Why Investors will buy Italian bonds after ECB monetisation

Disclaimer: These last three pieces on the impact of Italy’s potential insolvency on the sovereign debt crisis are not advocacy pieces. They are analysis – predictions of what I see as likely to occur.

Yesterday I wrote why questioning Italy’s solvency leads inevitably to monetisation. The long and short of it is that Italy is too big to fail. Too many undercapitalised European banks own lots of Italian sovereign government bonds for Italy to default without causing a major panic and a run on euro zone banks, massive bank failures and a major Depression. Even if the German, French, Dutch or Austrian governments were to step in and try to recapitalise their banks after an Italian default, I am not sure they could prevent a bank run. Moreover, German, French, Dutch and Austrian sovereign credit ratings would suffer considerable damage and questioning their solvency would begin as well. That’s what it means to have no currency sovereignty and no lender of last resort. This affects every nation within the euro zone.

I also wrote in conjunction with Friday’s video clip from RT “how I would provide the backstop”. The ECB would ‘guarantee’ a rate for Italian bonds that is high enough to be a penalty spread to Bunds – liquidity at a penalty rate – say 200 bps to German Bunds, which would be 3.8% on 10-year money. The ECB would not necessarily have to buy any BTPs to defend its target. The private sector “would do it” for the ECB via the language and confidence in the "guarantee". That’s how it works at the short end of the curve with the policy rate by the way and it is also exactly what the Fed did during the 1940s and 1950s; so we know ‘financial repression’ works. After an initial foray in the market to prove the credibility of the backstop and to ‘punish’ speculators, every speculator would blanch at going up against the ECB’s wall of liquidity for fear of insolvency. I added the part about speculators because that’s how policy makers in Europe think about this crisis.

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The point is that this is a moral hazard. The only way to credibly force countries within the euro zone to get onboard with fiscal tightening is fiscal integration. That’s why a future rump Euro will have it or be comprised of more similar national economies. In the absence of fiscal integration, you have these makeshift policies of moral suasion and empty threats. In Ireland, Portugal and Greece’s cases, the threats are more real because those economies are small. The ECB would not risk its anti-inflationary credibility to monetise the debt of smaller euro zone countries like Greece, Portugal or Ireland. However, Italy and Spain are too large to believe this threat is credible.

Now I don’t really think anyone who has run through the financial sector balances would claim fiscal integration or fiscal tightening is in the interest of Germany’s mercantilist trade policy since the euro zone is one giant vendor financing scheme. If the periphery tightens fiscally, this is unlikely to significantly reduce net savings in the private sector and is therefore, likely to have a big negative impact on German exports and economic growth. But what choice does the euro zone have? Either accept the fact that Germany must finance the periphery in order to sell their wares there or face shrinking export demand and economic growth. This is exactly the same dynamic we see between the US and China. Michael Pettis called it the “Dilemma over current account vendor financing”.

To sum up, the euro zone is in an existential crisis, brought on by fiscal, private sector and current account, imbalances in a fixed exchange rate environment lacking a lender of last resort. The morality of the economics of this situation are only relevant in regard to the economic nationalism to which these kinds of morality plays give rise. On the other hand, this arrangement necessarily means that some countries within the fixed exchange rate imbalance will eventually suffer a sovereign debt crisis due to the imbalances. Without a lender of last resort, such a crisis becomes existential as default is inevitable without at least an implicit backstop from the central bank. And sovereign default would inflict huge losses on sovereign creditors, cascading the insolvency down the line to the banks.

My conclusion: the ECB will backstop Italian (and Spanish) debt. What that means for Portugal, Ireland, and Greece, I don’t know.

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The likely impact of this kind of action is an increase in expected nominal GDP in the euro area. If these expectations don’t include an increase in future real GDP within the euro area, monetisation would lead to a rise in the euro-denominated gold and silver price, currency depreciation more generally, and increased inflation expectations. So, in that case, this could be considered a beggar thy neighbour economic policy – competitive currency devaluation, if you will. It may invite reactions from the US and other currency areas.

Is this kind of monetisation sustainable over the medium-term? 100%.

If a central bank guarantees investors credibly that they can invest in certain debt instruments and not suffer principal or interest repayment risk, but only currency and inflation risk, some investors are almost definitely going to buy the debt instruments with the greatest yield pick up. Put another way, the only reason not to buy Italian debt at 2 or 300 basis points over Bunds, or Greek debt at 3 or 400 basis points over Bunds is because those governments are not credibly backstopped by the ECB.

I should add that that is exactly why investors were in these bonds in the first place. It was only when the solvency issue came to a head that yields began to climb. Investors believed in convergence. They believed that Portugal, Ireland, Italy, Greece and Spain all had implicit backstops just as they believed Fannie Mae and Freddie Mac had them in the United States. In the US case, investors were right.

