AMERICAN FUTURE

If you’re going to read just one analysis of the origins and consequences of the Eurozone crisis, this speech delivered by Soros on June 2 should be it. The first three pages are a statement of his long-standing theory of “reflexivity” — a subject matter that may or may not be of interest to you. I became acquainted with his theory about 25 years ago; it has had a profound impact on my thinking about financial markets ever since.

The meat on the speech begins with the second paragraph on page 4. It’s certainly among the most insightful analyses of the disaster we see playing out in the Eurozone that I’ve seen. It may even be the most insightful analysis.

Don’t miss it.

As indicated by the fact that I haven’t added to this series of posts since the start of the year, the recent decoupling of the US equity market from events in Europe has made me complacent. I figure that the best way to prevent myself from paying (figuratively and literally) the consequences of overconfidence is to make sure that I once again pay very close attention to the goings-on “over-there.”

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The FT’s Wolfgang Münchau is upset with the IMF for earmarking 91% of its definitive commitments to programs in Europe. He says “no” to these two questions:

• Would an increase in IMF funds to bail out the eurozone be justified?
• Should non-eurozone countries participate in raising new capital?

Here’s his case:

It is not necessary because the eurozone has the financial capacity to help itself . . . Considering that the eurozone is economically unconstrained, and among the richest regions in the world, the request to involve the IMF in hypothetical future rescue operations is morally reprehensible. What is happening here is that eurozone member states find it hard to commit additional funds to the rescue operations, and find it politically more expedient to channel resources through the IMF as a way to bypass national parliaments.

But there is an even more important argument in my view. The way the eurozone member states have been dealing with the crisis has increased the chances of a catastrophic outcome. An extension of the IMF’s commitments is very likely to support current policies.

[...] The eurozone’s cumulative policy errors are turning a liquidity squeeze into a solvency crisis. And herein lies an acute risk for the IMF. If Italy were to become trapped in a long recession, the probability would increase significantly that it would not be able to repay its debt, currently at 120 per cent of GDP. News reports from Italy suggest that the IMF is about to forecast a two-year recession for the country, which could well lead to an increase in the debt-to-GDP ratio at the end of that period. Italy’s future solvency is entirely dependent on market interest rates and the prospect of a return to strong and sustainable economic growth. I struggle to think how this can be accomplished without a fiscal union and much greater burden-sharing.

There are additional technical arguments that would favour more cautious IMF involvement. Mario Blejer, the former governor of the central bank of Argentina, argued recently that the IMF’s preferred creditor status could become a problem, as an IMF loan would automatically subordinate every other bondholder. The probability of a default on those defaultable bonds is thus significantly higher. Furthermore, the situation could become so acute that the IMF’s seniority might fail, which in turn would endanger its capacity to lend at low interest rates.

There are several proposals on the table for how to involve the IMF in a clever way. But they all are subject to the same problem. Any outside liquidity assistance would encourage the eurozone to proceed with policies that are aggravating the crisis.

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Evidently, Münchau was responding to IMF chief Lagarde, who today said that the Fund was ready to help the eurozone and was seeking to increase its lending resources by up to $500 billion. She went on to say that the IMF estimates that in coming years, additional global financing of potentially $1 trillion could be needed.

She then said that there are three imperatives are needed to fully restore confidence: stronger growth, larger firewalls, and deeper integration. Regarding the second of the imperatives, Lagarde called on European policymakers to create a larger firewall. Without it, she stated, countries like Italy and Spain, that are fundamentally able to repay their debts, could potentially be forced into a solvency crisis by abnormal funding costs―a development she warned would have disastrous consequences for systemic stability.

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The FT reports that, soon after Lagarde’s address, Germany appeared to soften its longstanding resistance to increasing the eurozone’s rescue funds (to €750 billion) in exchange for strict budget rules in a new fiscal compact.

According to German and eurozone officials, Angela Merkel is prepared to let the existing European Financial Stability Facility, which has about €250bn in unused funds, run in parallel with its successor, the €500bn European Stability Mechanism, the launch of which has been brought forward to July.

In return the German chancellor wants eurozone heads of government to sign up to rules to cut budget deficits and public debt that are much tougher than those currently foreseen by eurozone governments.

The most recent version of the fiscal compact would allow governments to breach deficit limits in “periods of economic downturn” – a phrase criticised by the ECB as an “escape clause” that could lead to “easy circumvention” of what are meant to be cast-iron rules.

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On a positive note, US money market funds have begun moving back into European bank paper, a sign that central bank efforts to backstop key institutions are improving risk appetite.

This past week, the funds were buyers in increased issuance of French and Spanish banks’ commercial paper, according to bankers. Notes issued by US banks with foreign parents rose $6bn to $152bn and foreign domiciled bank notes outstanding rose nearly $3bn to $133bn, according to figures from the Federal Reserve.

