Thursday, 2 August 2012

Draghi's highly anticipated grand plan

Here are the relevant parts from Draghi's speech today regarding his highly anticipated grand plan...,

"The Governing Council extensively discussed the policy options to address the severe malfunctioning in the price formation process in the bond markets of euro area countries. Exceptionally high risk premia are observed in government bond prices in several countries and financial fragmentation hinders the effective working of monetary policy. Risk premia that are related to fears of the reversibility of the euro are unacceptable, and they need to be addressed in a fundamental manner. The euro is irreversible".

"In order to create the fundamental conditions for such risk premia to disappear, policy-makers in the euro area need to push ahead with fiscal consolidation, structural reform and European institution-building with great determination. As implementation takes time and financial markets often only adjust once success becomes clearly visible, governments must stand ready to activate the EFSF/ESM in the bond market when exceptional financial market circumstances and risks to financial stability exist – with strict and effective conditionality in line with the established guidelines".

"The adherence of governments to their commitments and the fulfilment by the EFSF/ESM of their role are necessary conditions. The Governing Council, within its mandate to maintain price stability over the medium term and in observance of its independence in determining monetary policy, may undertake outright open market operations of a size adequate to reach its objective. In this context, the concerns of private investors about seniority will be addressed. Furthermore, the Governing Council may consider undertaking further non-standard monetary policy measures according to what is required to repair monetary policy transmission. Over the coming weeks, we will design the appropriate modalities for such policy measures".

No need to comment on this other than to say that he needs to study some free-market economics and stop dictating to the markets what is right or wrong. They are very capable of figuring that out themselves and pricing risk accordingly.

Here's the transcript from his speech.


  1. A word about free markets, you probably know that a free market cannot be dictated in the first place (it is what is technically known as an oxymoron). Secondly, it is sentiment and speculation within the market that steer the market, and yes, in that sense Mario Draghi is "interfering" with the extremely volatile market conditions. But, emotion and ego aside, whatever he says will interfere, if he had said "the truth" (whatever that means...) and had been consistent saying they are not going to do anything ever, then we would be complaining about him depressing the market and condemning Europe. If it were the opposite than it would be false hope and all the artificial value generated would burst generating probably more losses (and I understand this is what is thought he did in London, but if you actually read his transcripts, both today's and the one from London, you will see he has been "fairly" consistent)
    Going a bit beyond all this paraphernalia and smoke, one thing is clear, and that is that the tools necessary for economies to stabilize are at grasp. All politicians and rulers (which are not the same, we have excess of the first and shortage of the latter)need to do is just put their heads down, acknowledge a situation that is superior to them and just ask for the help that is being offered, the help this man is telling them how to get. The ball is in the sovereigns' court now.
    Asking for rescue would reduce risk and uncertainty, make lending cheaper within troubled economies (i.e. Spain & Italy)and inject the long needed liquidity.
    Whomever thinks things do not have to get worse before they get better is naively wrong, and they are the ones that haven't studied enough in general. This is a reality check.

    (Thank you for your blog, I think it's great, I hope you don't take this the wrong way.)

    Your thoughts?

  2. Thank you for your comments. On your first point, one of the major problems in the financial markets, which have become ever more apparent in recent years, is central bank intervention. One of the major problems with this intervention is that it distorts the price discovery mechanisms and the markets therefore always end up having to second guess the central banks when pricing assets. This by itself distorts prices (which leads to the markets not being "free"). On your second point, yes, sentiment and speculation always play some role, but bond yields increasing in Spain and Italy is more than just sentiment and speculation. The markets are genuinly concerned about losing money on their investments due to the poor financial state of banks and governments and they therefore demand higher risk premiums to participate. Interfering with this process generates moral hazard, something we've seen plenty of in recent years and all it does is kicking the can further down the road and leading to the recession lasting much longer than it should. It is healthy, in the long run, for countries and companies to (partly) default when they are insolvent. Finally, low interest rates are not always a good thing and certainly not when it is manipulated artificially downwards from central banks (why should they know better than the markets, it's folly to think so) and central planners as it for example leads to less savings and even more speculation (chasing yields).

    1. Thank you for your prompt and comprehensive reply.

      On your point about risk premiums, I agree that risk premiums are not only sentiment-driven, but I must rebate and insist that (today) it is the main driver. Why else would it fluctuate so violently before and after EU, ECB or German official declarations? Yes, the state of European bank fundamentals are relatively constant. As an example the Spanish risk premium went up almost 20% (19.84%) during Draghi's speech, when European banking sector stress test results came out it did not vary nearly as much. The demand for higher risk premiums is based on the speculation of what will and will not happen in Europe. The market is "jittery" and very reactive to this, fundamentals did not change from 1:30 pm to 2:30 (GMT)and the risk of losing money, fundamentally speaking, was exactly the same before and after the press conference.

      Furthermore I couldn't agree more with the fact that the can is being kicked further, unnecessarily prolonging the recession, but (and I am not sure of whether this is what you meant) I believe it is sovereigns who are doing so. Legally and morally the ECB cannot intervene where they are not wanted. Given Europe's current institutional and legal structure, sovereigns are still kings (no pun intended) it is their choice to apply certain measures and conditionalities. The ECB is doing their job, no more and no less. The system (in this very specific sense) is rotten from withing each country, what's amazing is that they've lasted as long as they have(Spain, Italy; Portugal, Greece etc.).
      I admit I am more on the extreme side of opinion,and at the risk of sounding like the apocalypse's messenger, I believe the most effective solution is total default, clean slate and start over because we are too far gone to heal entirely(this will not happen and I do not wish it, I am merely posing a theoretical scenario). The defects are not in the measures "per se", (although their implementation is not being effective or comprehensive)but in the whole structure. A deformed economy cannot be healed with measures designed for a regular economy, but that's a whole different topic.
      What I am trying to get at will all this rambling (for which I apologize)is that interest rate cuts may only be treating the symptoms rather than the disease, but you have to get liquidity from somewhere. With this measure money should trickle down to the home economies an solve pressing issues such as unemployment or cost-push inflation by encouraging banks to lend again and try to encourage some growth. Speculation is a reality and a byproduct and a tradeoff but the opportunity cost I think of no liquidity is greater. (We could go into how Germany for years has misused interest to keep their inflation levels at bay).

      I will not dispute that markets are perfectly intelligent when it comes to logic and economics, but one of the main purposes of governments and authorities is to mitigate damages to those whom they rule, no matter how right the markets are they will act against market logic and make mistakes. It just so happens that governments are not making the right mistakes.

  3. Just a few quick comments:

    On your first point about risk premiums fluctuating so violently surrounding ECB announcements etc: This is a perfect example of what I explained about price discovery, having to second guess the ECB and it distorting the "free market" - the (expected) intervention itself is another risk factor the market needs to price in and this is not a good thing (and hence can cause even more fluctuations in risk premiums).

    On your last comment, this is where our opionions differ the most I think. I believe that "...the main purposes of governments and authorities is to mitigate damages to those whom they rule..." is not what a government should be about. And it definetely should not "rule". We can't rely on governments to make the right choices for us which is why they should be involved as little as possible in such matters, in line with libertarian thinking (and Austrian Economics). Rather than mitigating damages, it more often than not creates them. I am sure (at least I hope I am) you are not happy for the government to take your money (current and future taxes you pay) to bail out wealthy bankers etc.