Mario Draghi’s combative remarks at the global investment conference in London last week are a must read—not because they change the European game, but for how they illustrate the tension between the ECB chief’s tough-guy talk and the limited armoury under his command.
Draghi got off to a bad start with a bumbling metaphor apparently inspired by Oscar Wilde’s feckless Dr Chasuble: “The euro is like a bumblebee. This is a mystery of nature because it shouldn’t fly but instead it does. So the euro was a bumblebee that flew very well for several years. And now…. something must have changed in the air, and….The bumblebee would have to graduate to a real bee. And that’s what it’s doing.” Since the bumblebee has managed to keep flying for thousands of years without magically transforming itself into a different species, the comparison invites the thought that the euro’s woes can find happy resolution only in a fairy tale, not real life.
But Draghi later found his footing, and a more muscular literary model, with the bold statement that “the ECB is ready to do whatever it takes to preserve the euro. And believe me, it will be enough.” The Financial Times compared this to Dirty Harry threatening villains with his .44 Magnum and growling, “go ahead, make my day,” in the 1983 film Sudden Impact. We think markets would do better to ponder this more terrifying question from the original Dirty Harry:
"I know what you’re thinking: 'Did he fire six shots, or only five?' Well, to tell you the truth, in all this excitement, I’ve kinda lost track myself. But being this is a .44 Magnum, the most powerful handgun in the world, and would blow your head clean off, you’ve got to ask yourself one question: 'Do I feel lucky?' Well do ya, punk?'"
In the movie, the punk quickly surrenders, only to learn the Magnum’s magazine was indeed empty. If you are Clint Eastwood, fearsome bluff is all you need to achieve your ends. For Mario Draghi, alas, life is not so simple.
Draghi talks as if most of the conditions for a more stable eurozone have already been met, but this is scarcely so. Whatever the merits of the proposed fiscal compact and banking union, they cannot save the euro without an agreement on debt mutualization – an EU sharing of responsibility for the sovereign debts of member nations. So far Germany has steadfastly refused to accept debt burden sharing, and until it does one cannot take seriously Draghi’s insistence on the euro’s stable future.
Even leaving aside this crucial issue, other factors limit the power of the ECB’s rhetorical guarantees: the fiscal compact has yet to be approved, negotiations on banking union have only just begun, the Greek situation remains volatile, the German constitutional court will rule on September 12 on the legality of the ESM and the fiscal compact, and critical Dutch elections will be held the same day. And no amount of ECB activism can revive economic growth in the Club Med countries—growth without which a final resolution of the euro crisis is unlikely.
Yet Draghi may still manage to intimidate the market punks in the short term. Specifically, he threatens to limit markets’ ability to put a price on sovereign bonds:
"Sovereign risk premia have to do with default, with liquidity, but they also have to do more and more with the risk of convertibility. To the extent that the size of these premia hampers the functioning of the monetary policy transmission channel, they come within our mandate."
This means the ECB stands ready to cap Italian and Spanish bond yields at levels that reflect "normal" default and liquidity risks, and to eliminate the part of the yield spread reflecting euro breakup fears. That is, the ECB will let markets set sovereign yields only up to a certain limit. When yields breach that limit it will act to drive them back down to “normal” levels (however these are defined), rather like a central bank managing a dirty currency float.
If Draghi can make good on this threat, the summer rally on risk assets will be prolonged. The ECB—probably with help from the EFSF and the ESM in the primary market—will snap up most of the €700bn of the Spanish and Italian bonds still held by non-resident private investors. The investors who worry most about the conversion risk resulting from a euro break-up will be out of the market. The remaining Spanish and Italian domestic investors will still face default risk, but will care little if their holdings get converted into new lire or pesetas. With this effective re-nationalization of sovereign debt, a euro breakup becomes less disruptive and therefore more likely, unless forestalled by German acceptance of debt mutualization.
The key question for the moment, therefore, is how many bullets does Draghi really have in his monetary Magnum? If the ECB and its allies pump hundreds of billions of euros into Spanish and Italian bonds, then a relief rally will gain momentum. But if the ECB confines itself to symbolic intervention of a few billion euros, markets will quickly see through the bluff. And if, under German pressure, the ECB makes large-scale bond purchases conditional on onerous political or fiscal pledges that Italy and Spain are sure to break, markets will see through the bluff a month or two down the road.
For all his manly bluster, Draghi cannot engineer a permanent resolution of the euro crisis: that requires German consent to debt sharing, and a return to growth in Club Med. But he can perhaps enable a few more short rallies through quick fixes. Long-term investors should only buy European assets that are strong enough to survive the many more crises that lie ahead, and a possible euro breakup. Lower quality euro assets such as financial equities and Club Med bonds should only be bought when they are dirt cheap, and treated as short-term tactical trading opportunities. But even these opportunities will be fleeting unless Draghi is willing to back up his words with powerful actions. Dirty Harry style bluff works well enough in the movies, but won’t do the job in real-life Europe.
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