Thursday, 6 September 2012

Was Merkel taken in by Maestro Mario's sleight of hand or is she the magician's accomplice?

Mario Draghi is an astute magician. But it remains to be seen whether the tricks performed during the announcement of the "unlimited support" for the sovereign debt of the Eurosystem's troubled states will come unstuck when the curtains are fully open.

There is an inherent contradiction in the following two premises:

1. The tail risk to the future of the euro currency has been removed.

2. There will be strict conditionality on the manner in which the ECB supports troubled bonds.

Implied in the first premise is an absence of conditionality. For anxious asset managers who are concerned about the currency risk of holding euro denominated assets the only foolproof way of reassuring them that the EMU will not unravel, and that they wouldn't end up holding lire or peseta denominated assets, is for there to be an unequivocal guarantee that the EMU will be unconditionally supported by the ECB. This is what Draghi was trying to convince markets about in his press conference on September 6th.

At the same time, almost certainly to appease Angela Merkel and German politicians (although he failed to convince Jens Weidmann at the Bundesbank), he reiterated numerous times that there would be strict adherence to conditionality when the ECB intervenes in the markets to alleviate the kinds of stresses that have characterized the last three years. His intention, surely, is to finally convince private sector bond purchasers that they need have no fear of adding Spanish and Italian government bonds to their portfolios (let alone those of the other peripheral states that have already been "rescued").

But if Draghi was sincere about his emphasis on strict conditionality, and a recipient sovereign violates the terms and conditions upon which a decision by the ECB to intervene was predicated, then (logically) the support should be removed and the delinquent sovereign debt would become even more troubled in the absence of any further ECB safety net.

If Draghi's commitment to conditionality is not robustly applied then Angela Merkel and her colleagues in the Bundestag have been "conned" - they would have been the victims of a sleight of hand by Mario the maestro magician. Without robust enforcement of conditionality, Draghi and the members of the ECB's governing council (other than Weidmann) would have effectively provided unlimited usage of the German credit card to any of the politicians of the EZ states, to spend whatever they wanted with it, in order to ensure the longevity of their administrations.

The closing thought is that it could well have been the Angela/Mario magic act and that the ultimate "victims" when the curtains are fully open will, once again, have been German taxpayers.

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