A Brief Introduction To German Constitutional Law

Excerpts from the Sept. 12th decision of the Federal Constitutional Court:
“The ESM Treaty may only be ratified if, at the same time, it is ensured under international law that the limitation of liability limits the amount of all payment obligations arising to the Federal Republic of Germany from this Treaty to its share [EUR 190 billion] in the authorised capital stock of the ESM and that no provision of this Treaty may be interpreted in a way that establishes higher payment obligations for the Federal Republic of Germany without the agreement of the German representative.
“The German Bundestag is prohibited from establishing mechanisms of considerable financial importance which may result in incalculable burdens with budget significance being incurred without the mandatory approval of the Bundestag.
“To what extent the decision taken by the Governing Council of the European Central Bank on 6 September 2012 on a programme concerning the purchase of government bonds of financially weak Member States whose currency is the euro complies with these legal requirements was not a matter for decision in the present proceedings.”

For my sins, I actually read the Constitutional Court’s entire decision (in translation). I have excerpted what I think are the crucial parts. The court permitted the government  to sign the ESM treaty on the proviso that it does not bind Germany to future expenditures beyond its initial capital contribution of  EUR 190 billion. The Court did not express an opinion concerning Draghi’s OMT, although plaintiffs had asked it to do so.

The court’s decision has been widely interpreted as a green light for greater fiscal integration. Indeed, Jose Manuel Barroso, the president of the European commission, called for a federal European state in his annual “state of the union” address: "I call for a democratic federation of nation states that can tackle our common problems, through the sharing of sovereignty." Barroso said that a federation of Europe is "unavoidable" if Europe's embattled common currency is to survive the financial crisis. His aides said that he plans to recommend a plan for common eurozone bonds.

Somehow I fear that the president of the European Commission may not yet have read the Constitutional Court’s decision. It is as if the Court said the opposite of what it said, or that what it said doesn’t matter. The Court specifically prohibited the ratification of any treaty that bound Germany to pay or owe any more money than EUR 190 billion, which absolutely excludes the possibility of a eurobonds or a fiscal union. As best as I can tell, it also ruled out the idea of the ESM’s leveraging itself by borrowing from the ECB or the capital market.

In my view, this means that the ESM will be quite limited in scale, and will not be big enough to be helpful to either Spain or Italy. It will merely serve as the gateway to the ECB’s bond buying program--which will be challenged before this court.

If Barroso is correct that only a federation can save the eurozone, Germany’s constitution will need to start “evolving” very quickly.

Bernanke Hits It Out Of The Park

FOMC Statement, Sept. 13th, 2012:
“If the outlook for the labor market does not improve substantially, the Committee will continue its purchases of agency mortgage-backed securities, undertake additional asset purchases, and employ its other policy tools as appropriate until such improvement is achieved in a context of price stability.”


It may be safe to fight the Fed when it is floundering around ignoring its employment mandate. It isn't safe to fight the Fed when it decides to achieve its mandate.


I had predicted that the FOMC would announce another round of QE, in the amount of $500B. I criticized the decision in advance by saying that the Fed should target outcomes rather than endless incremental inputs.

I was wrong; I underestimated Bernanke’s powers of persuasion with the hawks.
It looks like he has finally used his considerable authority to begin to practice what he used to preach as a professor.

He has announced that the Fed will continue to buy securities (QE3+) until the outlook for the labor market improves substantially. While it is true that he will do this in increments of $85 billion per month, he made an open-ended promise to keep buying bonds until his target is achieved. This is a major intellectual breakthough for the Fed.

The Fed has begun to do what the ultra-doves (the “market monetarists”) have been begging for since 2007: use its unlimited resources to fulfill its full employment mandate.

I wonder if the hawks fully understand what they have just signed up for or, if they do understand it, whether they really mean it. That is because, I think it will cost at least another one trillion for the Fed to achieve its new target, and maybe two trillion. 

