With Ben Bernanke’s deeply inconclusive Jackson Hole missive now behind us, all eyes are firmly fixed on European Central Bank President Mario Draghi. Back in early August, Draghi publicly pledged to do “whatever it takes” to prevent the break-up of the single currency.
This statement, which a vacationing Angela Merkel didn’t contradict, was taken as a sign that the ECB would soon be buying large quantities of government bonds issued by essentially bankrupt eurozone nations. As such, Spanish and Italian yields stopped rising and global markets remained calm during the dog-days of summer – moving mainly sideways, albeit on very low volumes.
Encouraged, perhaps, by the soothing power of his rhetoric, and certainly by the German Chancellor’s silence, Draghi then stuck his head another few inches over the parapet. His “whatever it takes” message was followed-up with an anonymously sourced statement that the ECB is considering “caps on yields”. Such a policy would force the ECB to buy a nations’ bonds if the yield spread on those bonds widened a certain amount compared to its German equivalent.
If that sounds complicated, then take it from me the policy amounts to an open-ended ECB commitment to buy bonds on a potentially unlimited scale, even if financed by straight-forward monetization. Forbidden by the European Treaties, such an idea also cuts deep into Germany’s inflation-scarred psyche. No wonder the “yield cap” idea was unsourced. No wonder, also, there are now signs of serious resistance from Berlin – or, at least, from Frankfurt, courtesy of the mighty Bundesbank.
Jens Weidmann was last week unable to contain himself. The Bundesbank Chief lacerated not only yield caps but also the very idea of further ECB bond-buying. “Such a policy is, for me, too close to public financing by the printing-press,” Weidmann declared, well-aware that his words chimed precisely with mainstream German opinion. “We should not underestimate the risk that central bank financing can be addictive like a drug”.
Juergen Stark, a former ECB chief economist, also piled-in, declaring that “panic-fuelled and hyperactive measures” were having “negative effects on the credibility of and confidence in the bank and the currency”. The ECB is treading a “very dangerous path” in “allowing its independence to be eroded by politicians,” warned Stark, who resigned last year, in protest at earlier ECB bond-buying.
Weidmann’s predecessor as Bundesbank chief, Axel Weber, also quit last year, for the same reason. There have lately been rumours that Weidman is now thinking of doing the same, rumours he has been “forced to deny” – even if he started them himself.
On cue, Draghi has been in retreat in recent days, trying to mollify teutonic concerns that the eurozone printing presses will be fired-up, with dire inflationary consequences. “The ECB will do what is necessary to ensure price stability,” Draghi purred. “It will remain independent and will always act within the limits of its mandate”.
In practically the same breath, though, Draghi insisted that “exceptional measures” are also necessary. As such, “Super Mario” is widely-expected to detail a bond-buying plan to further contain Spanish and Italian borrowing costs after the next ECB policy meeting on 6th September – this coming Thursday. If he fails to do so, after all this hype, then the markets could surely rebel.
For even though financial markets have recently been calm, the eurozone zone is enduring an alarming slow-motion bank run. During previous chapters of this crisis, depositors and investors fled the “peripheral” countries, putting their money in “core” countries like Germany. Now, there are growing signs capital is quitting the eurozone altogether. Even after strengthening a little during August, courtesy of Draghi’s warm words, the euro is still down 6pc against the dollar since early May.
The exodus from monetary union has forced the Swiss National Bank to buy euros to prevent the franc appreciating. The Danish Central Bank, meanwhile, has taken the drastic step of charging for the use of its deposit facility – again to try to prevent an export-pummeling currency spike. Eurozone capital flight also explains, along with our own domestic money-printing, why UK gilts are so low.
With Draghi having whipped the markets up into a state of high expectation on the one hand, and the Bundesbank in open revolt on the other, the pressure on Merkel is now enormous. She has, since returning from vacation, said just enough not to shot down Draghi’s bond-buying plan completely, but it would still be a very big step indeed for her to actually give him the nod to proceed.
The eurozone economy continues to deteriorate. Unemployment hit a record-high of 18m in July, we learnt on Friday, as another 88,000 people lost their jobs. Surveys of business confidence are flashing red, indicating that even Germany itself could be on the brink of recession. Eurozone inflation, meanwhile, is refusing to abate, jumping to 2.6pc year-on-year in August, from 2.4pc the month before. That could dash any remaining hope of Draghi conjuring up an interest rate cut next week, to go alongside his “exceptional measures”.
Even the Chinese are now putting the thumb screws on Merkel. Premier Wen Jiabao last week told the German Chancellor that China and the broader international community are “worried” about the prospect of contagion from the single currency area, in the aftermath of a systemic collapse. Wen has asked Berlin for clarification over whether Italy and Spain would adopt the “comprehensive rescue measures” needed to unlock the EU bail-out machinery, so opening the door to bond purchases by the ECB.
While Merkel replied by insisting that euro-denominated sovereign debt remains a “safe investment”, it is clear that unless Beijing sees some ECB money-printing, and fast, it could soon become a net seller of eurozone government bonds. This is truly alarming. Until now, China has been propping-up bond prices with net debt purchases within the eurozone. All the eurocrats’ assumptions about funding for future bail-out packages also include a big chunk of money from Beijing. By breaking its silence, China seems to be putting a gun to the Iron Frau’s head.
In the end, though, while Merkel is in the spotlight, the decision on whether ECB bond-buying goes beyond the €50bn or so of Greek bonds hovered-up since mid-2010, extending to much bigger purchases of Spanish and Italian instruments, rests largely with Spain and Italy themselves. The real obstacle, as Wen intimated, is that Madrid and Rome must apply for assistance from the European Stability Mechanism, the successor to the European Financial Stability Facility, so accepting the attached policy conditions of a formal bail-out. Were this to happen, then Merkel could possibly – no more than that – muzzle the Bundesbank rottweilers and convince the German public, for now, to give her the benefit of the doubt.
What’s clear is that, whatever Draghi says this week, nothing will happen before 12th September, when the German constitutional court decides if the ESM is actually legal. Then the new bail-out fund must be ratified, which won’t happen at least until the end of the month – and that’s if all eurozone government’s agree.
Even bigger questions loom, though. Spain and Italy had been hoping the ECB would support them on the basis of home-grown austerity measures without enduring the political humiliation, and related market trauma, of applying for a condition-related bail-out. Will Madrid and Rome now bury their pride and agree to some tough Berlin-imposed limits on what they can and cannot do? Will the feisty Spanish and Italian electorates accept such demeaning anti-democratic subjugation?