Grillo's Corner with Graham McDevitt: Update on Europe
December 6, 2011
The latest phrase making the rounds of the financial media and market participants is that the European Central Bank (ECB) is “going all-in.” This phrase is particularly perplexing to us as market participants now seem to be all but begging the independent central bank for a market bailout. Anglo-Saxon countries, it seems, have gotten used to monetary bailouts from the Federal Reserve and the Bank of England. While the U.K. is actually trying to practice fiscal discipline, U.S. citizens enjoy monetary bailouts without the significant requisite fiscal austerity measures that other countries are being forced into. The Federal Reserve’s justifications for this monetary gift include its dual mandate, which includes both price stability and "maximum employment," along with the fact that members of the Federal Reserve’s Board of Governors saw deflationary risks in 2008 and 2010.
In contrast, the ECB does not have a dual mandate. Its sole mandate is to maintain price stability. Additionally, the ECB was created in the mold of the modern Bundesbank, which has a very conservative attitude toward loose monetary regimes or anything that could heighten inflationary pressures. Given this background, it is not surprising to us that the current ECB president, Mario Draghi, has denied requests to buy the sovereign debt of troubled euro zone nations in a quantitative easing exercise. With a policy rate of 1.25%, the bank can still provide additional easing by lowering rates.
The ECB has also remained very lax with loans to euro zone commercial banks. It is currently accepting dodgy collateral for loans to these institutions. The bank would need to move its policy rate to near zero before a justification for negative theoretical rates would be called for, in our opinion. At that time, if the ECB were to engage in a quantitative easing exercise, we believe it would specify a limited amount that could be employed to achieve additional monetary stimulus. In our opinion, there would be no yield target for euro zone peripheral bonds — the ECB would not engage in a rescue of a member's bond market as doing so could pose a number of difficult questions. How would it decide which country to rescue? Would it have guarantees of fiscal prudence from the country necessary to justify extreme monetary measures?
Finally, let's consider the position of Germany (Merkel and Bundesbank President Jens Weidmann): All the funding that Germany has provided throughout the crisis to this point has been conditional: (i) the International Monetary Fund-European Union loans to Greece, Ireland, and Portugal have strict requirements that need to be met in order for the recipients to receive each tranche; (ii) Germany’s commitment to the European Financial Stability Facility (EFSF) was strictly limited to just €240 million.
So, while many investors may argue that Germany is playing a dangerous game of “chicken” in preventing the ECB from going “all-in,” we believe Germany sees today’s crisis conditions as an opportunity, offering the greatest chance of achieving fiscal union. (Remember, it was Germany who demanded the inclusion of the Stability Pact in the EU Treaty.) Therefore, even if you dismiss the above analysis of why the ECB has not bent to market demands to go "all-in," we feel it should be remembered that Germany is insisting to the other EU member states that its commitment to a further bailout is conditional on achieving fiscal union.
We acknowledge that calls for extreme action by the ECB mean that market pressures are great, and financial entities and market participants are suffering. We remain committed to our resolve that this is a fragile investment environment, and we believe a conservative positioning is warranted in investment portfolios.
The views expressed were current as of Dec. 6, 2011, and are subject to change at any time.
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