That means that the Fed will have to buy bonds at $85 billion per month for one to two years. That is probably beyond Bernanke’s tenure in the job. Who knows what the next chairman will think of this policy? And if ever inflation dares to rise one iota over 2%, the Fed will have an excuse to stop the whole exercise.

Unlike the Supreme Court, the Fed is not bound by its own precedents, and can change its mind at any time (as it just did). Nonetheless, this is the first time in history that the Fed has targeted employment growth by any means necessary.

In the past, the Fed's weapons were conventional (interest rates) and unconventional (incremental QE), but never open-ended QE. The last time something like this happened was when FDR horrified economists by raising the price of gold until commodity prices recovered (which was 100% successful).
In my view, it is no longer safe to fight the Fed. The Fed has gone nuclear, and it can't lose at least as long as Bernanke is chairman. The era of weak recovery and high unemployment is over, if Ben follows through. The risk of an inflationary shock is low. Therefore, the Equity Risk Premium is high at the same time that the earnings outlook is good. Also, no matter what happens in Europe, the Fed can overcome it as long as it pursues its new policy. I find it hard not to be bullish. I am buying SPY.

Looking For Black Swans In The Eurozone's Infirmary

I thought that this might be a good time to take a quick look into the eurozone’s ICU to see how the PIIGS are doing. My particular interest is in identifying any countries that look likely to blow up this fall. I will review the PIIGS in the order of their current Moody’s bond rating, from highest to lowest.

Italy
(Baa2/Negative Outlook. Barely eligible for investment grade portfolios. Bonds at 5.1% trade as a Baa3.)

Italy is the Big Enchilada of the PIIGS.  As a major economy with EUR 2 trillion of debt, it is way too big to be allowed to default. However, refinancing a debt burden on that scale cannot be handled by the EFSF/ESM. It would require the full resources of the ECB, and then some.

Italy’s bond yield has been quite volatile. It was as high as 7.2% last fall. Since the OMT was announced, it has fallen to 5.1%, which is still too high.

Moody’s downgraded Italy from A3 to Baa2 in July, providing the following rationale:
“A key factor underlying Moody's two-notch downgrade was the assessment that the risk of a further sharp increase in Italy's funding costs or the loss of market access has increased due to fragile market confidence, contagion risk emanating from Greece and Spain and signs of an eroding non-domestic investor base. The risk of a Greek exit from the euro has risen, the Spanish banking system will experience greater credit losses than anticipated, and Spain's own funding challenges are greater than previously recognized. In this environment, Italy's high debt levels and significant annual funding needs of EUR 415 billion (25% of GDP) in 2012-13, as well as its diminished overseas investor base, generate an increasing liquidity risk. The second driver of the rating action was the deterioration of Italy's near-term economic outlook, as manifest in both weaker growth and higher unemployment, which creates risk of failure to meet fiscal consolidation targets. Failure to meet fiscal targets in turn could weaken market confidence further, raising the risk of a sudden stop in market funding”.

So far, Monti seems to be hoping that the ECB’s OMT announcement plus further reform  at home will bring Italy’s bond yields down further, which I doubt. His fiscal situation will worsen, and his government’s domestic power position will continue to decline. In the end, Monti will have to apply to the troika for assistance, and the ECB will have to move heaven and earth to establish an informal yield ceiling.

Spain
(Rated Baa3, on review for downgrade. Moody’s says that its review will continue through the end of September. Spain is already ineligible for most investment grade portfolios. Trading as a Ba1 at a yield of 5.6%.)

Spain, with EUR 750 billion of debt, is Europe's other big problem. Although Spain’s bond yield has come down since the OMT announcement, it is still high at 5.6%. The Spanish banking system has been steadily losing deposits due to convertibility risk (which is, of course, “unthinkable”).  Spain requires help from Europe to pay its maturing debt, recapitalize its banks, and bail out its regions. Rajoy has been slowly going through the stages of grief and is currently moving from denial to bargaining.

