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Greece Gets the Boot, Germany Takes the Lead: Europe's Endgame

Now consider Article 1.

"Under the terms of this Decision, Eurosystem central banks may purchase the following: (a) on the secondary market, eligible marketable debt instruments issued by the central governments or public entities of the Member States whose currency is the euro; and (b) on the primary and secondary markets, eligible marketable debt instruments issued by private entities incorporated in the euro area."

Now you see the restriction. They can only operate on the secondary market for government debt.

But how binding is this restriction?

Surely a local central bank can pressure one of its commercial banks (which might already be supported or partially owned by the government) to purchase sovereign debt. That debt could be flipped to the ECB through the SMP.


View from the Bundesbank

This is why the Bundesbank is very nervous about the actions of the SMP. Sovereigns can get around the technicalities. It is a stretch to characterize the recent actions of the ECB's SMP as ensuring liquidity and price stability.

There are two key items that any commentator needs to be aware of.

The first is the Treaty of Lisbon and, in particular, Article 123: (my emphasis)

"Overdraft facilities or any other type of credit facility with the European Central Bank or with the central banks of the Member States (hereinafter referred to as 'national central banks') in favour of Union institutions, bodies, offices or agencies, central governments, regional, local or other public authorities, other bodies governed by public law, or public undertakings of Member States shall be prohibited, as shall the purchase directly from them by the European Central Bank or national central banks of debt instruments."

Here's the whole treaty.

This is the "no bailout" clause. The Bundesbank sees this as an absolute. In addition, they view gimmicks such as commercial banks flipping sovereign debt as a violation of Article 123. Indeed, another idea has been floated whereby the ECB lends money to the IMF and then let the IMF bailout Greece, Italy and company. They view this as a violation of the treaty. Here is what Jens Weidmann (Bundesbank President) recently said:

"... the crucial point is that the eurosystem is not permitted to lend to eurozone member states -- no matter whether this is done directly or indirectly by using the IMF as an intermediary."

This is a must-read interview.

In the same FT interview, Weidmann categorically ruled out interest rate targeting of sovereign spreads. He said:

"Fixing an interest rate for a country is certainly not compatible with our mandate. You would guarantee a certain refinancing cost for a government and you could not argue that this was not monetary financing. The stated purpose of the SMP is to cope with dysfunctional markets and it's not to ensure a specific spread for a specific country."

Very clear.

While I am citing Weidmann, another important read is his very revealing speech at a Nov. 8 Deutsche Bundesbank conference. I refer to this as the "sweet poison" speech. Consider the following excerpt.

"In conjunction with central banks' independence, the prohibition of monetary financing, which is set forth in Article 123 of the EU Treaty, is one of the most important achievements in central banking. Specifically for Germany, it is also a key lesson from the experience of the hyperinflation after World War I. This prohibition takes account of the fact that governments may have a short-sighted incentive to use monetary policy to finance public debt, despite the substantial risk it entails. It undermines the incentives for sound public finances, creates appetite for ever more of that sweet poison and harms the credibility of the central bank in its quest for price stability."

The key points are:

¿ No "monetary financing," aka bailouts invoking Article 123.

¿ This is a big deal if it is considered "one of the most important achievements."

¿ The specter of the Weimar Republic's hyperinflation is still fresh.

¿ The "sweet poison" is the belief that bailing out creates the wrong incentives.
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