The ECB in July 2013 published an extremely interesting paper on “The Impact of Political Communication on Sovereign Bond Spreads.” Here are some highlights.
Keep in mind that, “Euro area countries are more exposed to the risk of self-fulfilling crises whereby investors generate a liquidity crisis that can degenerate into a solvency crisis.”
Correcting for financial, economic and other political events, this study finds that political communication – both of a positive and negative nature – does have a daily contemporaneous effect on sovereign bond yield spreads.
Similarly, an interesting finding is that economic fundamentals appear not to have a significant influence on bond spreads in the short term, but are instead overwhelmed by statements, credit rating changes and country specific events.
Bond investors will price risk appropriately only if the realistically face a danger of default. Governments will run sound fiscal policies only if they know that they are not going to be bailed out by the euro area and that they might face higher financing costs. This debate about incentives and principles is a fully legitimate one in open democratic societies. However, it has sent a possibly destabilising message to potential investors in the bonds issued by troubled countries, namely that those bonds are not safe assets because the probability of a complete redemption was seen as reduced, and this with a perceived (semi-)official sanction. Investors have therefore demanded a large risk premium. This, in turn, may have contributed further to the fiscal problems in the peripheral euro area countries over the past two years. Policy-makers are therefore confronted with a certain trade-off between conducting open democratic debates and respecting the needs of the financial markets, reflected by the controversy over the notion of a “democracy in conformity with market needs.”
This study does not find any strong empirical evidence that the amount of political communication has an impact on the level of government bond yields. Rather, our finding is that the connotation of the communication determines the type of impact on government bond yields: positive communication can lead to a compression of spreads, whereas negative communication can cause a widening of pspreads.
Communication policy would be more effective if certain principles were respected in the design and implementation of politicians’ communication strategies.
At several points during the crisis, certain types of political communication may have added uncertainty rather than certainty to market perceptions about the sovereign debt crisis in the euro area, and that unconstructive and inconsistent communication can have real and tangible effects on countries, their financing conditions, and by extension, on their populations, as well as on the cohesion of the euro area.
I fear that one can safely argue that the impact of governmental change in Germany in 2009 and especially the entry of the FDP into power was not a good thing for the Eurozone.
Heiner Flassbeck in the FTD reminded me of a development that Sarkozy had hinted at – or hoped for really – back in December already (am not finding that quote). Namely, that banks are using the ECB’s new liquidity providing rules in order to pull in a healthy profit on European governments’ debt. Thus at a time when those governments could very well use those profits themselves the ECB effectively is subsidizing commercial banks’ net gains at an – indirect – cost to taxpayers. Why are they doing? Mostly for – German – ideological reasons it seems.
Let’s expound. The ECB announced last December that it would give out unlimited long-term – up to three years now – loans to commercial banks at a refinancing rate of 1% and while accepting as collateral virtually anything tradeable – de iure not de facto – on the markets. In other words if I own a Greek government bond currently trading at somewhere around 30%, I may use it as collateral to receive a loan from the ECB of 100% – Disclaimer: I am not sure about this part. Please let me have it if you know any better – of its value at an interest rate of 1%. Now, if I were to invest that money in, say, Italian government bonds currently yielding at somewhere around 6% it’s easy to see, that I will be able to pull in a healthy profit on this transaction. This especially as this operation really functions as a sort of financial perpetuum mobile as I can now use my newly acquired Italian bonds as collateral with the ECB in order to acquire a new loan.
There is a risk involved of course, namely that Italy (or whichever country is involved in any particular scenario) will default or that the Eurozone will fail. If we’re abstracting from Greece though, how likely is that really? And seeing as lots of European commercial banks will go bankrupt anyway, wouldn’t it be worth it to double down and potentially significantly expanding on their profits, while not fundamentally changing their position in a default scenario?
Why is this a problem then? After all this sort of subsidized speculation attenuates the Eurozone crisis by increasing demand for periphery debt on secondary markets. Check Italy, Portugal, Ireland, or Spain bond yields. Think those improved numbers are due to the Fiscal Pact Treaty being discussed? Didn’t think so either. While this effect of the ECB’s increased lending – close to 500 billion € in the first week alone – seems to be rather limited according to Barclay’s, it is the best case scenario that I have laid out here.
To sum up then, the ECB has initiated a long-term, low-interest lending program that a) doesn’t really work and b) lower yields for governments bonds to some extent when it does function properly while creating a subsidized profit to commercial banks. Now let’s say the ECB were instead to spend most of that money on buying up sovereign debt itself. Not only would yields go down far more than they have but the profits accrued on these operations – assuming the Eurozone holds and Italy (or whoever else) does not default – would benefit the ECB itself, which in turn means the European national central banks of course and finally European governments and indirectly their taxpayers.
But then why should one do what makes sense when – German and other – ideology opposes this kind of monetary policy. After all ideological purity is more important than obtaining results. Right?
Last week saw a flurry of relevant players weighing on the debate of how to escape from the crisis trap and shape Europe going forward. Lots of interesting ideas and proposals floating around.