Because Spain is too big for the EFSF/ESM to rescue, it ultimately will be up to the ECB to bring Spain’s yields down to a financeable level. The immediate question is the size of the capital hole in the banking system. The longer that Rajoy waits to apply to the Troika for assistance, the more likely Moody’s is to downgrade Spain to below investment grade, which will add to the pressure.

Ireland
(Rated Ba1/Negative Outlook. Ineligible for investment grade portfolios. Bonds at 8.2% yield trade at their rating level.)

Ireland is the Troika’s poster boy for compliance and success. Ireland has executed its austerity program and is on track for continued fiscal consolidation.

Moody’s says that it  “sees a possibility that the end of the current support programme at year-end 2013 will not only prompt a need for further rounds of official financing, but that private sector creditor participation is also to be required as a precondition for such additional official support.”

One can only hope that Moody’s is mistaken in suggesting that the Troika will require a bond default as a precondition for additional assistance, since this would make Ireland a credit like Greece. Europe can’t be that stupid.

As a fully-compliant government, Ireland should be the first in line for bond purchases under the OMT. They don’t even have to apply. It will be interesting to see if the ECB steps up. I can see no reason why they shouldn’t, if they want the program to have any credibility. Let’s see how fast Draghi can bring down Ireland’s yields. What is he waiting for?

Portugal
(Rated Ba3/Negative Outlook. Ineligible for investment grade portfolios. Bonds yielding 8.1% trade at their rating level.)

Portugal remains in austerity hell. It has no market access, is in permanent depression, and still faces major additional cuts. It is on track but has a long way to go, with no light at the end of the tunnel.

Moody’s assessment is quite pessimistic: “considerable uncertainty over the prospects for institutional reform in the euro area and the increasingly poor macroeconomic outlook across the region will continue to weigh on already fragile market confidence and make it difficult to reverse Portugal's adverse government debt trajectory”. Moody’s adds that a Greek exit would not be helpful for Portugal.

Greece
(Rated C, in default; remaining bonds yield 22% in anticipation of a second default.)

Greece, on permanent life support from Europe, is way off track in the implementation of its Troika-designed program. It has done almost nothing to comply, and prefers rioting to reform. Greece is the proof that there is almost nothing that a eurozone government can do to get kicked out of the eurozone. Europe knows that a Greek exit would be another Lehman event and would put intolerable pressures on the other PIIGS. The Greek negotiators know that. I expect that Greece will get its money by once again agreeing to a plan it has no intention of implementing. Greece is impossible to reform and too big to fail.

Conclusion
If you want to gauge these five credits as potential black swans, you’d have to start with Greece, although I am confident that Greece will get bailed out no matter what. Next would be Spain which is playing chicken with Europe on the terms of its bailout, but this is political theater. Spain will have to apply, so the risk of an unanticipated explosion is low. Italy may be the sleeper of the bunch, because most of her plausible scenarios are on the downside, as Moody’s stated. Time is not on Monti’s side, and his credit is likely to worsen.

Because neither Italy nor Spain can be rescued by the ESM, they will ultimately have to be rescued by a display of shock-and-awe by the ECB. By shock-and-awe, I mean massive unsterilized bond buying. That can only occur when Draghi has enough votes. Let’s hope that, when one of these behemoths starts to keel over, Draghi will have the votes to do something.

Pathology Of The Eurozone Crisis

I have been asked a number of times “How did the eurozone crisis happen, and how did it grow so big before it was discovered?”

The crisis happened because European Monetary Union was poorly conceived, badly designed, and poorly executed. It grew so big because, like other such bubbles, it worked beautifully so long as it expanded.

EMU was conceived mainly for political reasons, namely to further cement “Europe”, and to further Europe’s desire for a restoration of its “world power” status. Instead of first creating a functioning political union with a government, a legislature and fiscal revenue, Europe put the cart before the horse and created a currency union without a nation, without centralized government, and without fiscal revenue or fiscal sharing.