Last year, money market funds were sellers of many European banks’ short-term commercial paper as worries grew about the repercussions of a possible European sovereign default. That was a critical factor in market anxiety, as the highly rated funds’ $2.7tn in liquid assets are a key source of dollar funding.

Money market funds bought French bank paper with maturities as long as one month, as well as small amounts of Spanish bank paper, according to bankers. The funds also bought longer-dated UK, Dutch and Scandinavian bank paper, up to six-month maturities.

The move comes despite France losing its triple A-rating but after a series of strong auctions for Spanish and French sovereign debts and hopes that Greece will reach agreements with creditors to avoid a default in the spring.

If you’ve wondered why I haven’t proffered a “solution” to the eurozone crisis, this post should suffice. Here we have experts far more knowledgeable than I who reach diametrically opposed conclusions regarding the fate of the eurozone and, by implication, the futures of economies and financial markets. The optimistic argument is that the euro will be saved because everyone realizes that the consequences of it not being saved are so dire. The pessimistic argument is that, while the euro’s collapse would have serious negative consequences, these consequences are preferrable to the political and financial costs of preventing the collapse.

The optimistic argument smacks of idealism (a.k.a.wishful thinking); the pessimistic of realism (a.k.a., defeatism). At the bottom of it all lies this question, which always arises at times of crisis: are there forces at work that are beyond the keen of even the most well-intentionned, hard-working, knowledgeable people?

The Peterson Institute’s Bergsten and Kirkegaard:

The economic and financial problems in the euro area are clearly serious and plentiful. An increasing number of commentators and economists have begun to question whether the euro can survive. There are only two alternatives. Europe can jettison the monetary union or it can adopt a complementary economic union. Every policymaker in Europe knows that the collapse of the euro would be a political and economic disaster for all and thus totally unacceptable. Europe’s overriding political imperative to preserve the integration project will surely drive its leaders to ultimately secure the euro and restore the economic health of the continent.

The key is to observe what Europe does rather than what it says. At each critical stage of the crisis, both Germany and the European Central Bank have demonstrated they will pay whatever is necessary to preserve the euro area and avoid defaults (except possibly Greece). But neither can say they will provide unlimited bailouts because this would alleviate the pressure on the debtor countries to reform and weaken the bargaining position of each creditor group (northern European governments, ECB, private lenders, IMF) vis-à-vis the others as they allocate the costs of the bailouts. Europe’s key political actors in Berlin, Frankfurt, Paris, Rome, Athens, and elsewhere will thus quite rationally exhaust all alternative options in searching for the best possible deal before at the last minute coming to an agreement. For all this turmoil, however, Europe is well on its way to completing a true economic and monetary union, and will emerge from the crisis much stronger as a result.

The Financial Times’ Münchau:

The eurozone has fallen into a spiral of downgrades, falling economic output, rising debt and further downgrades. A recession has just started. Greece is now likely to default on most of its debts and may even have to leave the eurozone. When that happens, the spotlight will fall immediately on Portugal, and the next contagious round of downgrades will begin.

Europe’s insufficient rescue fund, the European Financial Stability Facility, now also faces a downgrade because it had borrowed its ratings from its members. The way the EFSF is constructed means that its effective lending capacity will thus be reduced . . .

By downgrading France and Austria but not Germany and the Netherlands, Standard & Poor’s also managed to shape expectations of the economic geography of an eventual break-up. A downgrading of all triple A rated members would have been much easier to deal with politically. Germany is now the only large country left with a triple A rating. The decision will make it harder for Germany to accept eurozone bonds. The ratings wedge between France and Germany will make the relationship even more unbalanced.

[...] The conclusion of the fiscal treaty, which is the top priority of EU politics right now, is at best an irrelevant distraction. Most likely, it will enhance the trend towards pro-cyclical austerity of the kind we have seen in Greece . . .

[...] With each turn of the spiral, the financial and political costs of an effective resolution increase. We have moved past the point where electorates and their representatives are willing to pay the ever-rising costs of repairing the system. Last week a couple of senior parliamentarians from the ruling CDU party, whom I had previously considered voices of moderation, argued that a Greek exit from the eurozone would not be such a big deal. Expectations are changing quickly, and so is the acceptance of a violent ending.

And no, the European Central Bank’s huge liquidity boost is not going to fix the problem either. I do not want to underestimate the importance of that decision. The ECB prevented a credit crunch and deserves credit for that. The return of unlimited long-term money might even have a marginal impact on banks’ willingness to take part in government debt auctions. If we are lucky it might get us through the intense debt rollover period this spring. But a liquidity shower cannot address the underlying problem of a lack of macroeconomic adjustment.

