When it comes to its opinion on the shape of the bailout, Goldman is a force to be reckoned with (as in every other endeavor, no matter how self-serving the outcome ultimately is): after all it was Goldman which first proposed expanding the EFSF and using it as a "bad bank" SPV which has the extra benefit of being off the balance sheet, and can issue more debt than virtually any financial institution in the world (see EFSF - Too Small? Too Big? Or Just Wrong?). Which is why when Goldman discusses next steps, you can be positive, this is precisely what will end up happening, and that Goldman is already well positioned to profit from whatever policy recommendations it has imposed. So without further ado, here is Dirk Schumacher's latest outlook on how to perpetuate the European status quo.
European Views: Markets focusing on Italy and Spain: What are the options for policymakers?
With Italian and Spanish bond spreads widening substantially, market participants are starting to wonder what options remain for Euro-zone policymakers at this stage. The short answer is that a revival of the ECB’s securities markets program (SMP) is the only real option that would prevent a liquidity crisis for Spain and Italy. It is difficult to pinpoint the threshold at which the ECB would revive its SMP program, but we are convinced that the ECB will ultimately prevent any systemic event related to Spain or Italy, with the support of Euro-zone governments.
The following points are worth noting in this regard:
Reformed EFSF not ready yet. It will take a couple of weeks, or even months, before the EFSF can actually make use of its new powers, such as buying sovereign debt in the secondary market. The parliamentary process can be speeded up, but there are limits to how fast this process can be.
EFSF could lend money to governments, enabling them to buy their own debt in the market. What the EFSF could already do now in principle, however, is lend money either to Spain or Italy so that governments could start to buy debt themselves in the secondary market. Under current rules, such a loan from the EFSF would need to be accompanied by a program. However, this process could in principle be expedited, such that this option would become available in a matter of weeks. One drawback of this option is that a buy-back could be interpreted by some as an implicit attempt at a soft debt restructuring.
Even a reformed EFSF has insufficient lending capacity to cover Italy. Parliaments still need to approve the increase in the EFSF’s effective lending capacity to EUR440bn. But, even after that increase, and also taking into account the IMF’s and EFSM’s resources, the lending capacity would still be too small to provide Spain and Italy with a similar program to those for Ireland or Portugal (Italy’s financing needs until the end of 2013 are around EUR676bn). A further increase of the EFSF would be politically very difficult. Moreover, the ratings of the countries providing guarantees could eventually suffer as a result. Finally, one lesson that could be drawn from interventions in FX markets is that the overall amount available to intervene should remain unclear ex ante.
The ECB has unlimited fire power, in principle. Unlike the EFSF or governments, the ECB has no constraints on its ability to purchase sovereign debt. After all, it can create the money needed to buy these bonds at will. The ECB can - and has in the past - sterilise its purchases of sovereign debt, so that the liquidity in the banking sector, and hence the potential inflationary risks, remain contained. Note, however, that the ECB is currently conducting its repos in full allotment mode, implying that it does not control liquidity for banks anyway.
The ECB does not like buying bonds, as it does not want to fund governments – but things are different in a liquidity crisis where there is a risk of systemic events. Central bank independence and credibility are important pre-conditions for a successful monetary policy. Once central banks become too involved in funding governments, independence and credibility may suffer. This does not mean, however, that a central bank should not buy sovereign debt under any circumstances. After all, a central bank also has the function of a lender of last resort. Normally, that role is limited to supporting banks that face a sudden drying-up of liquidity. But in extreme scenarios, such as the current one, this role also refers to governments that face a liquidity crisis.Note in this respect that the EFSF, under the new arrangement, would start secondary market purchases only once the ECB would have declared a ‘state of emergency’ that would threaten the stability of the whole Euro-zone. If such circumstances were indeed to materialise, it would seem only legitimate that the ECB itself could also restart its SMP if the EFSF is not yet fully operational.
This is a liquidity, rather than solvency, crisis for Italy and Spain. We have discussed in the past on several occasions the solvency of Italy and Spain, and we remain of the view that it is feasible for both countries to stabilise their debt and return to a sustainable fiscal path. The concern now is a self-reinforcing run on sovereigns that, in our view, does not reflect any new fundamental information on either of these two countries.
Governments will support the ECB in preventing a liquidity crisis. Any systemic event involving Italy or Spain could potentially have very damaging consequences for the Euro-zone. Governments, and this includes the German government, are unlikely to prevent the ECB from doing what is necessary, not least as governments themselves are limited in their options in the event of a full-blown liquidity crisis. While governments have debated their options intensely in the past in order to support the Euro, there remains an overwhelming consensus among governments that they should not allow the Euro to fail.
Bottom line: Goldman's recommendation is to, surprise, surprise, do more of the same, i.e., monetize, only this time shift from just the EFSF SPV and force direct bank monetization, initially supposedly in the secondary market via the SMP. Naturally, this would impair the Euro, and also send the US stock market much lower due to the surging dollar, but who cares: there are far bigger structural issues that need to be resolved: such as the very violent end of the first leg of the transatlantic Ponzi, even if that means runaway inflation is the end result.
It also means that the next step for the Fed, in response to Swiss, Japanese and European intervention, is guaranteed.