The "Two Europes"
There is a lot of literature about the ideal conditions for a monetary union, and suffice it to say that the eurozone meets none of them. Europe is a geography, not a nation and not a culture. To be more specific about the differences, the northern part of Europe is more developed than the southern part. The north has stronger political institutions, greater national cohesion, disciplined labor markets, and a competitive private sector. Specifically, the northern European countries have been successful at maintaining international competitiveness despite having hard currencies. Unit labor costs are controlled in such a way that currency devaluation is not necessary.

By contrast, southern Europe is less developed than the north; it is more “Latin,” in the negative sense of the word. Political institutions are weaker, national cohesion is less evident, regionalism is more pronounced, and labor markets are inflexible. Southern Europe has never been successful at maintaining competitiveness with a hard currency. Southern Europe has historically dealt with poorly controlled labor costs by devaluation. Devaluation permits countries to avoid having to control labor costs.

This is why I say that EMU was poorly conceived: it was unsuitable for the heterogenous mix of countries involved.

Furthermore, the eurozone was badly designed. If, ex ante, one had wanted to create a European monetary union, one might have taken a close look at one of the world’s most successful monetary unions, the dollar zone. The dollar zone has three features that have been crucial to its success: (1) a national banking system which is nationally regulated and nationally guaranteed; (2) complete insulation of banks from the creditworthiness of their respective state governments; and (3) the absence of state-level convertibility risk.

The eurozone has none of these crucial features. It lacks a national banking system, national deposit insurance, and national bank regulation. Its banks are highly exposed to their respective governments, and they depend on these governments to guarantee their deposits. And depositors in eurozone banks are exposed to the risk that their deposits could be frozen or redenominated by their respective governments.

The Wrong Central Bank
The eurozone has another design flaw, an almost fatal one. That is that it chose the wrong model for its central bank. A monetary union which contains countries that rely upon a weak currency to remain competitive should not have chosen the Deutsche Bundesbank as its model. The eurozone’s central bank should have included Latin design elements, such as a higher inflation tolerance and a full-employment mandate. In other words, the ECB should have been modeled on the Banca d’Italia, a more forgiving institution.

By choosing the Bundesbank model, the solons had decided that it would be easier to change the nature of southern European society than for the Germans to accept the lira as their currency. That was a mistake: thirteen years of monetary union have not changed southern Europe. Unit labor costs are still uncontrolled, and the tolerance for deflationary policies remains low. Indeed, instead of the south changing, it is the ECB that will now have to change if EMU is to succeed.

The Bubble Economy
Now, given the foregoing flaws, how was the eurozone bubble able to grow so big for so long?  The answer is because it acted as a Ponzi-scheme. When EMU was embarked upon in the mid-nineties, a euphoric mania began in which, as if by magic, southern European countries lost their historic country risk. The magical word on everyone’s lips was “convergence”, the idea that somehow the creditworthiness of the southern countries would converge with the AAAs of the north.

The “convergence trade” meant that one could stop obsessing over southern budget deficits, secure in the knowledge that they were all on an inevitable path toward compliance with the Maastricht fiscal criteria (<3% deficit, <60% D/GDP). The thinking was, ignore the inevitable bumps, and ride the credit spreads down to zero. Overnight, these countries became magnets for capital inflows: their returns were high while their risks were low. A virtuous cycle began in which success fueled success and all the metrics pointed in the right direction. (All the metrics except the current account, but that was now “irrelevant”.)

This bubble started growing in 2002, and it was still growing when the great recession hit in 2008. In such a steep recession, it was natural for countries to run temporary budget deficits, so there was little concern over red ink in 2008 and into 2009.

Greek Perfidy
However, what ultimately poked a hole in the euro bubble was the discovery in late 2009 that Greece had been cooking its books for years, and had never been in compliance with the Maastricht criteria. (Imagine, a country knowingly publishing false statistics! Who had ever heard of such a thing?)

All of a sudden, Greece got hit with a big bucket of cold water. A country which had enjoyed much higher concentration limits than it deserved now began to discover what happens when your limits are reduced. Greece quickly lost market access and required a bailout.
   