Even economic reforms, necessary as they may be for other reasons, cannot solve this problem. This is another European illusion. We are now at a point where effective crisis resolution would require a strong central fiscal authority, with the power to tax and allocate resources across the eurozone. Of course, it will not happen.

This is the ultimate implication of last week’s ratings downgrades. We have moved beyond the point where a technical fix would work. The toolkit is exhausted.

“Without  the euro, the ECB ceases to exist. That is true of no other eurozone  institution. It gives it the incentive to act. It is also acting on a  large scale.”

– Martin Wolf, December 28, 2011

Regular readers of this blog are well-acquainted with the thoughts of Martin Wolf, the Financial Times’ chief economics commentator. Wolf has long been among the most vocal critics of the European Central Bank, charging that its refusal to act as the eurozone’s lender of last resort has worsened the currency union’s crisis and made it impossible to resolve that crisis.

It is therefore with considerable interest that, as suggested by the above quote, he seems to have changed his mind regarding the intentions and efficacy of the ECB’s policies and actions. Simply stated, without the euro, the ECB has no raison d’être. Like any and all institutions, it will do whatever is necessary to ensure its survival.

Wolf seems to have been greatly influenced by Mario Draghi (the ECB’s new president) who, in his interview with the FT on December 18, argued that the ECB had taken important actions during the previous week:

“We  cut the main interest rate by 25 basis points. We announced two  long-term refinancing operations, which for the first time will last  three years. We halved the minimum reserve ratio from 2 per cent to 1  per cent. We broadened collateral eligibility rules. Finally, the ECB  governing council agreed that the ECB would act as an agent for the  European Financial Stability Facility (EFSF).”

Wolf’s interpretation is as follows:

Thus the ECB is determined to fund banks freely, at low rates of interest, thereby subsidising them directly and the governments they lend to, indirectly.

Why lending to banks that use the money they borrow to lend to governments is good, while lending to governments directly is bad, is hard to understand. The only obvious difference is that in the case of lending via banks, the intermediaries may themselves go broke. That makes them unavoidably unreliable conduits. Yet if this complex procedure gets round theological objections to direct financing of governments, those who believe some financing of governments is now needed should be content.

In short, the recent decisions of the ECB look like a clever way of relieving the funding constraints suffered by banks and vulnerable sovereigns. This does not redress solvency concerns directly, though the subsidy may be large enough to make a difference even here, particularly for the banks. But it should mitigate – if not eliminate –liquidity constraints, which have proved of rising importance over the last year and half.

Focus on the European Central Bank

Well, so much for my forecasting how equity markets would initially respond to stronger than expected demand from eurozone banks for funds from the ECB’s emergency loan program (“longer-term refinancing operations,” or LTROs).

The sentiment reversal may be attributable to the fact that only about €190 billion was fresh liquidity; the remainder comprised funds that were switched from shorter term ECB lending programs.

At a time when the ECB is being heavily and widely criticized for not doing enough — for refusing to act as the lender of last resort for the eurozone — a new and diametrically-opposed concern is beginning to surface. That concern is, as Gavyn Davis puts it, is the explosion in the ECB’s balance sheet. Every time that the ECB lends euros to a bank, it does so in exchange for collateral — “of an increasingly dubious nature,” according to Davis — pledged to the ECB by the bank. These transactions show up in the ECB’s balance sheet, which, as shown in the following chart, has balloned this year.

Says Davis,

The increase from August [2011] to February [2012] will be about €700-800 billion, which is an extraordinary amount for a central bank which is supposed not to believe in QE [Quantitative Easing]. There is another three year liquidity injection due to take place in February, and this may well be even larger than today’s action.

The bulk of the borrowers under these facilities will presumably come from the peripheral economies, and the collateral offered will include single A asset-backed securities and also bank loan portfolios for the first time. Although this collateral will of course have been subject to haircuts before being accepted by the ECB, there can be no doubt that the ECB’s potential exposure to defaults in the peripheral economies will once again have ratcheted higher.

The first sentence in the next paragraph is of special interest in that ECB President Draghi (as did his predecessor) has repeatedly stated that serving as a lender of last resort isn’t within the EBC’s remit. If you find yourself confused, all I can say is: join the club.

The ECB’s justification for this action is that it is, and should be, the lender of last resort to the eurozone banking system. That seem fair enough. In the absence of today’s action, there would have been risks of bank failures in 2012 as banks tried to raise the money needed to redeem €600 billion of their own debt, which reaches maturity during the year. With their access to long term funding largely closed, banks would have been forced to reduce their balance sheets in order to meet these obligations, and this deleveraging would have involved forced sales of sovereign bond holdings and reductions in bank lending. Either way, the eurozone’s crisis would have deteriorated further.

