Draghi and friends just want your money

By Bill Gross, Financial Times

Psst! Investors – do you wanna know a secret? Do you wanna know what Angela Merkel, François Hollande, Christine Lagarde and Mario Draghi all share in common? They want your money!

They’ve wanted it for years now but you are resisting by holding on to it or investing it at negative interest rates in Switzerland, Germany and a growing number of other countries considered to be European Union havens. They want you to be less frugal and more risk-seeking. They want your money as a substitute for theirs in Spain, Italy and, of course, Greece, but they don’t mention that any more. The example would be too off-putting. “Investors,” they plead, “show us your money!”

The ultimate goal of monetary and fiscal policy in the EU is to re-engage the private sector. The EU needs the private sector as a willing (but not necessarily equal) partner in funding its economy. This often gets lost in the noisy details of all too frequent promises such as the one to defend the euro made by Mr Draghi, European Central Bank president.

Investors get distracted by the hundreds of billions of euros in sovereign policy checks, promises and IOUs that make for media headlines but forget it’s their trillions that are the real objective. Even Mr Hollande in left-leaning France recognises that the private sector is critical for future growth in the EU. He knows that, without its partnership, a one-sided funding via state-controlled banks and central banks will inevitably lead to high debt-to-GDP ratios, rating service downgrades and a downhill vicious cycle of recession.

But private investors are balking – and for what it seems are good reasons – because policy makers’ efforts have been, until now, a day late and a euro short, or more accurately, years late and a trillion euros short. Let’s look at some examples of this.

First, Greek bailouts that included private sector involvement but no official sector involvement, resulting in the inevitable investor conclusion that future programmes for Spain and Italy might resemble the same.

Second, an initial tightening and then a reluctant lowering of ECB policy rates.

Third, a bond purchase programme (securities markets programme or SMP) by the ECB that was too small and prematurely abandoned.

Fourth, fiscal austerity packages for individual countries that accelerated recessionary/depressionary growth paths.

Fifth, public fights among northern and southern EU countries that highlighted the seemingly perpetual dysfunctionality of the eurozone 17 and the EU 27.

Finally, Mr Draghi’s reversal last Thursday. Someone must have got to him between London and Frankfurt.

Policy makers now face an unprecedented expansion of risk spreads and credit agency downgrades which almost guarantee that sickbed countries can never be discharged from intensive care.

Interest rates over and above each country’s nominal GDP growth rate will inevitably add to a country’s debt as a percentage of GDP, even if budgets are in primary balance.Investors misguidedly focus on 7 per cent yields in Spanish and Italian bond markets as some sort of high watermark – below which swimmers can safely touch bottom. But even at 7 per cent deep, the toes cannot stretch. Maybe even 4 per cent is not shallow enough.

At current yields, growth rates, and deficits, the spread may incrementally add 2-3 per cent to Spain and Italy’s tenuous debt ratios every year. While it is true that both countries can shorten maturity offerings and even accept the benefit of prior terming of their debt stock, eventual drowning will occur even at 4 per cent or higher 10-year yields as long as nominal GDP growth is anywhere close to flat.

Policy makers will solicit the private market’s participation in an effort to get there, by attempting to lead via co-ordinated monetary/fiscal efforts involving the SMP from the ECB and hundreds of billions of euros from bailout funds – the European Financial Stability Facility and ultimately the European Stability Mechanism. But without the private sector’s co-operation, the effort may be futile.

The dirty little secret that sovereign debt issuing nations need to remember most of all is that credit and maturity extension is based upon trust. After all, “credere” is a Latin word meaning just that. After trust has been lost due to half-baked policy measures; after credit agencies belatedly have recognised embedded costs of debt that can no longer insure solvency; after marginal investors have been flushed from the system to what appear to be safer return of principal havens; and after policy makers finally appreciate the fragility of their rigged fiscal and monetary system; after all of that – there is no coming home, there is no going back in the water.

Psst investors: Stay dry my friends!

Bill Gross is founder and co-chief investment officer of Pimco

ECB Risks Inflation and Loss of Independence

An Analysis by Stefan Kaiser, Spiegel Online

The next taboo has already been broken in Europe, with the European Central Bank now buying up Italian bonds. With its interventionist policies, the ECB is becoming increasingly similar to the US Federal Reserve. It's a path fraught with serious risks.

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The original sin occurred 15 months ago -- in May 2010, when the European Central Bank (ECB) caved in for the first time. After a dispute with politicians that lasted weeks, the central bank agreed to purchase bonds from euro-zone member countries that had been brought to the abyss by the crisis. By doing so, the ECB also lost its independence -- at least that's how critics of the central bank's policy see it.

