up the Spanish government bond rate again.
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To stem the tide the ESM starts buying Spanish bonds. Suppose it buys €200 billion worth of Spanish bonds.
At the end of the operation it will be clear for everybody that the
ESM has seen its resources decline from €500 billion to €300 billion. Less will be left over to face new crises.
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Investors will start forecasting the moment when the ESM will run out of cash.
They will then do what one expects from clever people.
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They will sell bonds now rather than later.
The reason is not difficult to see. Anticipating the moment the
ESM runs out of cash forcing it to stop its intervention, they expect bond prices to crash. To prevent making large losses, they will have an incentive to bring their bond sales forward to the present rather than wait until the losses are incurred. Thus the interventions by the
ESM will trigger crises rather than avoid them.
This feature is well-known from the literature on foreign exchange crises. The classic Krugman model, for example, has the same features. A central bank that pegs the exchange rate and has a finite stock of international reserves to defend its currency against speculative attacks faces the same problem. At some point, the stock of reserves is depleted and the central bank has to stop defending the currency. Speculators do not wait for that moment to happen. They set in motion their speculative sales of the currency much before the moment of depletion, triggering a self-fulfilling crisis.
Only the ECB can stabilise bond markets
The only way to stabilise the government bond markets is to involve the ECB, either indirectly by giving a banking license to the
ESM so that it can draw on the resources of the ECB, or by direct interventions by the ECB. But the European leaders were unable (unwilling) to take that necessary step to stabilise the eurozone.
The
ECB is the only institution that can prevent panic in the sovereign bond markets from pushing countries into a bad equilibrium, because as a money-creating institution it has an infinite capacity to buy government bonds. The fact that resources are infinite is key to be able to stabilise bond rates. It is the only way to gain credibility in the market.
The SMP is the wrong precedent
The
ECB did buy government bond markets last year in the framework of its Securities Markets Programme (SMP). However it structured this programme in the worst possible way. By announcing it would be limited in size and time, it mimicked the fatal problem of an institution that has limited resources. No wonder that strategy did not work.
The only strategy that can work is the one that puts the fact that the
ECB has unlimited resources at the core of that strategy. Thus, the
ECB should announce a cap on the spreads of the Spanish and Italian government bonds, say of 300 basis points. Such an announcement is fully credible if the
ECB is committed to use all its firepower, which is infinite, to achieve this target.
If the
ECB achieves this credibility it creates an interesting investment opportunity for investors. The latter obtain a premium on their Spanish and Italian government bond holdings, while the
ECB guarantees that there is a floor below which the bond prices will not fall. (The floor price is the counterpart of the interest rate cap.) In addition, the 300 basis points acts as a penalty rate for the Spanish and Italian governments giving them incentives to reduce their debt levels.
The
ECB is unwilling to stabilise financial markets this way. Many arguments have been given why the
ECB should not be a lender of last resort in the government bond markets. Many of them are phony. Some are serious like the moral hazard risk. The latter, however, should be taken care of by separate institutions aimed at controlling excessive government debts and deficits. These are in the process of being set up (European Semester, Fiscal Pact, automatic sanctions, etc.). This disciplining and sanctioning mechanism should then relieve the
ECB of its fears of moral hazard (a fear it did not have when it provided €1,000 billion to banks at a low interest rate).
What should be done?
The correct business model for the
ECB is one that has it pursuing financial stability as its primary objective (together with price stability), even if that leads to losses. There is no limit to the size of the losses a central bank can bear, except the one that is imposed by its commitment to maintain price stability. In the present situation the
ECB is far from this limit (Buiter 2008).
The creation of the European Financial Stability Facility (EFSF) and the
ESM has been motivated by the overriding concern of the
ECB to protect its balance sheet. This has been misguided. The enlarged responsibilities that are now given to the
ESM are to be seen as a cover-up of the failure of the
ECB to take up its responsibility of the guardian of financial stability in the eurozone; a responsibility that only the
ECB can fulfil.
© VoxEU.org
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