Deleveraging would also have caused a shrinkage in broad money (M3) which the ECB is desperate to prevent or mitigate. What will now happen instead is that the monetary base will expand rapidly as central bank funding for the banking sector replaces private funding, and this is likely to prevent the large drop in M3 which would otherwise have occurred.

As I’ve argued on more than one occasion, money supply growth isn’t inflationary if the velocity of money (the rate at which economic transactions take place) isn’t rising.

Questions will be asked, especially in Germany, about whether this liquidity injection will be inflationary. It is probably better described as anti-deflationary. The money multiplier in the eurozone economy (ie M3 divided by the monetary base) is likely to drop, so M3 will stay subdued. Inflation risks will not crystallise until the rise in base money translates into much more buoyancy in bank lending and broad money growth. That may or may not ever happen.

Davis closes with the following:

. . . the ECB is certainly preventing banks from selling sovereign debt that they otherwise would have sold, and it is doing this by expanding its own balance sheet. The alternative to ECB action would have been to increase the size of the EFSF/ESM at a direct cost to government credit ratings. The ECB is also keeping alive banks which would otherwise have failed, and that would have involved new injections of capital from sovereign governments.

The truth is that, in the present state of the eurozone debt crisis, sovereigns and governments are now inextricably interlinked. It is hard to save one without being accused of saving the other. The ECB is not eager to admit it, but it is trying to save both.

If you’re interested in further pursuing the leveraging-up of the ECB’s balance sheet, I recommend reading a briefing note recently published by the UK-based Open Europe think tank. Among the key points in “The battle for the heart and soul of the ECB” are the following:

The ECB has taken on large amounts of low quality collateral in return for providing loans to banks, and has seen a massive surge in the number of asset-backed securities it has taken on to its balance-sheet. Though not all of these assets are bad or ‘toxic’, they are extremely difficult to value. At the same time, the number of banks which are becoming reliant on the ECB is alarming and hopes that the functioning of the European financial markets will ever return to normal are diminishing – creating a long-term threat to Europe’s economy.

Through its government bond buying and liquidity provision to banks, the ECB’s exposure to the PIIGS has now reached €705bn, up from €444bn in early summer. This is an increase of over 50% in only six months and shows how, contrary to popular belief, the ECB is already intervening quite heavily in the markets. It also highlights how the eurozone crisis continues to transfer risks away from private creditors to taxpayer backed institutions. It remains unclear how the ECB would cover losses in the event of asovereign default.

Moving forward, the ECB could offer a liquidity boost to Europe’s economy but little more. The term ‘lender of last resort’ is often misused or misunderstood – the ECB cannot fully backstop sovereign states or return them to solvency. At best it could ease the pressure on illiquid states, but even this depends on the legal constraints on the ECB’s defined role and being seen to give in to political demands that would hurt the ECB’s credibility and independence.

Earlier this month, the European Central Bank announced an emergency loan program known as “longer-term refinancing operations,” or LTROs. The program will become operational tomorrow (Wednesday). The Financial Times says that the ECB expects strong demand for the loans, which will be available in “unlimited” quantities.

The purpose of the program, which enables banks to avail themselves of three-year loans at extremely favorable interest rates, is to ease the severe strains in the eurozone’s financial system. If demand for the loans is strong, it should reduce the likelihood that banks will substantially shrink their balance sheets (by selling assets and reducing new loans to their customers) to meet their funding needs (which are especially large in early 2012). The hope, then, is that the LTRO will improve the economic performance of countries in the eurozone. It’s important to note, however, that this provision of additional liquidity doesn’t attack the eurozone’s fundamental problem: severe and persistent balance-of-payment imbalances among its members.

The funding problem that the LTRO is aimed to ease is having a contagion effect. Asset sales by European banks have put pressure on securitized mortgage prices in the U.S. Instead of selling distressed assets in their home markets, the banks are selling assets elsewhere (as encouraged by their governments).

In combination with the sharp drop in Spanish short-term interest rates that took place today, the imminent start of the LTRO program may be responsible for the sharp rally in the U.S. equity markets. If demand is as strong as the ECB expects, contagion fears could ease, allowing for a short-term bounce in the stocks of financial institutions holding mortgage-backed securities.

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A Financial Times video explains the workings of the eurozone’s financial plumbing and how it might leak if one or more countries exit from the currency union’s membership. The hard-copy is here.

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Excerpts from an FT editorial:

Europe’s economic prospects are deteriorating frighteningly fast, and the world outlook is darkening in step with the Old World’s woes. Unless the world’s leaders manage to pull together soon, we should brace ourselves for a second phase of the credit crisis that will be even worse than the first.