At first it appeared that Greece would only need temporary liquidity support to tide it over until it could get its budget back in balance. Then it appeared that Greece would be unable to repair itself quickly and would be out of the market for a long time, requiring Europe to refinance its maturing debt. When it became evident that not only could Greece not balance its budget, but also that its debt levels were unsustainable, Europe began to realize that fixing Greece was going to be time-consuming and costly.

It was at this point that Europe made its next major mistake. This was to announce that, if Europe were to continue funding Greece, its debts would have to be reduced to a manageable level. And, if the European taxpayer were to have to rescue Greece, its bondholders would have to contribute (what is known in credit circles as "default").

Contagion
That might sound perfectly reasonable to a politician, but it sounds perfectly unreasonable to a bondholder who has been repeatedly told that default by a eurozone government was “unthinkable”. Overnight, the unthinkable became not only thinkable but a fait accompli. Greece was rescued at the expense of its bondholders and, more importantly, at the expense of the eurozone’s credibility in the bond market. The eurozone minus credibility equals the end of euro mania.

Had Greece been quietly cleaned up, it would have been a manageable problem. But when the doctrine of  “bondholder bail-in” was proclaimed, that meant that every eurozone government instantly became a “credit” once again, to be evaluated on a stand-alone basis.

When the world’s credit analysts turned their microscopes onto the eurozone, they discovered a lot of ugly credits squirming around which were quickly named the “PIIGS”, for Portugal, Ireland, Italy, Greece and Spain. These countries then got hit with their own buckets of cold water, were declared personas non grata, and lost market access. This probably would not have happened if Greek bondholders had been protected (which would have cost very little in the scheme of things).

Epilogue
Ultimately, of the five PIIGS, two have been bailed out once (Portugal and Ireland), one has been bailed out twice (Greece), Spain is in the process of receiving multiple bailouts, and only Italy has survived on its own. And now Cyprus has been added to the list, even though it doesn’t fit into the acronym.

We have just now entered the next phase of the EMU crisis, in which the central bank has begun to develop Latin characteristics. But even now, it isn’t yet Latin, and it will need to be before this is over.

The Differences Between the Eurozone and the Dollarzone

How the US succeeds as a monetary union while Europe doesn’t, and why Greece is in a debt crisis while California isn’t:

1. The California banking system’s creditworthiness is not linked to the state’s.
>California’s banks are not heavily exposed to the California government’s credit risk because they are not the government’s principal source of funding, due to the tax-exempt nature of California’s debt.
>California has no responsibility for the solvency of the California banking system; instead the federal government is responsible for the solvency of all banks in the dollar zone.
>Bank deposits in the dollar zone are guaranteed by the US government.
>Because of the excellence of US bank accounting and regulation, dollar zone bank financial statements are credible.
>The American states have no control over their banks, and can’t order them to buy state debt.
>The Federal Reserve does not condition the provision of  bank liquidity on the fiscal performance of the California government.
>The federal government does not condition state-level funding on state government fiscal performance.
>The Federal Reserve does not buy state government debt.
2. California’s market access is unrelated to its credit rating
>Because of the Constitutional accident of tax-exempt state debt, most of California’s debt is held by California residents and not by foreigners.
>Because California has a monopoly on the issuance of debt that is tax exempt in California, her access to the bond market is unimpaired despite her volatile credit risk.
>The California bond market is entirely domestic. It is neither national nor international.

3. The government of California is a small part of California’s economy
>Most government spending in California is federal, not state.
>The California economy would survive the bankruptcy of the state, because it would not bring down the banking system, and federal spending would continue.
>The US government does not condition its California spending on the state’s fiscal performance.
>Most California residents are not employees of the state, and the California public sector is small compared to that of Greece.

4. California bank deposits have no convertibility risk
>There is no risk of a California currency redenomination because, pursuant to the US Constitution and the outcome of the Civil War, California cannot exit the dollar zone, nor can she be expelled from it.
>California cannot impose currency or capital controls.

