Spain and the European Central Bank - and, in effect, Spain and the EU authorities as a whole – are playing a game of chicken. Spain wants the ECB to restart the Securities Market Programme (i.e., the programme of sovereign bond purchases it began in May 2010), since market financing of its government debt has become too expensive. The threat is that, if the ECB does not agree, it will leave the Eurozone. In an e-mail of 11th May I suggested that ‘the ECB could still lend perhaps 200b. – 350b. euros more to Eurozone banks, subject to the availability of collateral. But, beyond that, there would surely be a massive rumpus if the ECB had to grow its balance sheet by a significant amount.’ According to the ECB’s weekly statement, not much has in fact happened to its lending to Eurozone banks in the last two/three weeks, but a large number of furious phone calls have clearly been taking place.

I of course have no inside knowledge of what is going on, but we need to remember that in similar circumstances in May 2010 three Frenchmen (Sarkozy, Trichet and Strauss-Kahn) bullied one German lady (Merkel) into agreeing ECB’s purchases of Greek government bonds. Sarkozy has been replaced by Hollande, who is far more ‘growth’-oriented than Sarkozy. My guess is that France and Spain have organized a Club Med alliance (almost certainly including Portugal and Greece, and probably Italy, Ireland and Cyprus), so that Germany (and the associated nations, i.e., the Netherlands, Austria and Luxembourg) will be outvoted on both the ECB Governing Council and Ecofin (i.e., the Council of Ministers, when the attendees are finance ministers). In other words, the Governing Council – with the support of an Ecofin majority – will vote for an enlargement of either the SMP or the long-term refinancing operations (the LTROs). That is just a guess, but I cannot see Hollande supporting anti-growth Germany in current circumstances and – although intellectually Monti would side with the Germans – politically he cannot do so.

What happens thereafter, no one knows. Again, my guess is that initially Germany will back down and the ECB balance sheet will move out into the 3,500b. – 4,000b. euro area, with the Bundesbank becoming an even larger net creditor versus the PIIGS central banks. But, to repeat, ‘a massive rumpus’ has started and we are in last chance saloon. There must be a limit to the Bundesbank’s net claims on other Eurosystem central banks.

The markets are in a tizzy, but – frankly – the only serious negative for equities from the Eurozone’s break-up would be the danger of further bank retrenchment (and another collapse in the quantity of money) following the wipe-out of bank capital from losses on peripheral sovereign bonds/inter-bank exposures. I have little respect for the people – the central bankers, regulators and so on – who have been ‘managing’ our currencies in the last few years, but I trust that even they realize that large-scale money creation by the state may be needed to stop another slide into recession. In this context the debate about ‘quantitative easing’ is likely to hot up again. Yesterday I had a debate with Paul Krugman on BBC radio’s World Service on this and other matters, which can be accessed via a link which will be sent out tomorrow. Attached is a discussion of Krugman’s apparent endorsement of $2,000b. of Fed asset purchases, a programme which I call ‘quantitative easing à outrance’ (i.e., quantitative easing to the uttermost, for those who are new to this subject).

By Prof. Tim Congdon

Chief Executive, International Monetary Research Ltd

Please share with others