Thursday, August 2, 2012

Super Mario and the Bazooka (ls)

Todays meeting of the ECB governing council has been eagerly awaited. ECB President Draghi fueled market expectations of a large-scale government bond purchase programme with some statements given in London a few days ago (see here). However, todays announcements are vague and disappointing. Markets expected a 'Bazooka-Solution', Draghi rather gave them a shot out of a Super-Soaker-Gun.

I  believe that the concept of central bank independence and monetary policy from the ivory tower is not suitable for a crisis of unprecedented scale as we do witness right now. While political unification of the EMU is not feasible in the short run, the ECB needs to do a dirty job. Hiding behind legal concerns and phrases such as 'ensuring the functioning of the monetary transmision mechanism' is ineffective. Our central bank is compromising itself step-by-step. Starting with the relaxation of collateral requirements we came to purchases of both covered and government bonds. In fact, the term 'unconventional policy measures' is an euphemism. The ECB is actively engaging in fiscal policy, and the established frontier between government and central bank balance sheets becomes increasingly blurred. To be clear, I am not complaining about this developements. I believe that these steps are necessary. But they should be communicated in an honest and transparent way in order to remove uncertainty and to boost market sentiment.Let me make some examples from todays press conference:

The Governing Council extensively discussed the policy options to address the severe malfunctioning in the price formation process in the bond markets of euro area countries. Exceptionally high risk premia are observed in government bond prices in several countries and financial fragmentation hinders the effective working of monetary policy. Risk premia that are related to fears of the reversibility of the euro are unacceptable, and they need to be addressed in a fundamental manner. The euro is irreversible. 

What is a severe malfunctioning in the price formation process? Is the ECB showing sympathy for a theory of multiple equilibria on government bond markets à la de Grauwe? Does she believe that current risk premia show signs of exaggeration? How to decompose risk premia into solvency concerns and concerns about an exit of the EMU?  And what about financial fragmentation? Maybe fragmented markets with persistent spreads are the new fundamental? It is now well known that the virtually non-existent spreads in the pre-crisis regime have to be attributed to a considerable extent to undifferentiated collateral and capital requirements. And by the way: Recent LTROs fostered fragmentation, since PIIGS-banks acquired governement bonds with a considerable home bias, thereby further intensifying potentially adverse feedback channels between government and bank solvency. All in all, the statement above lacks of guidance and leaves markets and observers puzzled.

In order to create the fundamental conditions for such risk premia to disappear, policy-makers in the euro area need to push ahead with fiscal consolidation, structural reform and European institution-building with great determination. As implementation takes time and financial markets often only adjust once success becomes clearly visible, governments must stand ready to activate the EFSF/ESM in the bond market when exceptional financial market circumstances and risks to financial stability exist – with strict and effective conditionality in line with the established guidelines.
Stressing conditionality again and again seems to be merely a lip service.The examples of Greece and Italy (Just remember Mr Berlusconi's reluctance to stick to his commitment to structural reforms after ECB interventions eased the refinancing pressure on his country!) show that conditionality is unrealisitic if not dynamically inconsistent. We rather witness dynamic bargaining processes which are constrained by political feasibility and the fear of disordered government defaults and their systemic implications.   

The Governing Council, within its mandate to maintain price stability over the medium term and in observance of its independence in determining monetary policy, may undertake outright open market operations of a size adequate to reach its objective. In this context, the concerns of private investors about seniority will be addressed. Furthermore, the Governing Council may consider undertaking further non-standard monetary policy measures according to what is required to repair monetary policy transmission. Over the coming weeks, we will design the appropriate modalities for such policy measures.

This is good news. But more details are needed. What about implicit yield targets? Any hints concerning the volume of this operations? What is meant by 'further non-standard monetary policy measures'? And seriously: It's not about ensuring price stability or repairing the transmission mechanism. It's about fixing this crisis. Quick. Let's hope that ECB communication will become more transparent and precise within the next weeks.