Promises, Promises, But More Than A Technical Detail

Well the eurozone government deficit problem has hit the agenda with a thud again in the last few days. Yesterday the FT ran a story about how the ECB has decided that it will not accept government paper (bonds) in the future from any country which has not maintained at least an A- rating from one or more of the principal debt assesment agencies. (Dave Altig at MacroBlog has also covered the story here, and Nouriel Roubini here). Today the FT has another story about how Trichet has confirmed the policy, and how the Commission too plans to get tough (well they would, wouldn't they, since this may now become a credibility auction).

This topic must appear appaulingly technical and yawn-provoking to the non-economist. In fact nothing could be further from the truth. Let me explain a bit.

Basically the situation we have had to date has been that the ECB has accepted the bonds of any one country as equivalent to the bonds of any other, just like a one euro coin from France is treated as equivalent to a one euro coin from Finland in any shop in the Eurozone. The ECB makes its presence felt on this via the assets it accepts as reserve deposits from eurozone central banks.

Now basically this decision is a vote of only limited confidence in the mechanisms put in place by the EU commission via the Stability and Growth Pact. Italy has been given two years grace to put its house in order. Serious doubts remain as to whether anything will really change significantly during the next two years, but if it doesn't the fiscal credibility of the Commission will be in tatters. The ECB is cleary concerned that its credibility may also go west in the process (a clear case if there was one of 'credibility rot'). So the bank has put up a marker: here and no further. This is always a difficult thing to do, since if you ever say never, and then change your mind, you obviously end up with egg all over your face (the 'moral hazard' issue is all about this).

This decision is an important one (I would even say a landmark one) since it is hard to see how there can be a turning back. Basically the ECB is saying to the Italian government: you may be able to pull the wool over their eyes up in Brussels, now try the same ploy with the rating agencies.

Well, if the Italian government desists from excess deficits there will be no issue, but my fear is that they may not be able to.


Basically, and plagiarising Brad Setser and Nouriel Roubini just a little: 'demographics also matter'. The problem isn't simply that Italy has had a series of governments that have been systematically profligate. It also has possibly the most rapidly ageing population on the planet (it is about to overtake Japan, and then in turn be overtaken by Spain as the oldest country if the UN projections are valid). So this is about sustainable fiscal dynamics and tax wedges vis-a-vis employment generation. The Italian government really is between the proverbial rock and the hard place.

In reality I imagine that what we will see is a steady drift away from central bank willingness to hold Italian paper in reserves (it is important to bear in mind here that the ECB itself has relatively little capitalisation, and each country still has its own central bank, and its own reserves). So the other central banks (and who knows, Asian central banks and anyone else who holds sizeable quantities of eurozone paper) may well slowly move Italian paper out of their reserves. After all, if the ultimate guarantor isn't willing to accept at par, who else is going to risk it.

The consequence of this is that the so-called yield spread - the difference in effective interest rate operating on a 10 year German bund and that on a similar bond from the country in question - should start to widen (at presnt Italian bonds are trading with a differential of a little over 20 base points, or 0.2%, over the German bund). This is very likely now to widen: probably slowly but steadily.

Morgan Stanley economist Joaquim Fels (who I do think is at least listened to over at the ECB these days) has been arguing for some time now that the fact that the ECB treated all euro-govt-bonds at par was one of the principal anchors preventing a thickening in the yield spread. Well now the anchor has been cut (rather than weighed). What can now happen is that each time the Italian deficit fails to comply with promises and forecasts, someone, somewhere can try and test the spread. In the beginning I imagine this will be a non event, but just give it time. A little crack has open up in the wall, and now some will know no rest until it has finally been breached. The ECB decision has opened up the real possibility of speculative attacks against sovereign debt inside the eurozone, and this is obviously a first, in fact *the* first new possibility on the horizon since the euro was launched.

As I say, I think a decision like this is very hard to go back on, so it is difficult to see how the ECB could 'blink' here even if it wanted to. A 'bail out' could be arranged indirectly if the yield spread grew too much, but to keep doing this you need to be convinced that Italian growth and fiscal policy will get back onto a sustainable trajectory. I am not convinced that they will, and thus there may well be a 'high-noon' situation.

Of course, we are only at the begining of a long process here, butas I say I think this decision is a landmark one.

Also, again plagiarising Nouriel Roubini and the late lamented Rudi Dornbusch: politics matter. The backdrop to all this is the recent failure of the EU constitution vote, long standing frustration at Eurostat about blatantly falsified Italian data, and now the Fazio affair, where EU internal market commissioner Charlie McCreevy seems to be so frustrated that he is actually demanding that legal action be taken against the governor of the central bank in a sovereign state. I guess this would also be another euro first.

Many worry these days about the level of tolerance for globalisation and the dangers of protectionism, but my guess is that the danger of a kind of 'internal protectionism' inside the EU, with citizens in one country being reluctant to bail out citizens in another, is a much more real and present danger. Note how Dutch finance minister Gerrit Zalm has taken a ringside seat to applaud the ECB initiative.

Bottom line: we've just pushed the boat out and there may now be no easy way to draw it back in again.


Anybody wanting a more serious academic background explanation to all this could do worse than this paper by Buiter and Sibert: How the Eurosystem’s Open Market Operations Weaken Fiscal Discipline in the Eurozone (and what to do about it) (Hat Tip to Nouriel Roubini).