Tuesday, November 22, 2011

How much time does Europe have left?

Let us begin by taking the following as given: there will be no deus ex machina for the eurozone. Neither Germany nor the ECB will have a change of heart about bailing out the eurozone. The EFSF will remain the chimera that it has been since its inception.

Given the foregoing, how much time does Europe have left?

Right now, all that stands between the eurozone and Armageddon is the ECB. The ECB has been buying peripheral sovereign bonds, and it has been providing eurozone banks with unlimited liquidity (EUR 247 billion at today’s auction). Buying peripheral bonds has blunted spread-widening, and the liquidity spigot has prevented a liquidity crisis.

In theory, the ECB may provide unlimited liquidity to solvent member banks. Eurozone banks are technically solvent because they have not marked their sovereign bonds to market, nor are they likely to do so anytime soon. However, the ECB cannot refinance the entire eurozone banking system; it is too big. To do so would expand the euro's monetary base and severely complicate the conduct of monetary policy. (Wise observers would be happy to see the ECB forced to create a little inflation, but that is not in the cards.)

The Bundesbank has made clear that the ECB cannot, under its governing statutes,  provide “monetary financing” to eurozone member states. The ECB is by no means independent of the Bundesbank. Therefore, unless the Bundesbank relents (which we have already ruled out), the ECB cannot buy the bonds of the peripheral sovereigns in the quantities they will require if the debt markets remain closed.

So how much time is there left before this crisis comes to a head? My guess is that the ECB will have exhausted its appetite for peripheral debt by the end of January. If, as and when the ECB stops buying, the prices of Italian and Spanish bonds will plummet, which will place great pressures on the “economic solvency” of the eurozone banks. 

I cannot predict whether at some point these pressures force revaluations and consequent recapitalization, but this will occur next year.

No comments: