An analysis on why ECB intervention to save Italy and Spain is a joke

2011-08-11

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Picture from the headquarters of the ECB in Frankfurt. Image Source: Forex Tv

The European Central Bank has intervened in the secondary markets through its Securities Markets Programme (SMP) in order to buy Spanish and Italian government bonds, in an attempt to lower their interest rates and calm down the markets. The intervention of the ECB is thought by some to be a clear message that the institution is determined to save the euro. This hypothesis has been reinforced by the fact that the intervention was indeed successful in lowering interest rates below the 6% limit.

This however is nothing more than a delusion for three main reasons (a) because the effects of the intervention on the secondary market will be very short-lived, since the ECB must spend hundreds of millions of euros to make an impact, which cannot be done as then there will be other problems (b) the interconnectedness of all member-states first through the quasi-bankrupt banking system of the euro, second through the highly toxic, ill-advised, European Financial Stability Facility (EFSF), which is the primary source of contagion mean that even minor cracks in other countries can have a major negative impact on the rest, (c) if the ECB was perfectly willing to save the European periphery then it would have long now abandoned its narrow-sighted hawkish interest rate policy, i.e. it would have lowered interest rates instead of increasing them (this of course is based on the ECB’s insistence to monitor and tackle headline inflation instead of core inflation – this however is not relevant to the current article but it can be explained in detail in a future post) and it would have also intervened in the secondary markets much earlier, before the markets went wild.

Point a is true since the sovereign debt of Spain for last year was more than €639 billion, which alone is more than the combined debt of Greece, Ireland and Portugal which is €637 billion. Add to that the €1.8 trillion sovereign debt of Italy and you immediately get a picture of how big the challenge is. For the ECB to control interest rates of Spain and Italy it will have to buy at least one quarter of that mountain of debt, which is not feasible, since then the bank will have problems of its own regarding its credibility (and viability), which will in turn fuel further speculation, thus making things worse. In short the intervention of the ECB is only buying time for politicians to find solutions, which they have not done yet – as for the decision of the July 21 summit that is not a solution to the problem and needs to be fundamentally revised.

Point b is perhaps the most trickiest one and the one which most analysts omit. European states are tied altogether like climbers on a cliff, whereby if one falls all fall down together. Firstly they are tied together by means of their banking system which is in a mess and which contains many zombie banks that only exist thanks to the liquidity provided by the ECB. Secondly the mechanism that was devised with the aim of stemming the crisis, i.e. the EFSF, is founded upon highly toxic grounds, again something that many ignore. Regarding the toxicity of the EFSF I have written in a previous article, among others, the following:

Hardly-pressed governments, whose economies are going through a serious recession and who have imposed austerity measures to reduce their spending are called to contribute to a common fund to bail out other countries. One country would be affordable but as time passes more and more countries join the club of the “fallen”, coming to the need of a bailout, thus making the burden even heavier for the rest. We currently see this in the plan that was decided on the July 21 EU summit, where countries that face serious problems in their economy, such as Cyprus, Spain and Italy are asked to pay a second bailout to Greece.</p>

So these hardly-pressed countries come to the point where they adopt strict austerity measures to put their finances under control at the expense of shrinking their economy and at the same time are called to increase their spending for the sake of saving another country. Hence austerity diminishes their economy and the EFSF further worsens their fiscal position. This means that interest rate spreads over government bonds increase, since everyone in the market realizes the inviability of the system.

In such an unstable structure the contamination of the healthier parts is inevitable. That is why the “Greek” crisis, became “Irish” and then “Portuguese” and now it has seriously affected Italy, Spain and Cyprus, while France and Belgium are close behind.

So even if the EFSF was expanded with lets say another 2 trillion euros to cover the needs of Italy and Spain, it would still be highly problematic and ineffective, as the burden of this extra funding will fall on the countries who are now still safe, but who will surely go into trouble once they put that burden on their shoulders. So the idea of the ECB buying time until the decision of the July 21 summit, which allows the EFSF to intervene in the secondary markets, is implemented is really bad, self-defeating and will surely lead to adverse effects.

As for point c it is more than clear to anyone that the increases in the primary interest rate are only serving the surplus countries of the European core and worsen the position of the deficit countries of the European periphery. When interest rates of the European Central Bank increase, then a natural increase comes to the interest rates of all private banks across the eurozone. This helps in controlling headline inflation, but at the same time makes the cost of money higher. Hence money supply in the market decreases. For the surplus countries this is good, but for the deficit countries this is catastrophic as it further hinders growth in the real economy, which would have helped in balancing government finances.

The above are the three main reasons why the intervention of the European Central Bank in the secondary markets, at this point in time and with the existing surrounding conditions, is a joke. The EU is playing a dangerous game of pretend and extend. It tries to avoid its problems, it pretends those are do not exist, it denies the truth, it makes cowardly steps forward and seeks to buy more time.

For one thing I am certain: ill-advised, ad hoc, semi-measures will have no effect in containing the crisis and in preventing the euro from falling apart. The sooner European leaders find the courage to embrace reality, i.e. to accept that the crisis is systemic and requires a system-wide solution, the better for everyone. The clock is ticking and with every moment that passes possibilities are decreasing.

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