Together with Mario Balotelli, the football player, Mario Monti was heralded in Italy for bashing Germany, in his case at the recent EU summit. For Monti’s supporters, the satisfaction stemmed from achieving an explicit mandate for the EFSF/ESM to 'stabilise' yields differentials by intervening in the primary and secondary market. Yet, as in the case of Italy's ephemeral victory against the German soccer team, which preceded a disastrous defeat against Spain, Mario Monti's achievement with the ESM may turn out similarly doomed. This is why.
The interpretation of the summit communiqué is, as usual, not very transparent. It says:
"We affirm our strong commitment to do what is necessary to ensure the financial stability of the euro area, in particular by using the existing EFSF/ESM instruments in a flexible and efficient manner in order to stabilise markets for Member States respecting their Country Specific Recommendations and their other commitments including their respective time lines, under the European Semester, the Stability and Growth Pact and the Macroeconomic Imbalances Procedure. These conditions should be reflected in a Memorandum of Understanding. We welcome that the ECB has agreed to serve as an agent to EFSF/ESM in conducting market operations in an effective and efficient manner. We task the Eurogroup to implement these decisions by 9 July 2012."
Although the details shall be filled by July 2012, some educated guesses are possible:
- Reference to existing instruments seem to allude to the fact that the current endowment of the EFSF/ESM, estimated around €700 billion, will not be increased, although the commitment to do what is necessary may hint to the fact that the matter is not yet settled. However, nothing is said about the possibility for the ESM to borrow from the ECB for this purpose (or to achieve the status of a “Bank", which amounts to the same thing). So the presumption is that no extra resources will be available for the ESM
This is clearly a problem.
We know from the way price-fixing schemes work (Salant and Henderson 1978) that an intervention fund will fail to achieve its goal if the underlying market disequilibria persist and the fund in limited. Sooner or later a speculative attack occurs. Investors sell in anticipation of a price fall that their action precipitates once all available official resources will be depleted in the defence of the target price.
In our context, this suggests that the ESM would buy Italian bonds in order to prevent the bond price falling below a given price target (and its yield to rise above a given level). But unless the dynamics of the Italian public debt are clearly inverted (by a rise in the primary surplus GDP ratio, an increase in the rate of growth, surprise inflation or a reduction in the existing stock, partial default or privatisation), the ESM will collapse in finite time. Investors will sell their holdings (almost €2 trillion) of Italian bonds to the ESM, which, that after having spent all its endowment (€700 billion) trying to prevent the spread from rising, will no longer be able to buy the bonds and will let the spread rise. This will occur unless the ESM can borrow from the ECB with no limit.
This logic may have occurred to Eurozone leaders, and explains the ambiguous language:
- The communique refers to a flexible and efficient intervention, which presumably means that the ESM would not openly announce a price target for the intervention.
This may be useful for avoiding the one-way-bet for the markets. That is, if markets sell Italian bonds and bond prices do not fall (and the spread is stable) they do not lose, whereas if the bond prices do fall (and the spread rises) they gain.
This sort of constructive ambiguity can only help a short while. Markets are surely going to test the authorities’ willingness to intervene. In this respect the fact that the ESM will be operated following a country's request, under light conditionality (the respect of the Country Specific Recommendations, the Stability and Growth Pact etc.) will not help: it will only focus the market expectations on which country is admittedly weaker.
Unless in this new role for the ESM is backed by the ECB’s deep pockets, or by a noticeable policy change in Italy, Monti's victory may prove as pyrrhic as that of Italy in the semi-finals. The summit outcome may have bought some time and access to the final match, without changing the ultimate outcome.
Of course the ESM scheme may turn out a big success if the 'multiple-equilibria' view of the crisis is right. This view claims that the current markets' distrust of peripheral countries does not stem from weak fundamentals but rather from self-fulfilling (bad) expectations. In this case, the ESM intervention will correct "market distortions" (to quote Mario Monti) and help market participants to focus on the "good equilibrium", where interest rates are low and countries are solvent.
Too bad the evidence suggests this view is wrong.
Euro Area summit communiqué (2012), "Euro Area summit statement", 29 June.
Manasse, Paolo and Luca Zavalloni (2012), “Contagion in Europe: Evidence from the sovereign debt crisis”, VoxEU.org, 25 June.
Salant, S. and D. Henderson (1978), "Market Anticipations of Government Policies and the Price of Gold", The Journal of Political Economy 86 (4), August, pp. 627-648.