[...] A credit crunch is gaining force, and Europe’s economy grinding to a halt because of it. This is making the twin crises – bank and sovereign – harder to resolve and is hitting emerging economies whose credit is drying up and whose export markets are withering. If the ECB cannot stimulate growth, governments must do so, and fast.

Today the whole world badly needs Europe to grow. Long-term growth and rebalancing are sine qua non for overcoming the debt crisis, but short-term recovery is a greater priority. Austerity by those who must should now be compensated by stimulus from those who can.

My sentiments, exactly.

In its just released Financial Stability Review, the European Central Bank cites four key risks to financial stability in the eurozone:

1. Contagion and negative feedback between the vulnerability of public finances, the financial sector and economic growth.
2. Funding strains in the eurozone banking sector.
3. Weakening macroeconomic activity, credit risks for banks and second-round effect through a reduced credit availability in the economy.
4. Imbalances of key global economies and the risk of a sharp global economic slowdown.

Sounds rather dire, doesn’t it?

After I’ve poured through this lengthy (210 page) document, I’ll have more to say. In particular, I’m interested in how closely the concerns and recommendations it contains relate to the decisions reached (and not reached) at the December 9-10 European Union summit meeting.

As usual, the Financial Times is chock full of articles on the never-ending crisis. Leading the list is an edited transcript of an interview between Mario Draghi, European Central Bank president, and Lionel Barber, Financial Times editor, and Ralph Atkins, Frankfurt bureau chief.

For those without the time or inclination to wade their way through the complete text of the interview (which follows), here’s a summary of what I believe to be the most significant words of the ECB’s new president:

• The recently-announced three-year refinancing operations will “not necessarily” give banks an incentive to buy the sovereign debt of the financially-troubled eurozone governments. The objective of the operations is “to ease the funding pressures” the banks are experiencing. The ECB doesn’t “know exactly” what the banks are going to do with the money provided by the operations; buying sovereign bonds is just one of the possibilities.
• Last week, the European Banking Authority (EBA) published a formal Recommendation, and the final figures, related to banks’ recapitalization needs. Draghi would have preferred having the European Financial Stability Facility (EFSF) “in place” before the public announcement of the EBA’s stress tests. Had this been the case, it “would have had certainly a positive impact on sovereign bonds, and therefore a positive impact on the capital positions of the banks with sovereign bonds in their balance sheet.” Because of the unfortunate sequencing, the stress tests “may exert pressure on banks to achieve better capital ratios by simply deleveraging.” Deleveraging takes two forms: selling assets or reducing lending. The second option is “by far the worst.”
• Draghi insists that “[t]here’s no trade-off between fiscal austerity, and growth and competitiveness.” However, he does not dispute that “fiscal consolidation leads to a contraction in the short-run.” In other words, he believes, as did Jean-Claude Trichet, that the necessary precondition for restoring the health of the eurozone economy in the long-term is to implement a policy that will worsen economic conditions in the short-term.

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FT Interview Transcript: Mario Draghi

Financial Times: We are now more than four years into the financial crisis. What lessons would you draw so far? What has gone right and what has gone wrong?

Mario Draghi: We have to distinguish two stages. First was the financial crisis, with its repercussions for the real economy. I think we learnt the lessons that we need a more resilient financial system, a system where we would have less debt and more capital. There has been substantial progress in designing new regulatory policies and some progress in implementing this new design.

The second stage of the crisis is really a combination of, I would say, a challenging political phase, where euro area leaders are reshaping what I called the fiscal “compact,” and a situation where banks and countries face serious funding constraints. These challenging funding conditions are now producing a credit tightening and have certainly increased the downside risks for the euro area economy.

Action is proceeding on two fronts. At last week’s European Union summit you saw a first step towards fiscal rules that are not only more binding, but actually are of a different nature. They would be binding ex ante, which is an entirely new quality, and written into the primary legislations of the member states.

The second line of action is a set of meaningful, significant decisions taken by the ECB last week. We cut the main interest rate by 25 basis points. We announced two long-term refinancing operations, which for the first time will last three years. We halved the minimum reserve ratio from 2 per cent to 1 per cent. We broadened collateral eligibility rules. Finally, the ECB governing council agreed that the ECB would act as an agent for the European Financial Stability Facility (EFSF).

FT: Will the three-year refinancing operations give banks an incentive to buy “periphery” eurozone bonds?

MD: Not necessarily. Of course banks also have capital difficulties, and these measures don’t necessarily help them on that side. The objective is to ease the funding pressures that banks are experiencing. They will then decide what the best use of these funds is. One aspiration is to have them financing the real economy, especially small and medium sized enterprises (SMEs). What we are observing is that small and medium sized banks are the ones having the biggest funding difficulties, and they are generally the ones who provide most of the financing for the SMEs. And SMEs account for about 70 per cent of employment in the euro area’s corporate sector.