Those same critics feel confirmed in their doubts now that the central bank in response to the debt crisis and market developments is not only buying up Greek, Portuguese and Irish bonds, but also those of Spain and Italy. "Back then, the claim was made that the bond purchasing was a one-time exception," said Joachim Scheide, head of the Forecasting Center at the Kiel Institute for the World Economy (IFW), an influential German economics think tank. "Now they are doing it again."

Furthermore, by expanding it to include a bond-buying program for Spain and Italy, the ECB is taking efforts to combat the crisis to an entirely new level. Up until last week, the ECB had around €76 billion ($108 billion) in government bonds on its books. With relatively small economies like Greece, Portugal or Ireland, that could actually make a dent on the bond markets. But in the case of Italy, it would require much greater dimensions if the action is expected to have any lasting success.

The entire volume of outstanding Italian government bonds is greater than €1 trillion. "If the ECB continues to operate with the kind of small amounts seen until now it will, at best, be able to quiet the markets in the short term, but it won't be able to change the (upward) trend in interest rates," Scheide said.

Independent ECB Driven By Politics

Critics see several problems in the ECB policy. One is that the central bank is seriously jeopardizing its independence. According to the European treaties, the ECB and national central banks are obliged to ensure price stability. In order to make them independent of political whims, the treaties hold that "neither the bank itself nor the national central banks or any member of their decision-making organs may request or accept instructions from Community organs or bodies, member state governments or any other organ."

Since the start of the crisis, however, those rules have reflected theory rather than practice. Indeed, the central bankers and ECB President Jean-Claude Trichet are now driven by politics. The governments of the euro zone frequently apply pressure on the central bank to intervene on the markets. And again and again, the central bankers in Frankfurt cave in.

During the baking crisis in 2008 the action was limited to providing unlimited liquidity to banks, where mutual distrust had grown so great that they stopped lending to each other, creating a credit crunch. Since the beginning of the debt crisis in early 2010, however, the ECB has also been expected to purchase government bonds in order to keep the interest rates on those bonds low.

By bending to pressure, the ECB is allowing itself to become a political central bank, making it look more and more like its American counterpart, the Fed.

The Fed has always had a different mandate than the ECB. In addition to ensuring monetary stability, the Fed is also expected to keep the unemployment rate and long-term interest rates low, which is why it has undertaken bond-buying programs that are far bigger than those in Europe. The last, which took place in June, had a volume of $600 billion. Fed Chairman Ben Bernanke has already hinted another may be in the offing.

"The Fed is no longer independent," said Scheide. "Monetary police and financial policy in the United States have been blurred. And that is exactly what Europe doesn't want because it would undermine trust in the ECB."

Expectations Could Fuel Inflation

The second problem inherent to the bond-purchasing program is the risk it poses to the central bank's balance sheet. Three years ago, European and American bonds were considered to be highly secure, but today there are doubts as to whether governments would actually be capable of making good on their debts -- and that is particularly true of the highly-indebted nations on the periphery of the euro zone. Some experts are already concerned that after rescuing banks and countries, the central bank itself will have to be bailed out at some point.

Critics' third argument against the current policies goes right to the core of the ECB's actual mandate: monetary stability. They argue that this, too, is threatened by bond purchases. "When the ECB purchases bonds on the capital market, it increases the base money supply," explained Thorsten Polleit, an economist at Britain's Barclays Capital. "If that money supply eventually reaches the private sector, experience has shown that, sooner or later, it will be offloaded through rising prices."

So far, this effect has been manageable in Europe because the volume of bond purchases has been limited. In addition, the ECB has always tried to neutralize the effects of the liquidity it creates by draining money from money markets or other places to compensate for it. But this "neutralization" will get increasingly difficult as the size of the bonds gets greater.


There is another way in which bond purchases can stoke inflation. "If the impression is created that the ECB is pursuing a weak monetary policy, then it will increase consumers' expectations of inflation -- and ultimately also the inflation rate," said IFW expert Scheide.

As so often is the case with the economy, that is attributable to psychology. If consumers anticipate a rise in prices, they then have a tendency to spend more of their money in order to prevent a devaluation. It is also possible that the unions will demand greater wages in order to offset the expected decline in income. Finally, companies can spot consumers' increasing demand and the higher wage demands of employees and respond by raising the prices of their products.

Despite all these risks, one must also ask what the alternative might be. So far, the governments of the euro-zone countries haven't found an answer that is acceptable to the markets. As long as they are unable to do so, the ECB will have to keep on resembling the Fed. The only consolation for the European currency guardians, it seems, is that the situation is no different for the proud Bank of England or the Japanese central bank. For some time now, both have been forced to purchase state bonds on a massive scale.