A Silver Lining to the Italian Debt Cloud

Okay, I admit it: I'm so depressed by the unrelentingly bad state of the world right now -- particularly but not exclusively in the realm of economics and finance -- that it's an ongoing struggle for me to make myself read through the news in the morning. And providing commentary about each day's Awful News often just seems simultaneously obvious and pointless. The fact that much of the news concerns Self-Inflicted Awfulness makes it even more depressing than it otherwise would be.



But I found a glimmer of light shining from Europe this morning as I was reading today's installment of Awful News. Okay, you have to squint really hard to see it, and it will probably be extinguished by more self-inflicted, intentionally generated black smoke. But for today, I saw a small hint of a possible beneficial side effect of the Euro debt crisis spreading to Italy.



The news item that gave me pause this morning was this:

ECB settled 14.3 bln euros of bond buys last week



FRANKFURT (MarketWatch) -- The European Central Bank on Monday said it settled 14.3 billion euros ($20.6 billion) in purchases of government bonds last week as part of its Securities Market Program. The ECB settled purchases totaling 22 billion euros the previous week. The purchases come as the ECB was seen stepping back into bond markets this month to push down yields on Italian and Spanish government debt in an effort to halt the spread of the euro-zone sovereign debt crisis... The ECB, which sterilizes purchases under the SMP, announced it would drain 110.5 billion euros from the system on Tuesday through a one-week deposit auction.

What does that mean? As you probably know, the ECB is buying Italian and Spanish government bonds to try to reassure investors that those bonds are safe, and will be defended vigorously by the ECB (and presumably other European institutions). But there's a curious technical side-effect of this action: these purchases of Italian debt end up boosting the eurozone's base money supply (i.e. bank reserves) by an equal amount, since that is essentially how the ECB pays for those Italian bonds.



Now, the ECB is widely recognized as the most hawkish central bank on the planet. (Obsessively so, in fact.) And one facet of that hawkishness is that the ECB is adamant that all such operations will be "sterilized", i.e. neutralized by countervailing operations. In essence, the ECB has said it will always and completely mop up any increase in the eurozone's base money supply that results from its efforts to support the Italian bond market. So that's why this week (tomorrow, in fact), the ECB will try to remove about 110 billion euros from the banking system.



But what happens when they are no longer able to do that? 110 billion euros is a LOT of money to vacuum out of the European banking system in one go. Even if the operation goes off without a hitch tomorrow, the ECB is now in the position of having to do that every couple of weeks. At some point the European banks may not be in a position to cooperate voluntarily. Already earlier in the summer the ECB was having difficulty with such vacuuming operations, and the quantities of euros to be soaked up were much smaller back then.



If the ECB is no longer able to completely sterilize the large-scale purchases of Italian bonds needed to keep the bond market stable (and thus to keep a potentially self-fulfilling euro crisis from becoming inevitable), the ECB will face a stark choice:



1. Cease purchases of Italian bonds in sufficient quantities to avert the crisis.

2. Give up on the commitment to always and completely sterilize.



It's quite simple: there are no other options. And the participants in the bond market know this as well as I do, which means that they will start selling off Italian bonds, forcing the issue to come to a head, the moment there is a sign that the ECB can not easily sterilize.



So what will the ECB do? If it chooses option 1, then there will probably be a rout in the Italian bond market, leading to all sorts of Awful Things, possibly and eventually including the crumbling of the eurozone to just a few core member countries. The ECB might decide that its reputation for utter and absolute inflexibility is more important than keeping the eurozone from falling apart, so it might choose option 1.



But maybe, just maybe, the ECB will choose option 2. And if it does so, the result could be a deep and lasting shift in the market's perceptions of the ECB. For the better.



Choosing option 2 will signal that the ECB is willing to allow bank liquidity to rise enormously in order to defend Italy and Spain's participation in the eurozone. And that, in turn, could cause inflation expectations in Europe to start rising, for the first time in many years, which could provide an important boost to the European economy. (Mark Thoma today provides a handy review of Krugman's explanation of that point.)



Note that I am not arguing that a massive expansion of the European monetary base would actually cause inflation; it almost certainly would not, just as such an expansion of the US monetary base has had no inflationary effects in the US. But I do think that it would have a dramatic effect on market perceptions and expectations, which in this case could be just as good, if not better.



And so we finally arrive at the promised silver lining to this massively dark cloud: At some point the ECB may find it difficult to soak up the excess liquidity it creates by supporting the Italian bond market. In which case, it might stop trying to do so.



It's not much of a hope, but it's better than nothing.