LDraghi Sets Out to Learn a Tough Lesson

Mario Draghi appears to have committed the ECB to a slew of open market purchases of European Sovereign debt. The argument is that if the ECB buys bonds, prices will rise thereby reducing the borrowing costs of the likes of Spain and Italy. The markets generally rejoiced at this prospect last week with global equity markets and European bonds rising sharply – only US Treasuries and the USD reacted negatively. Is Draghi correct and can the ECB sustain lower interest rates by buying bonds without the issuing governments changing their fiscal stance?

The simple answer is NO. One often forgotten fact in asset pricing is that the net supply of bonds in equilibrium is zero. This means that for every borrower there is a lender, and for every buyer there is a seller. Therefore, equilibrium bond prices reflect cash flows discounted by a risk premium. Nowhere in the pricing equations for sovereign debt does ‘Mario Draghi’s demand’ show up explicitly – if the ECB is to have any lasting impact it must be either through higher cash flow expectations or a lower risk premium. Neither of these are likely.

As for cash flows, the Greek experience speaks volumes. Investors had expected that if they bought the same bonds that the ECB owned then their cash flows would be guaranteed. Alas, no, this was not the case since the ECB cynically swapped their old bonds for ‘new bonds’ leaving private investors holding the old bonds which were promptly restructured.

As for the risk premium, as the ECB’s bond holdings rise the temptation to monetise debt must grow more and more. That is, the ECB will be increasingly likely to print money to repay the debt they own thereby creating higher inflation risk. Risk premia should rise under this scenario.

The prognosis for this policy looks bleak. The only thing that can reverse the growth in EU debt is for governments to stop spending and start taxing. Everyone needs to wake up to this fact.