FT: Is this Europe’s version of “quantitative easing”?

MD: Each jurisdiction has not only its own rules, but also its own vocabulary. We call them non-standard measures. They are certainly unprecedented. But the reliance on the banking channel falls squarely in our mandate, which is geared towards price stability in the medium term and bound by the prohibition of monetary financing [central bank funding of governments].

Coming back to what banks are going to do with this money: we don’t know exactly. The important thing was to relax the funding pressures. Banks will decide in total independence what they want to do, depending on what is the best risk / return combination for their businesses. One of the things that they may do is to buy sovereign bonds. But it is just one. And it is obviously not at all an equivalent to the ECB stepping-up bond buying.

FT: Do you expect, in the next six months, another round of bank recapitalisations and, in some cases, nationalisation?

MD: Last week, we had the results of the European Banking Authority (EBA) “stress tests” exercise. But ideally, the sequence ought to have been different: We should have had the EFSF in place first. This would have had certainly a positive impact on sovereign bonds, and therefore a positive impact on the capital positions of the banks with sovereign bonds in their balance sheet. So the ideal sequencing would have been to have the recapitalisation of the banks after EFSF had been in place and had been tested.

In fact, it was done the other way round, so the capital needs identified by the EBA exercise reflect stressed bond market conditions. That may exert pressure on banks to achieve better capital ratios by simply deleveraging.

Deleveraging means two things; selling assets and/or reducing lending. In the present business cycle conditions, I think the second option is by far the worst. I understand regulators have recommended to their banks that they shouldn’t go this way, so let’s hope they follow this advice.

FT: Couldn’t somebody just say to the EBA, look, just hold off now, this is completely unhelpful?

MD: I think the press statement by EBA somehow hints at that, because they say that there wouldn’t be another exercise next year.

To be fair to EBA, the shape of the exercise was decided at a time when the biggest economic threat seemed to be the banking system’s lack of credibility. People feared banks’ balance sheets concealed fragilities that in the end would strain the economies. So they started this exercise thinking that, being transparent, and marking-to-market sovereign bonds, would strengthen the credibility of the banking system and reduce risk premia. At the end, it did not work that way because of the sequencing. But I wouldn’t say it’s EBA’s fault.

FT: The big point here though is, at least the world in 2011, has fundamentally changed, if not for the last two years, where a position where equities would be seen as more risky than government bonds is now in reverse ….

MD: The big change is that assets which were considered absolutely safe are now viewed as potentially unsafe. We have to ask what can be done to restore confidence. I would say there are at least four answers.

The first, lies with national economic policies, because this crisis and this loss of confidence started from budgets that had got completely out of control.

The second answer is that we have to restore fiscal discipline in the euro area, and this is in a sense what last week’s EU summit started, with the redesign of the fiscal compact.

However, we are in a situation where premia for these risks overshot. When you have this high volatility – like we had after Lehman – you have an increase in the counterparty risk. In the worst case, you can have accidents and even if you don’t have accidents, you have a much reduced economic activity because people become exceedingly risk averse.

So the third answer to this is to have a firewall in place which is fully equipped and operational. And that was meant to be provided by the EFSF.

The fourth answer is to again ask: why are we in this situation. Part of this had to do with fiscal discipline, but the other part was the lack of growth. Countries have to undergo significant structural reforms that would revamp growth.

FT: And the fifth answer is that the idea of introducing private sector involvement (PSI) in eurozone bail-outs was, in retrospect, a mistake?

MD: The ideal sequencing would have been to first have a firewall in place, then do the recapitalisation of the banks, and only afterwards decide whether you need to have PSI. This would have allowed managing stressed sovereign conditions in an orderly way. This was not done. Neither the EFSF was in place, nor were banks recapitalised, before people started suggesting PSI. It was like letting a bank fail without having a proper mechanism for managing this failure, as it had happened with Lehman.

Now, to be fair again, one has to address another side of this. The lack of fiscal discipline by certain countries was perceived by other countries as a breach of the trust that should underlie the euro. And so PSI was a political answer given with a view to regaining the trust of these countries’ citizens.

FT: Coming to the fiscal pact, what is your answer to those who say there is excessive concentration on budgetary rigour at the expense of competitiveness and growth and that actually what is being created is a “stagnation and austerity union”?

MD: The answer is that they are right and wrong at the same time. They are right because there can’t be any sustainable economy without growth and competitiveness and job creation. They are wrong if they think that there is a trade-off between the two. There’s no trade-off between fiscal austerity, and growth and competitiveness. I would not dispute that fiscal consolidation leads to a contraction in the short run, but then you have to ask yourself: what can you do to mitigate this?

