The Flaws in Draghi's Plan

The ECB's plan for make unlimited bond purchases is riddled with inconsistencies and contradictions...

IN AN IMPASSIONED article published by the Frankfurter Allgemeine Zeitung last week, former European Central Bank chief economist Otmar Issing bewailed the ongoing  ‘Crisis and Leviathan' push towards a greater centralization of authority and a more intrusive bureaucracy which is being widely peddled as the supposed solution to the Continent's current woes, writes Sean Corrigan for the Cobden Centre.

Putting great stock in the argument that it was Europe's invigorating embrace of the power of competition and experiment – in its legal and political forms as much as in any narrower economic sense – which propelled its peoples to the vanguard of human progress, he sought to dismiss the idea that the imposition of some dreary unanimity, replete with top-down directives emanating from a faceless and self-perpetuating mandarinate in Brussels could somehow hasten the return of prosperity to the Union.

"How would it be," he concluded, plaintively, "if the cry for ‘More Europe' was replaced, at least temporarily, by the motto ‘pacta sunt servanda' – agreements must be kept? Shouldn't one try it out, reflecting instead on the idea of a "better Europe", a Europe of reliability and adherence to contract?"

But, of course, no-one would dream of breaking a contract, violating a constitution, of overstepping a mandate, now would they?

Certainly no-one at the ECB, that prelapsarian pillar of apolitical propriety. For has not even Germany's Herr Asmussen told us, with a straight face, that "In a fragmented Eurozone, we cannot pursue [our principal purpose of ensuring] price stability, for any alteration of rates is taking effect in at most one or two countries and has no impact on the rest."

Citing the example that, today, a small businessman in Spain might have to pay 2.5% above his German counterpart as evidence that the Bank needed to flex its muscles to eradicate any such regional disparities, he went on to argue that a bond-buying programme was clearly an "option under our primary mandate."

Just imagine the horror! To think that a petty entrepreneur, trying to make his way in a stricken land – who therefore faces the risk of sliding into an abyss of shrinking sales possibilities, uncollectable invoices, soaring taxes, unsubsidised utility prices, and rising input costs – has to pay almost 4% in real interest (even if this is hardly swingeing when compared to the 5.5% real rate typically paid by even prime borrowers in his father's, pre-EMU day), while his equivalent in a country as yet left relatively unscathed by the global turmoil can rely on financing his thriving business anywhere between 150-200 bps more cheaply, after allowing for inflation.

But, there it is. With only his compatriot, Jens Weidmann, to offer his ineffective voice of protest (and that not for much longer, if recent press reports are to be believed), Herr Asmussen is destined to be able to give free rein to his wildly egalitarian visions of monetary policy in support of his capo, Mario Draghi, as the latter seeks to reverse the three decade-old achievement of his countryman and predecessor in office, Carlo Ciampi, by turning the central bank back into a direct facilitator of fiscal incontinence – traditionally, the first step on the road to accelerating inflation, as well as to escalating indebtedness.

With a cynical touch of the Machiavellis, already, on the eve of the all-important meeting of the Bank's governing council, the essential details of what was latter officially proposed were leaked to a waiting world; a breach of protocol presumably calculated to present any backsliders with a fait accompli, thus daring them to maintain their resistance only at the expense of horribly disappointing the schemes of those actively speculating in markets for financial assets – members of a privileged cadre whose happiness has, alas, become the Alpha and Omega of policy implementation.

As Frau Merkel is also disingenuously pretending to be supporting both of the ECB's irreconcilable protagonists, her man and – err, well – her other man, the fix is in. The Chancellor herself, being a supreme example of that hollow, pragmatical egotism which so informs modern politics, will doubtless ignore the howls of protest from her current coalition partners and will look forward instead to retaining the perks of office in cahoots with the SPD opposition after next year's elections. We have already heard soothing words from her camp to the effect that the worthies of Karlsruhe will only offer up a few token preconditions for their endorsement of the ESM next week, so ensuring the dreaded Haftungsunion suffers no further let in its introduction.

