Sunday, November 27, 2011

Paris and Berlin try again

The latest front in the European civil war over the fate of the eurozone is no longer Athens or Rome or even Berlin. It is Frankfurt, headquarters of both the Deutsche Bundesbank and its “subsidiary”, the ECB.

To the west is Paris, which is desperately seeking to find a way to make the ECB rescue Italy before it's too late. To the east is Berlin, which is desperately seeking to find a way to make Italy creditworthy enough for the ECB to rescue. In the middle is the Bundesbank, which is the ultimate arbiter in this matter.

Last week, Paris, Berlin and Rome agreed to stop hectoring the ECB to act as Italy's lender of last resort. Next week, they plan to move to Phase II, in which they will replace demands with inducements. The plan, as reported, is for the eurozone to announce a new “stability pact” to enforce budget discipline, but without the insuperable hurdle of another EU treaty.

Reuters reports:
"Based upon these measures, there should be a majority within the ECB for a stronger intervention in capital markets," Welt am Sonntag said. It quotes a central banker as saying: "If the politicians can agree to a comprehensive step, the ECB will jump in and help."

There is no mention of the Bundesbank, but presumably it is included in this optimistic prediction.

I am skeptical. Rome can sign a hundred new stability pacts (Rome will sign anything), but pacts do not bind the Italian political process. Italian politics is about only one thing: how to slice the pie. There is no room in such a system for a smaller pie, only a larger one.

Italian politics developed over half a century of inflation and devaluation. When the pie got too big, the currency did the adjustment. Under the euro, it’s the pie itself which must do the adjusting: mission impossible.

Foreign observers labor under the illusion that replacing Berlusconi with Monti makes the slightest difference. It doesn’t. Monti and his technocratic cabinet are irrelevant in Italian party politics: they have no party. Their “base” is foreign: Brussels, Paris, Berlin. Only Italians get to vote in Italian elections.

So therefore, the key question is not whether a new stability pact will make Italy creditworthy; it can’t. The question, instead, is whether such a scheme could be used to induce the ECB to pretend that Italy is creditworthy. Or in even more crucial terms, whether Berlin has any leverage over the Bundesbank.

I don’t know the answer to this. I have no idea what levers Berlin might have to get the Bundesbank on board. Going by history, however, it does not have sufficient leverage. We should find out pretty quickly, because time is of the essence.

For argument’s sake, let’s assume that the Bundesbank and the ECB relent, and announce that the ECB will begin to bid directly at Italian bond auctions, with the goal of keeping yields below X%.

What would be the consequence? Clearly, there would be a major global rally across all asset classes, even euphoria. But we’ve been to euphoria before.

Once the shouting died down, would anyone trust the ECB enough to buy Italian bonds at the targetted yield, or would investors take advantage of the subsidized bid to unload? They would unload! Italy’s government debt exceeds EUR 1.5 trillion, which is a pill that the ECB would find hard to swallow, since its total assets are EUR 2.5 trillion.

So, over time, the ECB would be confronted with the choice of having to to sell every other asset it owned, giving up on Italy, or losing control of the monetary base. These are the considerations that have led the ECB to take the hard line that it has so far.

Political Addendum
It should go without saying that this latest scheme was cooked up by Sarkozy. It represents his latest effort to find a way out of the fix that the eurozone is in. Merkel has gone along because (a) she doesn't want to seem indifferent to the Italian crisis; and (b) it takes the ball out of her hands and drops it into the ECB's court. The Bundesbank has been saying that this is a problem for the eurozone governments to solve, while the eurozone governments have been saying that it is the ECB's problem.

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