What the eurozone would have to do to separate bank and state solvency and to eliminate convertibility risk:

1. The ECB guarantees bank deposits.
2. The ECB is responsible for bank solvency and regulation.
3. The ECB imposes strict, uniform and transparent solvency and liquidity standards on all eurozone banks.
4. The ECB’s bank regulatory regime is comprehensive, intrusive, incorruptible and independent of government interference and political pressure.
5. National central banks are abolished and removed from the ECB governing council.
6. ECB does not condition the fulfillment of its statutory responsibilities on the fiscal behavior of member governments.

7. The EU does not condition its spending policies on the fiscal behavior of member governments.

8. Governments can default on their debt but cannot redenominate.
9. Interest on government debt is tax-deductible for households but not for banks.
10. Government debt is marked to market, forcing timely recapitalization.
11. Concentration limits are imposed on bank exposure to government risk.

The ECB May Yet Save Europe!

Hat’s off to Mario Draghi, who may actually be the smartest man in Europe.

As a result of today's ECB board meeting, I now assign a higher probability to eurozone survival than I have since the crisis began in early 2010. For the first time, the cup is half-full. Europe has finally abandoned its hopeless strategy of mutual eurobonds backed by fiscal union (piling debt upon debt), and is moving toward the only possible solution: full-scale monetary rescue by the ECB.

The entire governing council (minus one, Weidmann of the Bundesbank) voted for Draghi’s bond-buying program (“outright monetary transactions”). Under this program, the ECB will spend an “unlimited” amount of euros to buy medium term government bonds in the secondary market. To be eligible for the OMT, governments will have to apply to the EFSF/ESM and submit to a comprehensive reform plan including both micro reforms and a path to budgetary balance. (This is a big mistake.)

But before I discuss the plan’s drawbacks, let me explain its good parts. First of all, this action embodies my fondest hope, which was that the ECB would finally ignore Weidmann and get on with rescuing the eurozone. Poor Mr. Draghi was forced to cook up an elaborate rationale explaining why buying peripheral bonds is in keeping with the ECB’s charter, which explicitly forbids it. He knows that his rationale is completely bogus but he needs it to help the Northern governments sell it to their people. (Note that both the Finnish and Dutch central banks went along with the plan, which may not please their governments, especially Finland. We haven’t heard from any governments yet.)

This announcement effectively means that the South (or should I say Europe?) has hijacked the ECB and left the Bundesbank in the dust, which was absolutely necessary. Weidmann will now have to resign or shut up. Merkel certainly wants him to shut up. (Germany’s other board member voted for the plan, which further isolates Weidmann.)

The ECB staff was unable to come up with a transparent formula for deciding how to target bond yields for each country, which is perhaps understandable given the political sensitivity. However, without an announced target, the markets can only flounder around trying to figure out what the ECB’s secret target really is. This will cost the ECB a lot of money that it wouldn’t have had to spend defending an announced target.

There will be a lot of commotion in the bond market for a while. The key numbers to watch will be Spanish 3-year and 10-year yields. The 3-year maturity would fall within the OMT program, and the 10-year will signal the market’s unmanipulated opinion of the program.

This program could contain the seeds for a complete monetary rescue of the eurozone, maybe including even Greece (which Draghi never mentioned and which no reporter asked about). Greece is now chump change. Once the ECB starts in on this, it is literally in a fight for its life. It will have to spend whatever it takes, or it will lose. I don’t know if Merkel fully understands what has just happened, but it really does mean the Italianization of the ECB. It may still be located in Frankfurt, but it’s now the Banca Centrale Europea. Some Germans besides Weidmann may not like this.

Now, the problems. As I indicated yesterday, it takes two to play the conditionality game and, for now, Spain isn’t playing. Rajoy’s position is that Spain has already launched a reform program and doesn’t need a new one imposed by the Troika. Draghi (meaning Merkel) left no room for compromise on this, so Rajoy will have to blink. When and how will he do so? He has run out of money except for the round-trip through his central bank. The ECB abandoned all collateral standards today, so in theory the Spanish banks can now pledge their paper clips and furniture, but I expect that Draghi will start closing the spigot. Rajoy will be forced to lose face or default. (This is not your father’s central bank!)