Does the ECB want to lose its trump card in dealing with Italy? No. That’s why they aren’t offering an explicit backstop. But if they don’t backstop Italy, Italian yields will remain elevated, Italy will default, all of the German and French banks with those bonds will be insolvent, and we will have a Depression. Italy is too big to fail.

If the ECB does backstop Italy credibly and fully, then yields will fall and investors will pile in again. However, this is nothing more than a temporary patch, a medium-term liquidity solution only. Clearly, the issue for the Dutch and the Germans is that Italy would have no reason under this arrangement to make reforms or move to fiscal consolidation. They fear Italy (and Portugal and Greece) would become permanent ‘free riders’, mooching off of Germany and the Netherlands’ fiscal probity, making the euro a weak currency. The right way to deal with that fear is to choose between greater fiscal integration or breaking the eurozone up at some point in the medium-term (say 2-5 years).

My conclusion: the ECB will eventually move to a lender of last resort role. The question is how much damage will be done before they do so.

Europe is already in a double dip recession and the sovereign debt crisis has already moved from Greece to Portugal to Ireland to Spain and now to Italy. Belgium, with its lack of a permanent government and 100% sovereign debt to GDP is next on this list. They would be followed by France and its implicit guarantee for a poorly capitalised banking system and Austria and its implicit guarantee for a banking system highly leveraged to central and eastern European debtors. Eventually, every country will feel the impact because a fixed exchange rate system with no lender of last resort is inherently unstable unless you have fiscal integration and/or compatibility.

The ECB’s backstopping Italy and Spain for fear of German and Dutch banks’ insolvency is like the Fed’s backstopping California and New York for fear of Bank of America, Wells Fargo, Citigroup and JPMorgan Chase’s insolvency. It is not a very palatable solution longer-term. Therefore, in the medium-term, the euro area will move to tighter fiscal integration. This may or may not include Eurobonds.

However, not all members will come along for the ride. Angela Merkel, admitting that leaving the euro zone is politically and legally possible during her commentary addressing the Greek referendum in Cannes, has already broken the taboo. Now everyone knows that it is possible to default, leave the euro zone and re-gain competitiveness in a move to a devalued currency. Given the lack of economic harmonisation in the euro area, some euro members will be forced to leave and choose this path. I predict that when Europe moves to change its constitution to include greater fiscal integration, it will also include explicit mechanisms for countries to leave the euro area.

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17 Comments
  1. Max says

    If the ECB guarantees Italian bonds, then there won’t be a spread, or at least not much of one. The difficulty is in maintaining a spread, not reducing it.

  2. Max says

    There is a way out for the Euro zone, although it’s unlikely to be implemented. That is for Germany to undertake a massive fiscal stimulus. This presents no risk for Germany since its bonds are implicitly backed by the ECB. This turns the moral hazard problem on its head: instead of worrying about Italy spending too much, you have to worry about Germany spending too much.

  3. Jo says

    +1 Max. In addition, Germany gonna be mighty pissed.

    Not going to happen friend – no sir.

  4. David Lazarus says

    Ed’s analysis is spot on. Each European nation has significant problems with their banks. Why the Netherlands has escaped any attention surprises me when it was the takeover of ABN AMRO that wiped out RBS. Austria has its east European problems. Sweden has its Baltic problems. Germany has problems everywhere. The problems are down to regulation arbitrage. No government wanted to be accused of holding its banks back, so allowed them to take on risks that they should never have even considered. In the end the only real solution is to write down these debts. If this means the end of the banks so be it. The state can then nationalise and break up the banks and restore banking services without the problems.

  5. ChrisBern says

    Excellent analysis Edward. I continue to think that the major wildcard, story, and political game-changer will be over the next few quarters when the pain of Europe’s recession starts to really hit its citizens via job losses and potential further drops in asset prices (e.g. real estate and equities). This will really test the resolve of the bailed out and soon-to-be-bailed-out countries to continue painful austerity and of the more fiscally sound countries to continue contributing capital to the EFSF, etc.

    For those citizens, this is a tragic situation, and as has been said many times over, there are no painless solutions to these issues.

    1. David Lazarus says

      I doubt that real estate will fall in countries that avoided the boom. It will exacerbate the problems in Ireland and Spain where there had been a housing boom which is still not fully deflated. In Ireland and Spain property could still fall further, that will hit lenders there.

      Further austerity will eliminate social cohesion everywhere. The problem is that the pain is not being administered evenly.