Improvement in budgetary positions should elicit some positive market response, lower spreads and lower cost of credit. But two further conditions have to be satisfied: Implementation at national level of the structural reforms needed to enhance growth and jobs creation. And finally, it is necessary to have the right euro area design, implementing the fiscal compact, so that the confidence is fully restored. Austerity by one single country and nothing else is not enough to regain confidence of the markets – as we are seeing today.

Consolidation must also go hand in hand with structural reforms. Each country has its own path that they should undertake. For some, the situation would not be sustainable even if they were outside the euro and were to devalue their currency. That would give only a temporary respite – and higher inflation, of course.

FT: But that was part of the answer in the early 1990s in Italy – it did have an exchange rate adjustment.

MD: If you take that as an example, remember there was no IMF around, there was no EFSF and gross [government bond] issuance in 1992 was a multiple of the figures that we see today. It’s true that Italy moved the exchange rate, but this cuts both ways. It brought a temporary respite to the economy, so that exports could grow, but it also widened sovereign bond spreads because exchange rate risk came on top of sovereign risk. Three or four years down the road Italy still had something like 600 basis point spread with respect to the German Bund. Furthermore, the effect of the devaluation would have been only temporary without the structural reforms (abolition of indexation among others) that followed.

FT: But these austerity programmes are very harsh. Don’t think that some countries are really in effect in a debtor’s prison?

MD: Do you see any alternative?

FT: They could leave the eurozone?

MD: But as I said before, this wouldn’t help. Leaving the euro area, devaluing your currency, you create a big inflation, and at the end of that road, the country would have to undertake the same reforms that were due to begin with, but in a much weaker position.

FT: … But maybe it would be the best thing for the rest of the eurozone?

MD: Well, then you would have a substantial breach of the existing treaty. And when one starts with this you never know how it ends really.

FT: You said earlier that it would have been far better if the EFSF had been in place. So where are we on creating this firewall – what size of bazooka are we talking about?

MD: One first observation is that the delay in making the EFSF operational has increased the resources necessary to stabilising markets. Why? Because anything that affects credibility has an immediate effect on the markets. A process that is fast, credible and robust needs less resources.

FT: It sounds like you’re a bit disappointed then with the outcome of last week’s summit then?

MD: Actually no, because there was confirmation of previous figures on the EFSF’s resources – and of an additional €200bn that could be provided by the International Monetary Fund. What was also overlooked by many is that the date for a first assessment of the adequacy of resources has been brought forward to March 2012 – in just three months’ time, when the leaders ask themselves whether the resources for the firewall will be adequate. In the meantime, the ECB acting as an agent will make the EFSF operational. Important was also the commitment to clearly restrict the PSI to IMF practices, which should reassure the investors.

FT: When do you think the EFSF will be operational?

MD: Our aim is to be ready to provide agency functions in January next year.

FT: But can we assume that the idea floated in October of leveraging the EFSF is not actually going to happen? And that bringing in other sovereign wealth funds, Chinese, all this was overpriced.

MD: No, I think it is premature and probably wrong to proclaim the EFSF dead. Furthermore I think that if one can show its usefulness in its present size, the argument for its enlargement would be much stronger.

FT: What do you say to those who say the solution is to have a very big firewall and ultimately put the ECB behind it, because that is the only thing which will tame the markets?

MD: People have to accept that we have to and always will act in accordance with our mandate and within our legal foundations.

FT: But if you look at the wording of the treaty, there is nothing that sets a limit on how many government bonds you buy ….

MD: We have to act within the Treaty. In general, there must be a system where the citizens will go back to trusting each other and where governments are trusted on fiscal discipline and structural reforms.

FT: Once the firewall is in place with the EFSF, perhaps as soon as the beginning of next year, might you actually stop the SMP (securities market programme)?

MD: We have not discussed a precise scenario for the SMP. As I often said, the SMP is neither eternal nor infinite.

Let’s not also forget that the SMP was initiated with the view to reactivating monetary policy transmission channels. So as long as we see that these channels are seriously impaired, then the SMP is justified.

FT: Arguably, the monetary transmission channels are more impaired than ever before, if you look at interest rates in Greece or Italy compared with Germany?

MD: The cost of credit is bound to differ because it’s geared to some extent not on our short-term policy rate but on sovereign spreads.

FT: Would the ECB consider putting a limit on yields or spreads, or would that violate the treaty in your view?

MD: Sovereign spreads have mostly to do with the sovereigns and with the nature of the compact between them. It is in this area that progress is ongoing. Monetary policy cannot do everything.

FT: But if the economic situation deteriorated, would you be prepared to embark on “quantitative easing” in the style of the US Federal Reserve or Bank of England, in terms of large-scale government bond purchases to support economic growth?

MD: The important thing is to restore the trust of the people – citizens as well as investors – in our continent. We won’t achieve that by destroying the credibility of the ECB. This is really, in a sense, the undertone of all our conversation today.