As I said earlier, the austerity requirement is a big mistake, since it leads inexorably to depression. These economies need growth, not asphyxiation. I’m sure Draghi knows this, but is an incrementalist. An even bigger mistake is the ECB’s ongoing monetary nonfeasance.

Draghi today:
Turning to the monetary analysis, the underlying pace of monetary expansion remained subdued. The annual growth rate of M3 increased to 3.8 percent in July 2012, up from 3.2 percent in June. Economic growth in the euro area is expected to remain weak.
Euro area real GDP contracted by 0.2 percent, quarter on quarter, in the second quarter of 2012, following zero growth in the previous quarter. Economic indicators point to a continued weak economic activity in the remainder of 2012 in an environment of heightened uncertainty.
Looking beyond the short term, we expect the euro area economy to recover only very gradually. The growth momentum is expected to remain dampened by the necessary process of balance sheet adjustment in the financial and nonfinancial sectors, by the existence of high unemployment, and by an uneven global recovery.

In plain English: “We don’t know when we will arrive at our destination because we are driving as slowly as we can and are taking frequent rest stops. Also, the motor may be broken."

You might ask: won’t unlimited bond purchases stimulate monetary growth? Not for these scientists. Draghi made clear that all such purchases will be fully sterilized and that the notion of not sterilizing  wasn’t even discussed (!). 

The ECB is apparently quite happy with zero real growth and negligible nominal growth. And one of the excuses Draghi gives for low growth is high unemployment! Maybe he isn’t the smartest man in Europe, or maybe he is playing the long game. After all, if he plans to monetize the entire debt of Spain and Italy, that will ultimately require a bigger balance sheet. I hope that’s what he’s thinking: in for a penny, in for three trillion euros.

As long as the ECB continues to deliver zero growth, nothing can save the periphery because only growth can grow government revenue and shrink relative debt. The ideal policy would be unlimited spending in support of across-the-board yield ceilings, no austerity, and massive monetary stimulus in order to achieve 5-6% nominal growth. We are nowhere near that plan, which is why I am not yet converted to the bull case for Europe.

Going forward, we will have to see what Rajoy says, what Monti says, what Merkel says, what happens to Spanish yields and--yes--what happens with Greece. But Spain is the crisis du jour.

Expect Little From The ECB on Thursday

Thursday is the next ECB board meeting. Will Draghi be able to do “whatever it takes” to save Spain?

In order for the ECB to start buying Spanish bonds, there are three conditions precedent: (1) the ESM must be inaugurated, which requires the OK of the German constitutional court; (2) Spain must apply for aid from the ESM; and (3) Spain must sign onto a fiscal plan approved by the Troika, including the IMF.

I presume that the German court will OK the ESM. But Spain is not willing to even discuss making an application to the ESM.  PM Rajoy says that he doesn’t need to agree to an austerity plan, and that in any case he won’t apply until the ECB agrees to unlimited bond purchases.

Draghi is left with no room for manoeuvre. He can’t agree to unlimited bond purchases, and he can’t do anything at all for Spain until the government applies for aid. Draghi stands ready to buy Spanish bonds, but he can’t do it yet.

Rajoy knows that Spain is TBTF, and he is prepared to play chicken with Europe to get what he wants. He has no desire for the “men in black” to take over his country.

If I were Mariano Rajoy, I would be doing exactly what he is doing. He does not want Spain to walk the path of starvation in exchange for minimal life-support. He wants the ECB to bring Spanish bond yields down to an affordable level without having to impose austerity. If he gets his way, it will be better for Spain; the strategy of spending cuts chasing revenue shortfalls is disastrous.

This is a battle between the North (Germany, Finland, Netherlands) and the South (France, Italy and Spain), and the cockpit is the ECB governing council. On Thursday, I expect neither side to win. I have no idea who will win in the end, but I’m rooting for the South.