Germans Will Allow Unconditional ECB Bond Buying

Italian 10yr Yield 02.28.2013

Analysis: Italy election punches hole in ECB’s euro defenses | Reuters.

Much has been made about the Italian election results, but the split decision is ultimately a nonevent.

The Reuters article espouses the position that shaky governments in Italy and Spain will be unable to implement a European aid program necessary to activate the ECB’s OMT program, a euphemism for debt monetization.  When the program was announced in September, the Germans and the northern tier of creditor countries were quite insistent that there would be no bond buying without conditions.

This statement amounts to political cover.  Merkel has an election to win this year, and the other governments must also answer to their bailout weary citizens.  Claiming that OMT would be subject to very strict conditions was a tactic deployed to place a floor under PIIGS sovereign bond prices without causing a voter revolt in the countries that will wind up paying for ECB munificence.

Market participants have figured out that the Germans are all in, whether they like it or not.  Bond prices fluctuated on Monday but have returned to approximate pre-election levels.

Suppose that Italian bond yields begin crashing pushing the country to the brink of default as demand dries up for its new debt issues with Spain being dragged along for the ride.  Both countries request activation of the OMT program.  After a tense negotiation with the ECB and the Germans, a package of mild reforms is agreed upon.

Italy has no prime minister, and Spain’s is neck deep in a corruption scandal.  Fearing voter backlash, legislatures in both countries fail to approve the reforms.  Cash needs have been delayed as long as possible, and defaults could occur in a matter of days.  What happens now?

Do you think the Germans will allow either country to default beginning serious of events that will lead to the dissolution of the eurozone? Will they stand on the principal, or will they cave and allow an ECB rescue to take place?

The cost of  a eurozone breakup is impermissibly high to Germany. As long as it is cheaper to bailout these countries rather than allowing them to exit the eurozone, then they will be bailed out.  Eventually, the costs will force a breakup, but in the short term permitting the ECB to turn on the magic money machine is an inexpensive way to maintain the current status quo.


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