A happy ending for the euro?

  • 1 December 2011
  • From the section Business
  • comments

The ECB president's comments before the European Parliament this morning have added to a mood of cautious - very cautious - optimism about the eurozone crisis, just as the governor of the Bank of England has highlighted the great risks for UK banks.

How so? Well, out of the confusion of finance ministers' meetings and diplomatic phone-calls, investors are starting to see the outlines of a compromise deal to "save" the euro.

Mario Draghi's remarks have added to the picture.

But goodness knows, we have been here before: there's still plenty of details to fill in, and plenty of time for disappointments. Also, even the most optimistic versions of the deal say nothing about the re-balancing of the European economy, which is not happening and will be crucial for any long-term success.

The rosy scenario is a story of three acts, and as ever, the fiscal comes first. Chancellor Merkel will not budge on anything until she gets agreement on a new fiscal pact for the eurozone.

As Mario Draghi repeated today, the ECB needs this too: governments have do their part to make this a viable union, both right now and into the future.

Legal bind

In the end, they need to change the treaties to legally bind countries into accepting collective control of budgets. But in the short term, Draghi seems confident a stop gap is possible which would help "frame expectations" in the markets.

Some ECB watchers think it will encourage the ECB to do more as well. Here's part of what he said on the fiscal pact. Later I'll get to what he said about the ECB: "On the precise legal process that brings about a move towards a genuine economic union, we should keep our options open. Far-reaching Treaty changes should not be discarded, but faster processes are also conceivable."

If you assume this kind of fiscal pact is now within the leaders' grasp, plus some revamped policy commitments from countries like Italy, we would then move to the second act in this feel-good tale, in which Germany agrees to some form of collective underwriting of eurozone debt.

Even on the optimistic view, this is presumably not going to be eurobonds, which the German Chancellor has trashed so often, and so recently. But, short-term, her agreement to stand by a more ambitious version of the European Financial Stability Facility (EFSF) could do the same job.

When I say "more ambitious", I mean a lot more ambitious than the options for leveraging the EFSF which emerged out of European finance ministers meeting on Tuesday.

Bank of EFSF

You'd need something like turning the EFSF into a bank, which could borrow from the ECB to lend to governments (I wrote about this idea in September - see Central banks and the 'spirit of 2008' ).

Germany still seems quite far from accepting this. But the optimists say, it might still be possible to jump to Act 3, in which the ECB responds to the future promise of fiscal union - and the clear and immediate threat of a serious credit crunch - by launching much more aggressive purchases of Italian and other sovereign debt.

Didn't Draghi rule out precisely this kind of rescue today, repeating the old mantra that the ECB's bond purchasing scheme was "temporary" and "limited", and solely designed to make monetary policy work more effectively?

The answer is yes. But then he clarified that temporary and limited meant that it wasn't "eternal" or "infinite".

To me - and others, such as Julian Callow, at Barclays Capital - that is sending a rather different message than we've heard before. It allows for the possibility that the ECB will up the pace of purchases quite substantially, especially if the tensions in bond markets intensify.

After all, very few things in this world are infinite or eternal. The bond purchases might not be either of these things, and still be pretty large - and long-lived.

Though Draghi also explicitly ruled out the ECB lending to governments - or "subsidising" them - he chose to remind everyone that the ECB was a "lender of last resort' to solvent banks.

This has not previously been a phrase that ECB officials have used very often recently, even in connection with banks.

Enormous sum

Given all the criticism the ECB has been getting about its failure to be a "lender of last resort" for the Euro, you have to wonder whether Draghi wanted to remind his audience that the ECB was already playing that function, to a significant extent, in the enormous amounts of emergency liquidity it had provided periphery banks (see blog Sir Mervyn King's two messages).

That emergency liquidity has not followed the Bagehot formula for last resort lending, because there has been no penalty rate, and the institutions concerned are not necessarily solvent - notably the Greek ones. But these banks have been required to offer collateral, as Bagehot would have wanted. And crucially, that collateral (mostly national sovereign bonds), has been marked to current market value.

That is critical for the ECB, because it means the liquidity has "only" been propping up the financial system in countries like Greece. It has not been directly propping up the governments.

But, if countries like Italy start to lose market access altogether, then you could see how the ECB could end up playing "lender of last resort, one step removed", effectively funding private bank purchases of Italian bonds.

No white charger

So, we are back to the main issue: will we see the ECB play a bigger role in "saving" the euro? I think it's inevitable. And I think Draghi is very carefully preparing the way.

But governments will need to do a lot, too. And even then, don't expect him to ride in on a white charger labelled "lender of last resort to governments". It is much more likely to come a part of a monetary policy response to the dramatic deterioration of the economic situation, which will be exacerbated in the periphery by barely suppressed panic in sovereign bond markets.

In other words, the ECB's "rescue" it is likely to look more and more like quantitative easing. This, of course, is all speculation.

And Mervyn King is still right to say that the central bank, alone, cannot fix the crisis.

But it is intriguing food for thought.