The European Central Bank’s Losing Game Of Chicken
European Central Bank (ECB) President Mario Draghi is losing a game of chicken with the Euro Area’s distressed peripheral countries. Earlier this month, Draghi announced that the ECB would buy an “unlimited” amount of Euro Area sovereign bonds provided that the distressed party follows austerity conditions set forth by the European Stability Mechanism (ESM). But countries like Spain, Italy, Portugal, and Greece are content to continue evading painful reform while eeking-out bailout funding from the Eurozone core.
Since the financial crisis hit European shores in early 2009, the ECB maintained that it would not bailout indebted sovereigns or banks. Such is consistent with the central bank’s mandate prohibiting bailouts of other member states. Yet Draghi and his predecessor, Jean-Claude Trichet, have bent this rule further and further with every new cry for help from the Eurozone periphery. Indeed, the ECB had already been indirectly buying sovereign bonds through over 1 trillion euro of Long Term Refinancing Operations extended to Eurozone banks between July 2011 and April 2012. The ECB called this “providing liquidity” instead of calling it a bailout, and for a time, the central bank could still pretend it was operating within the confines of its mandate.
But Draghi bent the no-bailout rule past its breaking point earlier this month when he introduced “Outright Monetary Transactions” (OMT), in which the ECB would directly buy sovereign bonds in secondary markets. Although Draghi explained that there was no limit to the amount of bonds that the ECB would buy, OMT is not necessarily a blank check for unreformed governments. The sovereign in question must have already requested rescue funds from the ESM, which are conditional upon the implementation of strict austerity measures. But these are the same reforms that Southern European countries have skillfully avoided since international financial markets began to question their solvency three years ago.
The distressed countries of Southern Europe want the bailout but don’t want the terms. Greece has received two bailouts since 2009. After failing to implement the conditions behind the first one, the “troika” (the ECB, European Commission, and IMF) agreed on a second one this spring. But Greece has fallen behind yet again. Spanish Prime Minister Mariano Rajoy has since followed the Greek example. After having agreed to a 4.4-percent deficit target within the March 2012 EU fiscal pact — a precondition for more German financial support of Europe’s bailout fund — Rajoy reneged and unilaterally set a new 2012 deficit target for Spain of 5.8 percent. And despite this, the German Bundestag approved 100 billion euro in Spanish rescue funds just months later. Now facing lower bond yields on the heels of Draghi’s OMT announcement, Rajoy claims that Spain won’t need to request rescue funds from the ESM and therefore trigger the ECB’s OMT program. This is farce. The financial market relief that Spain now feels is temporary. Investor confidence has rebounded in Spain solely because of Draghi’s announcement of OMT, which markets expect Spain to tap. But Rajoy wants to push Draghi to his breaking point and get a bailout for free.
The ECB and Southern Europe are playing a game of chicken. Draghi doesn’t want to dish out any more cash before the periphery begins to rein in its public sectors and liberalize its labor markets. But political leaders don’t want to take these politically unpopular measures, and they know that they can continue threatening Draghi with increasing bond spreads from the German Bund to get their bailouts sans-conditions. So who will blink first? Judging by his recent declaration to do “whatever it takes” to keep the Euro alive and his penchant for increasing the ECB’s balance sheet, it’s going to be Draghi.
This game is without a winner. Southern European countries will remain unreformed and monetary stimulus will continue to become less and less effective at boosting investor confidence (i.e., lowering bond yields). Markets will eventually demand change. That’s when it’s really Game Over.