Saturday, September 8, 2012

The Magic Tricks of Mario Draghi

Tyler Cowen over at Marginal Revolution calls out one of the problems with Mario Draghi's plan to prop up the debt of Euro zone governments:
The notion of “unlimited” but “sterilized” bond-buying interventions is a problematic one.  How much “Dran-O” is there to remove the newly created money?  Surely the ECB can’t respond by selling from its current portfolio of periphery bonds.
How very true. What exactly is Draghi going to sell to sterilize bond purchases and how much does he have to sell?

This is a very important question. It appears to be a Mario Draghi magic trick unfolding before our eyes.

Yet, while Cowen details this problem and comments on other aspects of the program, Cowen, who may be considered something of a convoluted communicator in his own right, appears to have completed missed the core, as most everyone else has, of the convoluted Draghi plan. The bombshell, if you will, is in Draghi's other hand.

On the same day as the ECB announced the bond buying program, the ECB released a sister press release that said:

The Governing Council of the ECB has decided to suspend the application of the minimum credit rating threshold in the collateral eligibility requirements for the purposes of the Eurosystem’s credit operations in the case of marketable debt instruments issued or guaranteed by the central government, and credit claims granted to or guaranteed by the central government, of countries that are eligible for Outright Monetary Transactions or are under an EU-IMF programme and comply with the attached conditionality as assessed by the Governing Council.
The suspension applies to all outstanding and new assets of the type described above.
As Robert Noble at RBC Capital puts it (my bold):
This effectively removes the issue of ratings downgrades if a country enters programme. It also is suggestive that banks in a country under programme will be able to use self issued government guaranteed debt as collateral, which was limited earlier this year. Effectively this is a small additional encouragement and promise of liquidity if a country is to enter programme, a nudge to the Spanish banking system which has recently created significant amounts of collateral through lending to its regional governments.
While, Noble sees it as a nudge for countries like Spain and Italy to get with the program, most important, it creates a backdoor through which massive ECB monetization of Eurozone sovereign debt can occur. If you are an EZ government having trouble raising funds, just issue paper that will be bought by local banks that have ability to go to the ECB and use it as collateral for newly issued ECB euros.

This is the serious magic trick in Mario's bag of magic tricks. His sterilized bond buying is smoke and mirrors. The new collateral rules create the potential for unlimited backdoor money printing. What needs to be monitored is how much printing will be done through this backdoor.

1 comment:

  1. The sterilization aspect of the ECB bond buying plan was purely a political move to appease the Germans and deflect charges that it would be inflationary (which, as noted, it almost certainly will be). Really what this whole plan is about is transferring the bad debts of Spain and Italy from the balance sheets of those countries to the balance sheet of the ECB. As the EU lacks an independent taxation authority, some backdoor means to monetitize these bad debts away will have to be be utilized as the Germans are unlikely to pay directly for the bad debts of Spain and Italy.