From time to time, Hedge Fund Manager Stephen Jen from London writes comments about the world economy and financial markets. Here is his newest, extraordinarily juicy analysis about the Euro.
Von Gerald Braunberger
In an elaborate comment, which also covers the Fed policy, Jen writes:
“(1) In trying to process the stream of comments from the various European politicians and policy makers, I keep in mind the following. What the non-Germans say is about what they wish to do, but what the Germans say is about what can be done. Messrs Hollande, Monti, and Rajoy could say what they want, but their comments reflect their wish lists. At the end of the day, Berlin will decide what can be done. This dichotomy is one of the key reasons why European officials, collectively, have tended to over-promise, but under-deliver, because the people doing the promising tend to be non-Germans.
(2) The core policy concern in Europe is moral hazard (i.e., a fundamental distrust between governments… sorry to be blunt): if everyone were certain that the peripheral countries will be relentless in pursuing aggressive structural reforms and austerity, then policies in Europe would be much more straightforward. Because the ECB does not want to create a moral hazard problem by removing or reducing the incentives for the governments to stick to their commitments, it has a preference of conducting SMP operations only in parallel with bond buying by the EFSF. Before the EFSF is activated to buying bonds from a member country, that country must (i) formally request help and (ii) sign a MOU (Memorandum of Understanding), which is sort of like a light version of an IMF program, showing their commitment to certain measures. The reason why the German FinMin Schäuble said that the EFSF won’t be buying bonds any time soon is because Spain has not made the formal request for help from the EFSF. In turn, the reason why Madrid has not done so, despite the intense pressures in their bond markets, is that it prefers not to have more conditionalities tied to the financial aid it is getting. (Mr Schäuble is big on conditionality. In his joint statement with Mr Geithner from Sylt, he emphasised the need for continued reforms.) If the EFSF is not activated soon, the ECB will be compelled to buy sovereign bonds on its own, unconditionally. It’s hard for me to imagine that Buba’s Weidmann will endorse such an idea. (By the way, Sylt is a beautiful island, whose beach atmosphere is very different from that of the Southern European beaches. I can see why Mr Schäuble would want to vacation on Sylt, both because of its relative tranquillity and safety: not sure if he would be very popular in Southern Spain now…)
(3) It is not clear why Mr Draghi made the declaration to the world on Thursday in London, without having consulted his colleagues beforehand, including Mr Weidmann. Mr Draghi, subsequent to his comment in London, circled back to Mr Holland, and in turn Ms Merkel, to elicit political support. Even FinMin Schäuble was asked to give a supportive comment, before a meeting with Mr Weidmann was announced. It almost seems as if Mr Draghi intentionally tried to corner Mr Weidmann, forcing him to choose between (i) standing his ground and eventually be forced out like Messrs Weber and Stark before him, or (ii) bow to Mr Draghi, and lose his credibility. However, in the last two days, we have heard enough from other German sources to know that Mr Weidmann will be only one of Mr Draghi’s worries, i.e., no EFSF bond buying for now, no bank license for the ESM. Ironically, come Thursday, it could be Mr Draghi who will be cornered, as he could not not deliver a bazooka, after having taunted the world like make-my-day Clint Eastwood.
(4) Mr Weidmann may be the de facto spokesperson for the ‘North’, but he is not the only ECB Council Member who is opposed to open-ended SMP operations. Finland, the Netherlands, and Belgium reportedly are also strongly against the idea. In theory, the Southern European countries could out-vote the North. But that would be tough in practice, in my view, as it would be the debtors out-voting the creditors to force the latter to underwrite possible losses to the ECB. In short, Mr Weidmann, I suspect, still matters a lot, even if he looks to be isolated.
(5) Large-scale SMP purchases have obvious risks: is the ECB really big enough to overwhelm the bond markets in Spain and Italy? Also, the side-effects are huge: moral hazard problems, as mentioned above. Much of the EUR50 billion in the ECB’s Greek bond holdings will probably be written down one day. Further, the EUR210 billion in SMP bond purchases have little to show for. Will the ECB be willing to buy EUR1 trillion of Spanish and Italian bonds? If the ECB does buy EUR1 trillion of bonds, would it not crowd out the private sector, given the ECB’s senior creditor status?
(6) If one looks at the chart for the Spanish bond yields, one clearly sees that the recent rise in yields began in early-March. What was the trigger for this? On March 2, 2012, Mr Rajoy surprised the world by not only announcing that Spain had fallen behind on their fiscal obligations, and that Madrid had unilaterally decided to adopt a new, higher, fiscal deficit target. Brussels were merely informed of Madrid’s unilateral decision. Some may even recall the angry reactions by Mr Monti, who immediately realised that that may mark the beginning of a very difficult period for Italy’s bond markets. My point is that Spain’s failure to honour its fiscal commitment was the beginning of the selloff in Spanish bonds. It was not irrational speculators aiming to destroy a proud kingdom, as some policy makers have claimed. Nor did it have anything to do with the growth-versus-austerity debate. The story was much simpler than that: bond investors want to see governments doing the right things. Why was Ireland able to return to the market, in the midst of the ‘crisis’ in Spain? Why has Portugal been so quiet and their bond yields so stable? Governments and the general population should take responsibility for their actions, and stop looking for easier and less painful ways out. Bond markets are usually fair.
(7) Conceptually, the idea of the ECB printing money to help support the peripheral countries is not too different from an IMF program. Let me explain. The IMF gets its resources from pledges of foreign reserves by its member countries. So when the IMF lends Country A money, it calls on Country B to pledge its reserves with the IMF, and the IMF creates money (SDR) to lend to Country A. The process, therefore, is monetary, not fiscal, in nature, and it involves the IMF creating money. Imagine that the collection of the European central banks pledge money to and entity called the ECB, and the ECB accepts the pledges from the European central banks, and creates money to on-lend to selected EMU members. The process is monetary, and it entails money printing. In other words, if all of the IMF’s lending comes from pledges from European countries, then the two processes would be almost identical. The key difference, however, would be the strong conditionality of IMF loans, versus the ECB’s spending, which will be unconditional.
(8) I do believe the ECB will take major actions and QE is almost certain, at some point. However, this process may take a bit longer than some may think or hope. At the end of the day, the prospective operations deal with the symptoms (high bond yields of two countries) but not the root cause of the crisis in Europe. I always believed that there are no short-cuts to resolving the crisis in Europe. Anything that looks like a short-cut is not a solution. QE by the ECB is one of them, even though it may stabilise the markets temporarily to buy time.”
P.S.: Stephen Jen’s comments are not public on the internet
P.P.S.: Jen’s comments contradict the assumption that anglo-saxon financial players only had world views similar to the Southern European views and didn’t understand German views.
