An EU Debt Crisis Update

Just because you have not heard a lot about the European welfare-state debt crisis does not mean the crisis is over. Quite the contrary, it is alive and kicking. This story from the EU Observer is a good update:

The European Central Bank (ECB) is prepared to back its promise to do “whatever it takes” to save the euro by utilising its controversial government bond purchase programme, an ECB executive board member has said. Speaking on Monday (2 September) at a conference organised by the German Institute for Economic Research in Berlin, Benoit Couere, a member of the ECB’s executive board, said the bank’s Outright Monetary Transactions programme remained “necessary from a monetary policy perspective.” “OMTs are not just words: the ECB is fully prepared to use them,” he added.

The practical meaning of this is that the ECB is ready to buy up as much EU member state debt as is needed to continue to give the impression that the debt crisis is either over (haha) or stabilized (yeah right).

The Frankfurt-based bank unveiled its OMT programme in August 2012, with President Mario Draghi saying that the ECB would do “whatever it takes” to prevent countries being forced out of the eurozone by spiralling debt costs. The programme, which allows the ECB to buy up government bonds with maturities of between one and three years, has been widely credited for ending fears about a possible break-up of the eurozone.

Obviously. If you can buy a Spanish treasury bond at seven percent interest and then sell it to the ECB with the same reliability of getting your money back as if you had bought a Swiss government bond at a fraction of that interest rate, then what reason does anyone have to ponder the possibility that the euro zone would break apart? Never mind that this program means that the ECB will have to keep its monetary printing press working overtime, flooding the world with increasingly worthless euros.

The EU Observer again:

It has also calmed the bloc’s sovereign debt markets, pushing down borrowing costs faced by Spain and Italy, regarded as the eurozone’s ‘too big to fail’ economies.

That is only because demand for those bonds increased as a result of the ECB’s guarantee. Higher bond prices by definition mean lower interest rate on those same bonds. The Eurocrats, on the other hand, take this as a sign that they have somehow solved the crisis. All they have done is put a more effective band aid on it.

Then the EU Observer lets us know that the austerity programs put in place by the EU-ECB-IMF troika are also alive and well:

The ECB has also insisted that it will only use the programme if countries keep to tough economic reforms agreed with the eurozone’s permanent bailout fund, the European Stability Mechanism (ESM). For his part, Couere added that the programme would “never be used to indiscriminately push down government bond spreads” which should “continue to reflect the underlying country specific economic fundamentals.”

Nonsense. The very existence of the buy-all-your-bonds program neutralizes the “underlying country … fundamentals”. Bond buyers now know that once a country in crisis reaches a certain “boiling point” in its path from macroeconomic health to a Greek meltdown, the ECB will step in with its cash-for-bonds program. At that point it does not matter what the specific country risk profile looks like.

Interestingly, the ECB boasts about the program to the point where they make big noise of not having had to use it:

“The irony of this success is that it has actually been a pure psychological tool so far. The ECB has not bought any single bond under the OMT programme, yet,” ING chief economist Carsten Brzeski told this website.

Of course not. It was just created. But just wait until the next major euro zone  country plunges into the hole. France is a good candidate, with its ridiculous tax hikes. When that happens, the exposure of the bond buyback program will reach entirely new levels.

In short: there will come a point  when the international bond market will test the ECB’s cash-for-bonds promise. Just to give an idea of how much money the ECB could be forced to print, here is a list of government debt by the most troubled euro zone countries:

Government debt 2012
Italy 1,988 bn
Ireland 192 bn
France 1,833 bn
Spain 884 bn
Portugal 204 bn
TOTAL 5,101 bn

Greece, notably, does not report its government debt to Eurostat. Nevertheless, here alone we are talking about five trillion euros worth of government debt. If the ECB had to execute on its bonds buyback program for only ten percent of that, it would have to rapidly print 500 billion euros.

To put this in perspective, according to the latest monetary statistical report from the ECB, M-1 money supply in the euro zone is 5.3 trillion euros. Of this, 884 billion euros is currency in circulation while the rest is overnight deposits. If the ECB had to print money to meet a run on the bonds in the countries listed above, it would find itself having to expand the M-1 money supply by up to ten percent in a very short time window (theoretically over night). This is to be compared to the 7.7 average annual growth rate of M-1 in May, June and July of 2013.

A more than doubled growth rate in the M-1 money supply is not a good way to run an already weak currency.

The welfare-state debt crisis in Europe is far from over. It is brimming and brewing under the surface, bursting out occasionally, with the ECB running around as a whack’em’all player trying to beat down the symptoms of the crisis.