On Draghi's part, the pretext of needing to clear the mechanisms for the ‘transmission' of policy decisions is being used to lever open the door to the ‘unlimited' (‘believe me, it will be enough') purchase of secondary market government debt, though ‘only' of such paper with no more than three years remaining to maturity. Notably, collateral standards will again be loosened: no government-guaranteed or –issued paper will be refused, nor will the obligations of any near-bankrupt subject to an EU or IMF ‘programme'. A ‘Schrottpapierecharta', indeed!

As a sop to those who still retain some trace of monetary probity, it is also intended that all such purchases will be ‘sterilized' – by which one presumably means that term deposits will again be issued against them since it seems uncountenanceable that the ECB will actually sell what would be higher quality securities from its existing portfolio – something which it cannot, in any case, undertake in ‘unlimited' quantities.

However clever this whole ruse may superficially appear, the problems are, in truth, multiple.

Firstly, this process of garnering offsetting deposits does not prevent the initial bond purchase from constituting an inflationary addition to the money supply, but it merely acts to prevent that first addition from becoming a multiple one.

To see this, simply ask yourself whether it might be expected to disturb price relations if, the morning after the scheme is introduced, the Italians suddenly decided to take full advantage of the available subsidy and to issue €2.5 trillion in 2-year paper – thus refinancing their entire existing debt stock more cheaply and pre-funding their next 10 years' deficits at a stroke.

At this juncture, the banks and others who were initially persuaded to take up this mass of paper (thereby making it an eligible ‘secondary' issue, rather than a proscribed primary one) would naturally job it straight on to the ECB at what would presumably be some trifling spread over Bunds and/or the going repo rate [another canard here, incidentally, is the idea that, having been derided as unworkable when first floated, there will be no specific rate cap imposed when, obviously, there will be a fairly narrow, practically indistinguishable, upper zone of intervention instead].

So, even if the banks were subsequently forced to keep the whole of this €2.5 trillion on deposit with the ECB in order to ‘sterilize' it, there would still arise an equal sum on the liability side of their balance sheets, where previously there was none – this representing the cash paid out by the Italian government to all those from whom it had redeemed its existing securities or, in the case of the prefunding component, on whom it had spent, or to whom it had lent, the residual proceeds.

All such claims appurtenant to non-bank entities, which were also subject to check or other instantaneous transfer, would constitute 100%, full value money where before there existed only non-money financial assets, many trading below par, each of variable prospective capital worth, and each possessed of a less than perfectly realisable liquidity – and hence this switch would represent a vast, if one-time, act of inflation. [The sole exception pertains to bonds already owned or financed by the banks]

This may smack of a reductio ad absurdum, but the logic is, in fact, unimpeachable – something which cannot be said for those who believe the ECB can flash freeze its injections into the system, leaving the matrix of economic data otherwise serenely unaltered.

As we have seen from the past two years of failed operations, however, such extra money as is created can easily disappear into the relatively inactive ‘hoards' of the still-solvent. Look at what is presently taking place across the frontier in Switzerland, where FX accumulation equivalent to 60% of GDP, and a concomitant doubling of the money supply during the Crisis, has so far had no appreciable effect (on the official CPI basket, at least) because the new holders wish to do exactly that with their shiny, new, cut-price francs – hold them.

Similarly, in Europe, once the newly-printed money trickles into the hands of those not absolutely desperate for funds for basic sustenance, it may do little to alleviate the travails of the already zombified (which is why debt renegotiation, not monetary chicanery, is the answer to the problem, as we have said all along).

Thus, it is not to be expected that Europe – or at least not all of Europe – will immediately start trundling along to shops to the accompaniment of a handy wheelbarrow or two. Nevertheless, we should not minimize the risks posed by any further extension of the already sizeable overhang of liquidity in the region, nor should we forget to differentiate the possible effects between the member states, or between groups and individuals residing within them.

From the forgoing, too, comes the second objection to the scheme, viz., how are already capital-constrained banks going to find the means to provide funds to the productive economy if even more of their battered balance sheets are clogged up with funds parked with the ESCB? Already they have €1 trillion housed at the ECB proper (€342 bln in short-term deposits, €209bln in fixed-term ones, and €544 bln in current account balances), with another €1 trillion tied up in the TARGET2 (non)-clearing system.