  6. Ed says

    Ed

    Always enjoy your thoughts. If in fact the ECB totally backstops the most important (indispensable) trading partners (Spain and Italy) of the exporting Euro zone countries then I believe you are correct that investors will buy those bonds. If you also believe that some of the profits of the Euro zone exporting countries were actually “phantom” ones in that they were selling under “vendor financing” to marginal credits who were backstopped a Euro Central Bank then I think that would need to be an important intellectual concept for say a Germany to accept in order to move forward. Under that scenario core exporters may concede the Euro had a too elevated value and would have normally been lower. Wouldn’t it also be in the “exporters” best interests to also have the Euro value lower to move to new export markets to replace demand from say a Greece or Portugal. Does not the ECB now also have a powerful and aggressive new Chairman who acted very quickly to easy policy, cheapen the currency and will continue to do so as required?
    You mentioned a reaction from the US. To the extent the unlimited ECB backstopping of Spain and Italian bonds increases the market value of those bonds then that takes pressure off of key Euro Zone Banks as well as American counter parties. That I would think would be welcomed by the Fed even if some attendant rise in the dollar would not. It would seem to me there would have to be some agreement between the ECB and the Fed that they would not compete in a race to the bottom, that the Fed would not attempt neutralize all USD strength from new ECB policy directives. Does that make sense?

  7. Jim says

    Edward,

    Assuming ECB monetization is sustainable over the medium term, what do you suspect might be the impact of debt monetization over the longer term? Debt monetization tends to have unhappy endings – so this is why I wonder.

    Also, what’s your definition of medium term? A year? 5 years?

  8. PLB says

    Ed,

    I don’t see how this monetisation scheme can work for much longer than 1-2 years nor do I see how Fiscal integration will solve the fundamental solvency issue here.

    Sure under your scenario domestic EZ investors will get all their principal and interest back but what about foreign investors, wouldn’t they suffer from the necessary currency devaluation as the ECB prints away. If so, when will foreign investors stop taking the bait? I think sooner than 2 years (as soon as the “veiled threat” has been lifted) and without foreign investors wouldn’t the ECB be like a watermill feeding leaking canals… it will break at some point.

    But, more importantly, this is an economic solvency crisis. Most of Europe’s economies are on a secular downtrend (negative demo/growth path, etc.) and any austerity program is bound to ignite social unrest and tax revulsion at this point… making any IMF-SAP imposed on the periphery laughable and insulting. So the EZ is a different situation than the GSEs (Investors believe the US still has room to grow)… I don’t see that in Europe and I don’t believe monetisation addresses that issue.

    You seem to believe that it will work for 2-5 years and then will necessarily lead to Fiscal integration… which you imply (am I mistaken?) is the savior of a reduced homogeneous Europe (France in?)…

    Aside from the negative economic impacts of such a reduced group (higher exchange rate, fewer export mkts, etc.) I have yet read a coherent paper explaining how Fiscal Integration would solve the negative demographic / growth trends in Europe. You?

    1. Edward Harrison says

      Three things:

      1. Calling this monetisation is a misnomer really. It assumes bond purchases. But the ECB would not necessarily have to buy any BTPs to defend its target. The private sector “would do it” for the ECB via the language and confidence in the “guarantee”. That’s how it works at the short end of the curve with the policy rate by the way and it is also exactly what the Fed did during the 1940s and 1950s. The Fed doesn’t have to do QE to keep rates low in the US. It doesn’t have to buy bonds at all.

      2. As I wrote in the piece, the only reason not to buy Italian debt at 2 or 300 basis points over Bunds, or Greek debt at 3 or 400 basis points over Bunds is because those governments are not credibly backstopped by the ECB. If you are going to be exposed to the euro zone, you can buy Italy just as easily as Germany, the difference mainly being the credit risk i.e. no ECB backstop. Will Italy fail and go bust, seriously?

      3.Monetisation is about price not quantity. QE and other quantity targets are misguided. You have to target a spread or interest rate for this to work – and you won’t have to buy up a lot of paper either. The likely impact of this is an increase in expected nominal GDP in the euro area. That doesn’t mean increased inflation expectations – especially if the ECB doesn’t continue to buy bonds.

      1. PLB says

        Sounds like a lot of smoke and mirrors in the case of the EZ… all the ECB needs to do is “guarantee” to be there if/when needed? And it can do that without incurring any costs whatsoever? And without Italy going through massive internal deval … meaning depression.

        I believe the Fed can do it because investors believe in the economic growth potential of the US. But Italy? Hmmm…

        1. Edward Harrison says

          So, you’re telling me you think investors also believe in the economic growth potential of Japan too, right?

          It’s not about what investors believe or don’t believe. The central bank is the monopoly supplier of reserves. They have an unlimited supply of money they can use to defend any debt instrument in the currency for which they have this monopoly. The central bank sets the rate and the markets adhere to it or get overrun by the central bank. It’s that simple.

          1. PLB says

            I agree with the liquidity powers of a sovereign currency issuer but I dont think it solves all the solvency issues, mostly for ageing Europe (although Japan is succeeding at just that for a prolonged period). Surely, expectations of future economic growth must have a bearing in investor decisions.

          2. Edward Harrison says

            If the CB is a lender of last resort, solvency is meaningless for a government borrowing in a currency its central bank creates. In a nonconvertible floating exchange rate world, the adjustment mechanism is the exchange rate, not the interest rate.

            http://pro.creditwritedowns.com/2011/10/currency-revulsion-2.html

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