ECB intervention is most definitely not the answer to the problems facing the Eurozone. Each infected country needs to reform its own economy and fiscal situation in order to escape the debt trap. Somehow, people believe that Draghi can turn on the money machine and make the years of bad decision disappear.
Since investors can examine the financial situation of the infected countries, they can see that each of them is suffering from economic ills. Spain, Greece and Portugal are in depressions, and Italy is in a recession. This is why their bonds are cheaper. It is not the markets or those evil speculators fault.
Each country’s worsening economic situation is causing larger government budget deficits. If they had been running surpluses during the good times pre-2008, a large deficit would not be a problem today. Even during the good times, they were unable to balance their budgets resulting in piles of debt that must be taken into account when analyzing today’s credit situation. That analysis leads investors to shun the bonds.
Furthermore, these countries belong to an ill-advised currency union. A country that has its own currency has a built in stabilizer. When the country runs into a recession, the demand for its currency decreases causing a devaluation in the currency. This devaluation makes its exports and labor cheaper resulting in more exports and more labor for the economy. These benefits lead to higher government revenues.
The PIIGS do not have their own currency. Hence, they are locked into the current debt trap with no way of escaping. No amount of bond buying is going to change this basic math. Anything that the central bank can do is temporary in nature and comes with a slew of unintended consequences.
One of these consequences is that the ECB claims seniority on the bonds it owns. When Greece went belly-up, the ECB did not take a haircut on its substantial holdings of Greek debt. The ECB discusses ridding the markets of this preference, but the problem is that it was not legal in the first place. Nothing in the covenants of the bonds or the charter of the ECB gives it a preference on its debt holdings. How can you stop an activity that was not mandated in the first place? That is where trust comes in.
The ECB lost a great deal of credibility when it gave itself a preference. Today, it needs that credibility more than ever. If it starts buying bonds of the PIIGS to support their prices, all the other investors have to realize that they could wind up behind the ECB if these countries default. That means that ECB bond buying creates two classes of bonds, senior ECB-held bonds and junior privately held bonds.
If two classes of a financial instrument exist, they will be valued differently. Look at the prices of a dual class stock on the Google, if you don’t believe me. Every bond that the ECB buys will erode the value of the bonds left in private circulation. Any analysis of ECB bond buying has to do deal with the ECB preference to be complete.
In addition to ignoring the most important issue regarding a bond buying program, the article inexplicably gets optimistic regarding the foreign holdings of Eurozone bonds.
The Eurozone does need foreign purchases of Eurozone debt; it requires foreign purchases outside of the Eurozone. The Eurozone has a slight current account surplus, but it requires a huge surplus in order to finance the deficit spending of its members. Without this huge surplus, it must get foreign investors outside the Eurozone to buy the debt.
All indications are that non-Europeans have been abandoning Eurozone debt since 2010. The article parrots Italy’s claim that foreigners hold €700bn of its debt and Spain’s claim that foreigners hold €200bn of its debt without scrutiny. Virtually all of those foreigners are from countries within the Eurozone.
Then, the article gets hopey on us:
Policymakers are keen to keep international investors on board…Early signs have been encouraging. China’s Premier Wen Jiabao said on Thursday China was willing to continue buying euro zone sovereign debt.
Wen sort of said that, but the article leaves out the key caveat:
But Mr. Wen stopped short of concrete pledges and noted that China’s purchases would require “fully evaluating risk,” suggesting that meaningful aid still can’t be assured.
from this article:
Additionally, China never said that it would buy or continue buying PIIGS debt, just Eurozone debt. Have you noticed how low French and German yields are? Chinese money is not and will not flow into the PIIGS.
There is another solution to this Eurocrisis, but it is rarely mentioned in the mainstream media. Each affected country can revert back to its national currency and pay back their bondholders with it. This would create what is known as a default by devaluation.
This devaluation would be painful, but the whole mess would be over much more quickly. This does not happen because European politicians belong to the cult of the euro. They believe that the euro is a means to the end of an eventual political union. The politicians want to create a United States of Europe and don’t mind allowing their constituents to suffer for their ambitions.
Eventually, politicians will come along and promise to leave the Eurozone to fix the country, and jobless voters will begin listening to them. Then things will get interesting.