The speech that arguably caused the biggest uproar was Radek Sikorski‘s (the Foreign Minister of Poland) in Berlin. He laid out a stark dystopian-utopian dichotomy of Europe warning of ‘disintegration with appalling human cost‘ (Yugoslavia) or federation, ‘deeper integration, or collapse‘. His choice is clear as he – in broad strokes – lays out what a reformed European Union could look like. His proposals effectively includes more majority-vote decision-making (even if he never explicitly says so), automatic sanctions to strengthen fiscal discipline, stronger roles for the Commission, the Council and the European Court of Justice, the European Central Bank (ECB) as a true lender of last resort (LoLR) and calling on it to act soon, a smaller (‘Member States should rotate to have their commissioner‘!), more effective Commission, an empowered European Parliament formed at least in part via ‘pan-European‘ lists. In other words a strong move towards a more federalized EU, spearheaded by the Eurozone but not taking place outside of existing community institutions and based on significant treaty changes. For this, in a striking statement, he calls for Germany to lead, to – finally – act. ‘I fear German power less than I am beginning to fear German inactivity.’
So much for Poland, in France two differing visions were put forward by President Nicolas Sarkozy in Toulon and the French Parti Socialiste‘s presidential candidate François Hollande in front of the Socialist Group in the European Parliament. Hollande attacks the German-inspired austerity model as a solution to the crisis and disdains the need for treaty change, he in turn proposes a pact of responsibility, governance, and growth (‘une pacte de responsabilité, de gouvernance et de croissance‘). Most notably this were to include an increase in the guarantees going to the EFSF, a partial European debt collectivization (maybe along the lines of the Redemption Pact proposed by the economic advisers of the German government), and the ECB as a true LoLR. He wants an investment program at the same time financed via Eurobonds (Me: ’cause that’s gonna happen…) even while promising to lower French debt in the short- and mid-term (‘un déficit de 3% du PIB en 2013, un retour à l’équilibre en 2017‘).
Sarkozy has less manoevure for campaign promises as the opposition candidate in his proposals on Europe’s future. He also wants to reduce French government debt, while also reforming labor market laws (‘la retraite à 60 ans et les 35 heures ont été des fautes graves‘). Sarkozy stresses the Franco-German partnership, ‘la convergence‘ between the two in a Europe of stability (‘une zone de stabilité‘). He puts forward the (Franco-German) company line of more European solidarity necessitating more (fiscal) discipline (‘L’Europe a besoin de plus de solidarité. Mais plus de solidarité exige plus de discipline‘). He wants to re-found Europe (‘Elle doit être refondée‘) not in a supranational manner though but in a (Gaullist) intergovernmental one. At the same time he wants to move more decision-making into qualified majority voting (QMV) procedures. He is in favor of a government of the Eurozone, essentially run or at least dominated by the heads of state and government. He wants to create a European Monetary Fund (EMF), which were to take its decisions under QMV. The ECB he considers an independent actor, while emphasizing his hope and conviction that it will intervene in the face of deflationary pressure. Finally, he is in favor of increased coordination on budgetary questions coupled with automatic and more severe sanctions for those states not adhering to the debt rules. All this should be reflected in a new treaty. One last add-on, in a typical Sarko populist move, he wants to revise Schengen to be able to deal better with immigration questions.
On to the Germans then, were Bundeskanzlerin Merkel laid out her vision in front of the Bundestag on Friday. Following Merkozy’s newly agreed upon decision to not lay pressure on the ECB anymore she also stresses the bank’s independence. What she stresses – little surprisingly – are automated actions against states in infraction of debt rules, these procedures should be controlled by the Commission or the ECJ. Merkel once again stresses that Eurobonds are not a viable solution right now (‘Euro-Bonds [können] jetzt nicht als Rettungsmaßnahme gegen die Krise eingesetzt werden’). She wants to empower the ECJ to allow it to take cases because of infractions against the debt rules. More generally she wants to create a -n ill-defined – Stability and Fiscal Union, including a strong ESM and reforms of labor laws in some member states. Does that mean her proposed treaty changes include labor and maybe social policy transfer to the European level, at least partly? She makes clear that the treaties need to be changed either within the EU 27 or within the Eurozone if not possible otherwise.
Last but most definitely not least, here is arguably the most important speech of last week (at least in the short term). Mario Draghi’s, the President of the ECB, statement in front of an apparently almost empty European Parliament. Draghi interestingly enough stressed the ECB’s goal ‘of maintaining price stability […] in either direction‘ and as applied to ‘both the setting of official interest rates and the implementation of non-standard measures‘. Will the ECB increase its – non-sterilized – intervention then? Secondary Market Purchases (SMP) 3.0? Draghi also calls for ‘fiscal compact‘ as the ‘most important signal from euro area governments for embarking on a path of comprehensive deepening of economic integration.’ He then answers to critics wondering how such a ‘longer-term vision can be helpful in the short term‘ by telling them that ‘other elements might follow‘. Ever greater, monetary expansionary union?
So what are we left with then? Sarkozy and Merkel are preparing treaty changes – intergovernmental one, much more federalist the other. Both are stressing the independence of the ECB, Sarkozy with the explicit hope of it intervening massively, Merkel – as insinuated by the opposition – only praying for it at night. Sarkozy wants more solidarity (Eurobonds!), Merkel believes they are the wrong solution as of this moment. Sarkozy wants to move ahead with tighter – again: inter-governmental – economic governance within the Eurozone, Merkel prefers treaty change for the EU 27 or at least with an opt-in for everybody interested (Poland! Sweden?). Lots of issues to work out before Monday’s episode of Merkozy running Europe. The German opposition wants the EFSF to become a bank, Hollande is looking for a European investment program based on Eurobonds – I think we can safely ignore both of these for the time being, the latter more so than the former. Sikorski is practically begging the Germans to finally put an end to this crisis, while effectively calling for a federation of Europe. Draghi, finally, hints at ECB intervention once a ‘fiscal compact‘ is underway.
It’ll be an interesting week once more to say the least.