A Spread Fixing Scheme: Monti’s Pyrrhic Victory?

from  voxeu.org
Together with Mario Balotelli, Mario Monti was heralded in Italy for
bashing Germany at the recent EU Summit. In the latter case, the satisfaction
stemmed for achieving an explicit mandate for the EFSF/ESM to
“stabilize” yields differentials by intervening in the primary and
secondary market. Yet , as in the case of Italy’s ephemeral victory against the
German team,  which ended in a disastrous defeat against Spain, also 
Mario Monti’s achievement with the ESM may turnout similarly doomed. 
This is why.
The  Summit
  is not, asusual, very transparent. It says:
“We affirm our strong commitment to do what is necessary to ensure the
financial stability of the euro area, in particular by using the existing
EFSF/ESM instruments in a flexible and efficient manner in order to stabilise
markets for Member States respecting their Country Specific Recommendations and
their other commitments including their respective time lines, under the
European Semester, the Stability and Growth Pact and the Macroeconomic
Imbalances Procedure. These conditions should be reflected in a Memorandum of
Understanding. We welcome that the ECB has agreed to serve as an agent to
EFSF/ESM in conducting market operations in an effective and efficient
manner. We task the Eurogroup to implement these decisions by 9 July
Although the details shall be filled by July 2012, some educated guesses in
interpretaation are possible:
  • reference
    to existing instruments seem to allude to the fact that the current
    endowment of the EFSF/ESM , estimated around 700 billion, will not be
    increased, although the commitment to do what is necessary may hint
    to the fact that the matter is not yet settled. However, nothing is said
    about the possibility for the ESM to borrow from the ECB for this purpose
    (or to achieve the status of a “Bank”, which amounts to the same
    thing). So the presumption is that no extra resources will be available
    for the ESM
This is clearly a problem. We know from the way price fixing schemes work (
Salant and  Henderson, 1978) that if  the intervention fund has
finite resources and the underlying market disequilibria persist, the
price fixing scheme is doomed: sooner or later a speculative attack will occur,
as  investors will sell,  anticipating the price fall, until all
available official resources will be depleted in the defence of the target
price. In our context  this suggests that the ESM would buy Italian bonds
in order to prevent the bond price to fall below a given price target (and its
yield to rise above a given level). But unless the dynamics of the Italian
public debt will be clearly inverted (by a rise in the primary surplus GDP
ratio, an increase in the rate of growth, surprise inflation or a reduction in
the existing stock, partial default or privatization), the ESM will collapse in
finite time: investors  will sell their holdings (almost 2 trillion) of
Italian bonds to the ESM, which, after having spent all its endownment (700
billion) trying to prevent the spread from rising, will no longer be able to
buy the bonds and will let the spread go. This unless the ESM can borrow fron
the ECB with no limit.
  • There communique
    also refer to a flexible and efficient intervention, which
    presumably means that the ESM would not openly  announce a price
    target for the intervention. 
This for avoiding to offer “speculators” a one-way-bet they
cannot loose: if the bond  price does not fall (and the spread is
stable)  they do not lose by selling; if the bond price falls (and the
spread rises) they gain from selling. Yet such uncertainty on the target price
will be soon resolved as markets are going to test the authorities willingness
(and the price target) to intervene. In this respect tha fact that the ESM will
be operated following a country’s request, under light conditionality 
(the respect of the  Country Specific Recommendations, the Stability and
Growth Pact etc.) will not help: it will only focus the market expectations on
which country is admittedly weaker.
Thus unless the new role of the ESM will backed by the ECB or by a
noticeable policy change, Monti’s victory may prove as Pyrrhic as that of the
Italian soccer team: it bought the team some time, the access to the final
match, but eventually ended up in a disaster. Of course the ESM scheme may turn
out a big success if “multiple-equilibria” view of the crisis is
right: this view says that the current markets’ distrust of peripheral
countries does not stem from weak fundamentals but  only from
self-fulfilling (bad) expectations. In this case, the ESM intervention will
correct “market distortions” (quoting Mario Monti) and help
market participants  focus on the “good equilibrium”, 
where interest rates are low and countries are solvent. Too bad the evidence suggest this view is wrong.