Evan Soltas
Aug 21, 2012

Is This It?

EZB-Chef Mario Draghi auf der IX. Ludwig Erhard Lecture
I am convinced that European policymakers have collectively decided that they will get their act together this autumn.

Consider the evidence: Germany has signaled their support for an European Central Bank bond-buying program and their acceptance of "small concessions" on the terms of the Greece bailout. Greece is putting together an 11.5-billion euro austerity plan which includes significant cuts to public pensions and wages as well as reductions in public-sector employment -- but more importantly, it looks like exactly like what Germany and the ECB need as evidence of progress to meet the conditionality requirements for central bank action. Bond yields in Italy, Spain, Portugal, and Greece are all plummeting to levels not seen in months.

This is all driven by a newfound recognition that, absent immediate action, the situation in the European Monetary Union could deteriorate beyond the point of rescue. That's how I read the comments from Draghi and Asmussen about "convertibility risk" -- if the ECB and European governments can step in at the last moment and prevent collapse of the EMU at such a point, then there should be no such risk. Convertibility risk only exists if we assume that policymakers do not have the tools to prevent the worst-case scenario, only the lighter tremors.

I think the existence of a "point of no return" has become much more clear, also, over the past few months. The slow-mo version of a bank run -- a so-called "bank jog" -- has left the European financial system in such a fragile state that I doubt its ability to withstand another negative shock of any real magnitude. Most banks in the European periphery are without any funding sources besides the ECB and their domestic constituencies. This is called "financial fragmentation," and it will likely represent an auxiliary rationale for further intervention. The private European interbank lending market appears to be deeply frozen -- and that should ring alarm bells for those who remember the prerequisites of the 2008 crisis in the United States.

One more event, in my opinion, would make the EMU unsalvageable: if Germany began to have severe economic difficulties. And guess what -- Germany's Bundesbank is concerned now. "Confidence in German public finances is a key anchor of stability in the current crisis but it cannot be taken for granted," they said in a report released yesterday. These concerns are well-founded in the data: German year-over-year real GDP growth slowed to 1.2 percent in the first quarter and 0.3 percent in the second quarter.

I expect bad news in Germany to propel ECB action, as I've shown statistically in the past that the ECB weights its policy according to a "50-50 rule" -- that is, one eye exclusively on Germany, the other eye on the all the rest of Europe. German inflation, which now is also slowing, represents empirically the single most powerful determinant of ECB monetary policy.

So here is what I expect to happen, looking at market data and this report in Der Spiegel. The ECB will announce in September a bond-buying program which will cap the yield spreads of Spanish and Italian 5- and 10-year bonds at 4 percent against German bonds of the same maturity on the condition that Spain and Italy continue their structural adjustment. Such a plan would assure these governments' access to funds and would push down yields across the board, and the spread data appear to be converging to such a point. Separate arrangements may be worked out with Portugal and Greece, but it's not clear what they will look like.