The ECB captivity and the Italian, Spanish and Belgian prisoners

2011-10-12

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The ECB is trapped in a multi-faceted jigsaw. Euro states are participating in a “war of all against all” instead of cooperating. Italy, Spain and soon Belgium, are the prisoners, unable to act.

Image Source: Zimbio

I have been saying since August that Italy and Spain have practically fallen to market pressures, however this is not yet apparent due to the constant intervention of the European Central Bank (ECB) in the bond markets, through its Securities Markets Programme (SMP), which succeeds in temporarily keeping interest rates at “affordable” levels. The ECB is fighting a war of attrition that it cannot win. It is already buying debt because of a loophole, a “gray zone” in its charter which has raised political objections, since the ECB is not supposed to provide a backstop to member-states; it has also accumulated 163 bn euro in sovereign bonds from Greece, Ireland, Portugal, Italy and Spain, which again raise a number of questions.

The ECB knows that the threat coming from the volatility of Italy and Spain is about to grow that is the reason why it hopes the new powers of the EFSF are ratified so that it can end its SMP and allow the EFSF to carry that task. Contrary to the ECB’s wishes, German Chancellor Merkel and French President Sarkozy, under the increasing pressures from their national electorates against bailouts to “profligate” states, are seeking ways to utilize the EFSF as a mechanism that will recapitalize banks, which leaves the ECB with a very unpleasant dilemma: to either absorb the debts of Italy and Spain or to put an end to its intervention and let all hell break loose. Due to the inability of Europe’s leaders to provide system-wide solutions, the ECB is forced to go deeper into the tunnel by keep fighting a losing battle with the markets, so it will continue buying Italian and Spanish debt (yesterday ECB chief, Jean-Claude Trichet said that the crisis in Europe is ‘systemic’ – I have been saying this for months now and you can see my latest Full analysis of the Euro Crisis). I would only like to say that the ECB will soon have an extra burden called “Belgium” since that country is the next target.

The ECB is trapped in a political game with three main parameters.

1) Germany, France and those states who have the upper hand in the political bargaining maintain their own agendas on how to act (see The crisis of the Euro is deeply Political). No matter how cynical this might sound, they are using the crisis to push for deep reforms in Europe’s South (the troika in Greece is even asking for lowering wages in the private sector, which is by all means ridiculous and unacceptable, as it will only make things even worse). The approach of front-loaded austerity which is more of a punishment than an assistance from European partners is plunging the periphery into a deeper crisis and there is absolutely no chance the much-vaunted “growth friendly fiscal consolidation” will work, since the crisis is not just about public finances, but rather evolves in a number of realms (see Full analysis of the Euro Crisis).

2) Italy, Spain (and very soon Belgium) are in a position where they cannot possibly speak their mind, for three main reasons. First because they will meet the staunch resistance of those countries who are providing the lion’s share of the fundings. Second, they will raise uncertainty in the markets regarding their solvency, which implies that interest rates will go wild, leading to a self-fulfilling process that leads to the need for bailouts. Third because they are forced to implement front-loaded austerity to show that they are “behaving well” to the rest of their European partners and to demonstrate to the markets their “determination” and “willingness” to deal with their fiscal issues. However this situation only means one thing. Italy and Spain have already taken a downward path since front-loaded austerity will reduce their aggregate demand, thus increasing the debt ratio which suggests that markets will ask for higher interest rates. In short they are heading with mathematical accuracy to the same fate of Greece, Ireland and Portugal – now whether bailouts to these countries are feasible is another issue, I say they are not, but no need to discuss it now.

3) A “haircut” on Greek bonds will lead to serious loses in European banks. As the case of zombie-bank Dexia suggests, many European banks will have to be recapitalized to prevent a complete financial meltdown that will lead the world to a mire of lost decades. But if banks are recapitalized by states, then France will most probably lose its triple-A credit rating which will in turn jeopardize the EFSF and consequently the programmes in Ireland and Portugal.

The ECB remains captive in this multi-faceted political and economic jigsaw. Italy, Spain and Belgium are also prisoners and can only hope that some “solution” will be delivered on the approaching EU summit. But to be honest and to be realists the next summit will be just another failure for it will center around a programme to recapitalize banks and to lead Greece to an orderly default. In other words, it will be another step along the path of the failing half-measures that have brought the euro on the brink of collapse.

The euro is falling apart, as all players from the ECB to the member-states are participating in a “bellum omnium contra omnes” (“war of all against all” by Thomas Hobbes) instead of cooperating and treating the crisis as it really is: a systemic crisis of the euro. Deterioration and disintegration will continue to gain momentum and the sooner we get rid of any delusions the better.