The ECB's Catch-22

 | Nov 17, 2011 | 12:00 PM EST  | Comments
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Sovereign bond yields across Europe are now increasing synchronously. Spain, Italy, Portugal, Ireland and Greece all have sovereign yields above default levels now. Sovereign yields for the eastern member states are also rising. And yields on Belgium and French debt are rising now, too.

German sovereign yields have actually declined dramatically because capital has flowed from the rest of Europe, on a flight to safety into the perceived security of German bonds.

Over the next year, capital will likely begin fleeing Germany as well though, on a flight to safety away from Europe altogether. I will write about that in more detail at another time, but keep it in mind for now.

Throughout this process and increasingly as the magnitude of the potential size of the problem for Europe has increased, global investors have expected that ultimately the European Central Bank (ECB) would step in to preclude cascading sovereign defaults that could destroy the Union.

There are allowances for such emergency action by the ECB through the Securities Markets Programme. However, the ECB has been hesitant to use its emergency powers and it is clearly still well behind where it could be in counteracting economic contraction -- let alone fear of its results.

And this is the real story of Europe today: Most pundits are still missing. By failing to step in with a more aggressive response to the sovereign crises unfolding in Europe, the ECB has profoundly, and negatively, impacted the ability of future actions to achieve its intended goals. I have repeatedly written about this, but I will reiterate that the core problem in Europe is a lack of confidence and trust in the actions being taken by the political and monetary leadership.

The best way to consider this is to compare the ECB and its actions to that of the U.S. Federal Reserve. Following the Lehman Brothers crisis, Fed Chair Bernanke pushed the fed funds rate to 0% for the first time in history.

Since then, there have two rounds of quantitative easing and a concurrent acceptance of illiquid mortgage debt onto its balance sheet, along with promises to keep the fed funds at 0-25 basis points for years, and duration extension of their balance sheet through Operation Twist. QE3 is imminent and the Fed is considering shifting its policy into nominal GDP targeting -- which is essentially institutionalized quantitative easing.

Whether you agree with what the Fed is doing or not, investors know what to expect from Ben Bernanke and the U.S. Federal Reserve. And that is: "Damn the torpedoes! Full speed ahead." There is conviction and leadership in that approach. The outcome is unknown but we know how we are going to get there.

With the ECB, investors have no conviction on anything. They don't know if the ECB will intervene again or, if it does, to what extent it will take action. There is no clarity on rates, sovereign bond buying or unsterilized intervention.  The ECB itself is not commenting on any of these issues nor on what its financial capacity to intervene is

The result of this failure to communicate -- as well as to act -- is that investors have no confidence in any actions taken by the ECB. The principal implication of this is very important for investors to understand. The ECB is more effective at containing the crisis in Europe by doing nothing rather than doing something that investors don't trust.

When ECB President Draghi unexpectedly lowered the main refinance rate from 1.5% to 1.25% a few weeks ago, investors were not impressed and sovereign debt yields in Europe continued their steady ascent. This was because investors did not view this action as part of a new operational mode for the ECB. It was considered to be a one-off emergency measure -- just enough to stop the immediate concerns investors had about the solvency of Greece.

More importantly, however, the speculators and vulture funds anticipating further financial and economic crisis for Europe crossed off a tool that had been expended uselessly by the ECB.

The more the ECB intervenes with measures that do not convince investors and speculators of its conviction, the less ammunition it has to use in the future. The result of that process is that it accelerates the rate of crisis in Europe as speculators and vultures will increase their attacks on the sovereigns as the ECB slowly uses up its ammunition.

It is true that the ECB has the financial capacity to successfully counter the economic issues enveloping Europe. But this is not a deterrent to speculators, nor does it provide security for investors if it is so meek in using rather minor monetary policies such as lower rates and increased sovereign bond buying. 

The bottom line is that Europe is better off with an inactive ECB than an ineffectual one.

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