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As I have already noted in my analysis of Mr Mario Draghi’s speech on August 2, the ECB may at any time place an upper limit on the yields of Spanish and Italian bonds. An arbitrary maximum limit will be set on the absolute rate of interest or on the interest rate spread vis-à-vis benchmark German sovereign bonds. Either way the idea is for the ECB to buy as much Spanish and Italian bonds as necessary –unlimited that is– to influence the yield curve, so that borrowing costs may become more affordable for these governments.
The trick is that the ECB may only do so for short-term bonds, with maturities of maximum up to 1 year. The main reason for that is that it is easier for the ECB’s shrewd lawyers to justify such a programme as part of an ordinary operation to maintain price stability across the euro area by keeping money markets liquid, given that these short-term bonds are close to such markets.
It therefore allows for the broad interpretation of the ECB’s mandate, or for the exploitation of the “gray zones” within the mandate, to justify such a monetary expansion while remaining legal; whereby the term “legal” has practically lost its meaning in this eurocrisis if we come to think of all those “clauses” that have been repeatedly violated by all sides involved.
The second and perhaps most important reason why the ECB will only focus on short-term yields, is that it cannot possibly influence the longer-part of the yield curve. In simple terms, if investors remain highly uncertain that Spain or Italy will be part of the euro zone in 3, 5 or 10 years; or perhaps that there might not even be a euro zone by that time; they will refrain from investing, for there is a high convertibility risk involved, i.e. a risk that investors will lose part of their expected returns as national currencies are re-introduced – de facto writedowns. Whereas in the short-term such concerns are indeed less significant, at least with things as they currently are.
In theory such an operation may be conducted at any time, however in practice there are many issues which raise concerns. Professor Varoufakis has argued trenchantly for the following three conditions:
- 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.)
- 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.)
- 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’).
While I agree with these conditions and with the thesis of Dr Varoufakis that the ECB will not be as audacious as the emphatic rhetoric of Mr Draghi had suggested; I do believe that the ECB will nevertheless proceed to the implementation of a programme along the lines of yield targeting, in a narrow-sighted, clumsy effort to keep interest rates artificially low, so that steps towards a banking and fiscal union may be made by policy-makers. The idea therefore being to extend and pretend a little bit longer, in hope of some magical shift in spirit among investors, as the new regulations take place. Complexity over complexity, the standard opaque EU legal practice, will allow officials to keep investors confused as the new institutions are set in place. Though some might venerate these efforts as rational attempts to defend against “market attacks” (markets do not and cannot attack), the fact is that the particular and the general roots of the crisis will not be addressed at all.
It must be made clear that capping interest rates is a policy that addresses the symptoms of the problem, not the problem per se. Rising yields are caused by the uncertainty of investors in the very integrity of the euro zone on one hand, and on the willingness of national governments to restructure all those policies which either led to excessive deficits/debts or which facilitated the creation of bubbles in the pre-crisis years. For as long as these issues are not dealt with, all that a short-term yield targeting will achieve is the further distortion of the capital structure, as more liquidity will be channeled into state coffers instead of the real economy. Production will be bereft of funding, as money will be used to sustain toxic debts. This is the exact opposite of what ought to be done.
Putting all concerns aside and focusing on the present, it must be mentioned that the plan which has been gradually taking shape over the last months, at least ever since the first round of the LTRO, is to ease the crisis in the periphery by propping up a bubble in Germany. The low interest rates on all German bonds, in conjunction with the massive capital flight from the periphery, part of which ended up in Germany; will sooner or later lead to irresistible inflationary pressures there.
Since a thoroughgoing reformation of the financial and broader economic model has been ruled out and instead the support of all inefficient entities has been decided, the solution to the crisis has been the setting up of another one. This will most probably work in the short term, just like the inflationist “cure” to the dot.com bubble did, bringing us the Great Recession.
Picture credit: Wikipedia