How much more would Sig. Draghi like to add to that particular Teufelsberg before he is satisfied, one might ask?

A third sticking point is that we are being proffered the flimsy pretext that the bond buying will be subject of strict ‘conditionality' (supposedly to be overseen by the Olympian objectivists at the IMF) and that the ECB will reserve the right to punish any hint of future fiscal recidivism by promptly selling the bonds back into the market, thereby denying the recusants any further access to its nourishing teat!

For the first of these ‘safeguards', we might simply point to Greece's continual attempts to secure itself extra wriggle room whenever the magnitude of its commitments becomes too much to bear; or perhaps we can take heed of Sr. Rajoy's recent, unsubtle brinkmanship in threatening to treat his creditors' demands for a say in the use of their monies with as much respect as Samson displayed towards the pillars of the Philistine's temple.

As to the second threat, this raises the farcical spectacle of an ECB which has abandoned all of its founding principles, ostensibly in order to continue the existence of the single currency and to restore its ability to ‘transmit' its diktats regarding the apposite cost of borrowing, now turning round and adding considerably to the woes of one or other of that union's members should its weak-willed politicians, or the fickle electorate they presume to represent, stray from the path of righteousness and renege on their commitments, upon some bleak tomorrow.

Here is a fine, self-imposed conundrum. For thus would the inviolability of the Euro and the sacred transmissibility of monetary settings truly be put in jeopardy, at the moment of maximum tension, all in the name of better preserving them!
Nor should we refrain from pointing out that this whole charade would involve a political apparatus of decidedly dubious democratic provenance – together with one of its more important, if equally technocratic, institutions – attempting to chastise one of the circle's own sovereign members for the very same crime of asserting, in the face of a dire enough necessity, ‘pacta non sunt servanda', that they themselves have been guilty of all through this crisis, if not throughout their entire existence!

Here perhaps we should leave off to take some cognisance of the divergent fate of such money as the ECB has so far managed to create at the expense of the near-schism of its council and the politicised doubling of its assets. To begin the analysis, a look at bank balance sheets and balance of payments numbers will allow us to put a little gloss on what the headline TARGET numbers really imply for the various member states.

For example, in the year to June, Spain's BOP report shows the land lost a net €102 billion to repatriation across the portfolio account and a massive €242 on the ‘other financial' (largely, the banking) account. You can easily see why the Banco d‘Espana's T2 liabilities soared by €314 bln over the period.

Worryingly, no less than €103 bln of that latter entry was not foreign withdrawal (whether by active liquidation or via the more passive non-renewal of expiring credits), but rather reflected an anxious domestic flight into the wider world of safer (Nordic?) holdings, a level which was three times the rate suffered in the previous 12 months.

Nor did it stop there, for in July – the latest period for which we have data – Spanish banks lost another €74.2 billion in deposits in the ‘non-bank, EZ-resident ‘category which encompassed most of the earlier flight (the sum owing on TARGET simultaneously rose another €43 billion).  Given that this figure represented, in just one calendar month, almost half the total (€159 bln) drained out in the previous twelve, the crisis was, if anything, still intensifying – at least to the point, in the final week, that Draghi made his notorious pledge and succeeded in slowing the haemorrhage somewhat (a further TARGET increment of €20 billion in August shows he failed to staunch it entirely).

By contrast, the fact that its Intra-ESCB tally has barely budged since March shows that matters have broadly stabilised for Italy, even though the year to June saw the country stage a reversal from minor creditor to major debtor of €288 billion net, corresponding roughly to a €150 billion of foreign disposal of local securities and €128 billion's worth of domestic flight. Also telling is the €107 billion of securities issued and the €94 billion of government securities bought with the proceeds: the bootstrap financing of drowning banks by drowning governments and vice-versa is presumably here in action on a grand, ECB-endorsed scale.

What is also somewhat remarkable – if, in fact, almost completely unremarked upon since it has taken place within, rather than across, the country's borders – is what has been happening in France all this while. Here, banking asset growth over the year to June was easily the greatest in the entire Zone at €839 billion – a sum which comprised fully a third of the aggregate total and one which grew at an even more rapid pace in July (+€119 billion, then almost half the system-wide total).

