Friday, September 14, 2012

No Limits

Frederick J. Sheehan is the author of Panderer to Power: The Untold Story of How Alan Greenspan Enriched Wall Street and Left a Legacy of Recession  (McGraw-Hill, 2009) and "The Coming Collapse of the Municipal Bond Market" (, 2009)

            The European Central Bank's latest maneuvers jettison limits to the expansion of its balance sheet. The ECB's manner of improvisation is reminiscent of Federal Reserve Chairman Ben S. Bernanke's dismissal of legal restrictions in 2008, when Bernanke talked his way around the law before pliant, ignorant, and frightened politicians.

European Central Bank President Mario Draghi's abandonment of monetary restrictions would be, in due time, an incitement to unlimited price inflation. This is also true for the United States. However, practical matters (discussed below) will restrict this central bankers' nirvana. After watching how swiftly opposition to the ECB's latest decrees melted away, Ben Bernanke may feel reassurance of his freedom to roam. However, he too can only go so far. Maybe he'll be stoned to death.
So, buy gold, silver, and gold and silver stocks.

It was not just Alan Greenspan. Now, central bankers the world round draw greater devotion than Britney Spears (who, according to Forbes magazine's 2012 rating, is the world's sixth most powerful celebrity, demonstrating once again that no matter how egregiously these mystical abstractions behave, they can do no wrong). On September 6, 2012, "Mario Draghi's press conference was covered as if it were a soccer match. We are told that all across Europe shop stalls and bistros had TVs showing his presentation," reported Art Cashin at UBS. (Cashin's Comments, September 7, 2012). Comparisons with the waning of the middle ages are apt.

            The European Central Bank president, wearing an "immaculately tailored dark suit," delivered an address that left no doubt he will do whatever it takes to preserve the euro. "I am what I am," Draghi warned his Frankfurt audience, which was sitting (and possibly shaking) within a stone's throw of the Bundesbank.

            Draghi's announced a new acronym OMT, (Outright Monetary Transactions). Henceforth, the ECB will buy unlimited quantities of "sovereign bonds in the euro area." In the not-too-distant future, the betting line here is an expansion beyond sovereign bonds, to suit an unknown (as this is written) but a greater crisis. Draghi's declarations on September 6 addressed the current meltdown of falling European sovereign bond prices - particularly those issued by Spain and Italy. Yields are rising and buyers at auctions are disappearing, so the ECB will buy and hold yields below an unstated ceiling.

            This objective is clearly outside the ECB's sole mandate to maintain price stability. Draghi's description of how his actions are consistent with the ECB's function is a monument to bureaucratic malfeasance. His rationale of the compatibility between unlimited money printing and price stability was explained in a three-step syllogism: [Step 1:] "We aim to preserve the singleness of our monetary policy and to ensure the proper transmission of our policy stance." [Step 2:] "OMTs will enable us to address severe distortions in government bond markets which originate from, in particular, unfounded fears on the part of investors of the reversibility of the euro." [Step 3:] "Hence, under appropriate conditions, we will have a fully effective backstop to avoid destructive scenarios with potentially severe challenges for price stability in the euro area." [My italics. - FJS] If the Greeks were in a surplus position, they might tutor Draghi on his misconstruction of logic.
Draghi let his audience know there will be no expansion of the money supply. If this is so, inflationary tendencies from his newest initiatives will be second-order consequences. The press release from the ECB that accompanied Draghi's speech states: "STERILIZATION: The liquidity created through Outright Monetary Transactions will be sterilized." That is the full statement. The ECB established an airtight condition: For every sovereign bond the ECB takes in-house, it will sell a bond of equal price.
This being true, the ECB's buying operations are not unlimited. But hark! Draghi squirmed out. The September 7, 2012, Grant's Interest Rate Observer reports Draghi told euro zone officials if the debt matures within three years, it does not "constitute the act of monetarily financing a government."

The importance here is not so much the specific ukase, but that by Draghi stating such, it is so. Flipping through October 2008 archives is a reminder of expedient decrees in the United States. In the here and now, the ECB can do what it wants on the fly: so watch out. For instance, no private bondholder - pension fund, insurance company, hedge fund - should accept Draghi's word that it holds equal footing with the ECB in a sovereign workout.

Back to the specific "three-year rule," it is a short step for the ECB to declare (since the purchase of these particular sovereign bonds does not constitute the purchase of a sovereign bond) the requirement to sterilize Outright Monetary Transactions of three-and-under bonds does not apply. And, even if the ECB attempts to live by its promise of sterilization, the poor quality of its balance sheet will restrict such operations. There will be no buyers for the unspeakable trash it is hiding.

At the press conference, Draghi once again loosened the ECB's requirements of what constitutes acceptable collateral. At this stage, it would be more helpful to produce a summary of what is not acceptable: a very short or non-existent list. Here lies the greatest problem of all, that of trust. European banks already restrict their overnight lending to the ECB. If they decide the solvency of the European Central Bank is untrustworthy, the ECB, Fed, Bank of England, and Swiss National Bank may fall like toy ducks in a shooting gallery.

In any event, Mario Draghi has put the ECB in a position of no return. He must now "do whatever it takes," meaning engage in "unlimited" purchases, or he, and the euro, will lose all credibility. In 1957, Federal Reserve Chairman William McChesney Martin found himself in the same position. The U.S. Senate lobbied the Federal Reserve to cap interest rates. Should it accept the mission, Martin's Fed would buy U.S. Treasury bonds with newly created Federal Reserve notes and institute a ceiling on rates. Martin knew better. He told the U.S. Senate Committee on Finance, on August 13, 1957:

"It has been suggested, from time to time, that the Federal Reserve System could relieve current pressures in money and capital markets without, at the same time, contributing to inflationary pressures. These suggestions usually involve Federal Reserve support of the Unites States Government securities market through one form or another of pegging operations. There is no way for the Federal Reserve System to peg the price of Government bonds at any given level unless it stands ready to buy all of the bonds offered to it at that price. This process inevitably provides additional funds for the banking system, permits the expansion of loans and investments and a comparable increase in the money supply - a process sometimes referred to as monetization of the public debt. This amount of inflationary force generated by such a policy depends to some extent upon the demand pressures in the market at the time. It would be dangerously inflationary under conditions that prevail today. In the present circumstances the Reserve System could not peg the government securities without, at the same time, igniting explosive inflationary fuel."  

Martin was unschooled in economics. He made it through life with only a baccalaureate degree, in English and Latin.