FT: What will be the effect of the British staying out of Europe’s fiscal compact, and is there in your view a risk to the City of London?

MD: The UK certainly has shown a capacity to undertake a fiscal correction of an extraordinary size. My more general reaction to all this is that it’s sad. I think the UK needs Europe and Europe needs the UK. There’s a lot that can be learnt from both sides.

FT: The UK has taken legal action against the ECB [over the location of financial market clearing houses] …

MD: I can’t comment on that.

FT: What are you expectations for global growth next year?

MD: You could have a significant slowdown in several parts of the world. Global growth is decelerating, and uncertainty has risen. At the same time, we have laid a lot of groundwork for a better functioning of economic union in the future and we should draw confidence from that.

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For those with nothing better to do with their time, here are links to related articles in the FT:

• “Draghi warns on eurozone break-up“
• “Mario Draghi: tasked to save the euro“

Bad signs abound: IMF warns about depression; efforts underway to water-down EU summit agreement; EFSF prospectus may warn the euro could collapse; European banks not interested in buying more government debt

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Could another Great Depression happen? The IMF thinks so:

The managing director of the International Monetary Fund has warned that the global economy faces the prospect of “economic retraction, rising protectionism, isolation and . . . what happened in the 30s [Depression]” . . .

“There is no economy in the world, whether low-income countries, emerging markets, middle-income countries or super-advanced economies that will be immune to the crisis that we see not only unfolding but escalating. It is not a crisis that will be resolved by one group of countries taking action. It is going to be hopefully resolved by all countries, all regions, all categories of countries actually taking action.”

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Efforts to water-down the treaty on budget discipline proposed at last week’s EU summit have started:

European negotiators say momentum is building towards making a highly touted new treaty on budgetary discipline extremely narrow, enabling its smoother passage through national parliaments but hindering Franco-German ambitions to create a fiscal union in the eurozone.

Diplomats said several European Union countries are lining up in favour of a draft that would contain only two elements: a so-called “debt brake” obliging signatories to write debt and deficit limits into national constitutions; and a measure making EU sanctions against fiscal rule-breakers more automatic.

According to a senior German official, while France and Germany will go further in bilateral agreements, Ms Merkel now supports a treaty of only two or three pages that would not even enshrine regular eurozone summits – something Nicolas Sarkozy, the French president, has championed.

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The European Financial Stability Facility (EFSF) may insert a euro warning clause in a draft prospectus:

A draft prospectus prepared for the latest eurozone bail-out instruments includes explicit warnings to investors that the euro could break apart or even cease to be a “lawful currency” entirely.

The European Financial Stability Facility, which is creating the products to insure bonds of troubled countries against default, is debating whether the “risk factors” should be included in the final version.

In the latest draft of the prospectus, seen by the Financial Times, a summary of the dangers to investors includes: “[R]isks arising from a Reference Sovereign ceasing to use the euro as its lawful currency . . . or the cessation of the euro as a lawful currency”.

Including such a warning in an official document from the eurozone’s own rescue fund would be a surprising move. European leaders have frequently insisted that a euro break-up is unthinkable, although last month France’s Nicolas Sarkozy and Germany’s Angela Merkel accepted for the first time that Greece might leave.

The draft appears to be almost complete, ahead of the expected launch of the instruments in January. But the details of the risks of euro exit remain blank, as the EFSF debates whether to include them. Lawyers are debating the merits of including warnings about the euro in corporate prospectuses, although several London bond lawyers and bankers said they had yet to see them added.

The new EFSF products, known as Euro Sovereign Credit-Linked Certificates, are modelled on credit default swaps, a type of derivative used to protect against corporate or sovereign default. European countries hope the financial engineering will allow the EFSF to spread its limited resources more widely.

The certificates will use the standards of private-sector CDS to judge whether default has occurred – a test Greece is trying to sidestep by the use of a “voluntary” restructuring.

Earlier today, I posted a presentation prepared by the EFSF. I’m repeating it here.

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The big European banks aren’t stepping up to the plate:

Eurozone governments are facing disappointment for their hopes that banks in the region would use new longer-term finance offered the European Central Bank to buy up beleaguered sovereign bonds.

Bankers say big European banks are unlikely to buy more government debt using the three-year loans on offer from the ECB for the first time next week.

The ECB announced earlier this month that it would make three-year loans to the region’s banks, in an effort to provide a lifeline to lenders locked out of public funding markets . . .

How banks will use the new three-year loans, called longer-term refinancing operations or LTROs, has been a matter of much debate in markets. Some governments had hoped banks would use the cheap ECB money to purchase higher-yielding government bonds, earning a return and helping to prop up debt-ridden countries.