The greater part of this explosion lay sadly undetailed, €480-plus being booked under the catch all entries for ‘remaining' assets and liabilities, but a good part of the residuum consisted of a huge, circa €300 billion orgy of new interbank dealings, partly predicated upon an extraordinary jump in assistance from the Banque de France of €142 billion in credits. If financing is really that hard to come by, that the CB needs to provide half of it, the apocryphally American banks who were responsible for the loss of €114 of ROW liabilities over this same stretch are probably very pleased to be out from under such a sizeable slice of their exposure.

What all this has meant in less specific terms, is that the Zone finds itself split into three broad camps – The Good, the Bad, and not so much the Ugly as the Wallflowers, perhaps; i.e., those like France, Belgium, and Austria who have so far remained on the sidelines of the main whirl of the TARGET tarantella.
In the PIIGS, naturally enough, things are pretty grim: even before thinking about the erosion of purchasing power being suffered as prices continue to rise amid the local depression, money supply is shrinking at 5% p.a. or more (-21% for benighted Greece, -9% for Portugal, -5% for Italy, and at minus 2-3% for Ireland and Spain).

In France, by contrast, growth of around 4.5% is in place – perhaps half the speed typical of the pre-crisis experience, but, nevertheless positive in both real and nominal terms. For the other two, matters are already starting to hum along; Belgium is running at a rapid 12.3% and Austria at 10.2% yoy.

Among the four members of the Good, where €1 trillion of credits has been piled up at the local central bank, the average rate of increase has risen steadily since this phase of the crisis began last summer, to reach its present lick of 11.4% per annum. Finland has been relatively steady (+5.4%), but the Germans (10.6%), and the Dutch (12.1%) are beginning to enter the red zone, while Luxembourg (+21.3%) would be well within it, were this a plain vanilla economy, rather than a vanilla bond one, that is to say, a parking lot for Continental assets and liquidity.

Here a word of caution: just as we argued in the case of Swiss monetary expansion, some significant, if indefinite, fraction of this Teutonic increment is not really German money, built up at the expense of, say, a Spanish drain. If Senor Garcia closes his account at his local Caixa and opens one at his Landesbank of choice, just in case either the first bank or the Euro itself collapses, this does not mean the money is freely available for spending in the Brauereien of Bremen rather than in the bodegas of Bilbao. Nor should we ignore the fact that the recycling of his money via TARGET effectively prevents its fractional multiplication by the recipient bank (it ‘sterilizes' it, we might be tempted to say!) Not all Graeco-Latin deflation, nor all Nordic inflation, is quite as extreme as it first appears, therefore.

Nonetheless, the discrepancy is such that it is not entirely a surprise to note that while Iberia languishes amid a cataclysmic housing crash, there are already evident signs of property booms underway inside the confines of the old Holy Roman Empire. It is, after all, a rule of modern, non-liquidative, Keynesian counter-cyclical policy that the only way to restore one dilapidated balance sheet is to ruin a more pristine one and, in a Europe fast running out of alternatives, the private sector north of the Alps and east of the Rhine is about the only game in town.

All to the good, the bien pensants would say, for is it not true – as no less a luminary than the OECD's Pier Carlo Padoan argued this week – that the laggards can better catch up with the leaders if the latter submit themselves to be hobbled? Or as the man himself put it in the course of a press conference he gave a few days back:

"The [debtor] nations are undergoing an adjustment in terms of lower wages, higher productivity [sic] and higher unemployment... But the process remains slow, incomplete and painful ... Tolerance for fiscal adjustment may be reaching its limit... with recession in a number of countries... a combination of enduring financial fragility, rising unemployment, and social pain may spark social contagion and adverse market reaction."

Mr. Padoan's quack remedy for what ails them? Well, it's time for those naughty Germans to loosen their purse-strings and start pricing themselves back out of the jobs they spent a decade of sweat working so assiduously to secure – for only by "accepting higher wage inflation" could creditor countries such as Germany "provide a boost to debtor countries via increased consumption, as lower wages would allow the Eurozone's debtor nations to be more competitive in the global market..."

Somehow, I don't think even IG Metall would be dumb enough to fall for that one.

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