Just as we will not tire of pointing out the unintended consequence of the Fed's central-planning efforts, so it is time, courtesy of the IMF's latest missive, to point out the vicious circle that the ECB has created and encouraged in Europe. The unintended consequence of the ECB's intervention - as both perpetual backstop and lender of last resort - has created an ever-increasing fragmentation between the core and the periphery (exactly the supposed 'issue' Draghi is attempting to fix with his OMT). The toxic-debt-loop as capital leaves the periphery for the core, pressuring peripheral bond yields/spreads, and forcing private sector borrowing to be replaced by public-sector not only clouds the true picture for real-money investors or depositors (risk-based pricing has been destroyed) but encourages front-running fast-money flows which do nothing but provide short-term cover for banks/sovereigns to delay the inevitable (and potential market-clearing) deleveraging/restructuring that is required. Because the fundamental issue is one of solvency - not liquidity - the ECB's continued artifice of plugging liquidity shortfalls does nothing but lessen the confidence in the system and reduce any faith in price levels as without addressing the real insolvency, trust will never return.
Europe's ECB-Driven Toxic Debt Loop...
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1) Capital flight from the periphery to the core...
...due to uncertainty over the future: intervention preventing price discovery and challenges views of any sustained confidence...
Portfolio and Other Investment Capital Flows in the Euro Area, Excluding Central Banks.
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...leads to
2) widening sovereign spreads as foreign holdings of periphery debt fall
...which continues but has also lost any signaling since the ECB's 'promise' of intervention - which causes private borrowing to fall (since risk-based pricing is obscured), but does encourage speculative hot-money flows to front-run the actions (further removing any risk-appropriate comprehension of value)...
Spain and Italy: Changes in Foreign Investor Shares and Yields
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[e.g. GGBs at 10% of Par MAY be a good value, but at 20% of Par (supported by the incessant hope of another extension) they provide nothing that fundamentally signals real-money to re-enter anything but their most short-term market]
which means...
3) Private borrowing is being replaced by public sector flows...
... as the ECB (and its peers EFSF/EFSM and SMP of the future) will replace the missing private borrowers with public sectors flows...
Euro Area Exposures to Greece, Italy, Ireland, Portugal, and Spain
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which leads to...
even more obscuring of any market-based signaling which will inevitably make capital seeking safety nervous and therefore we rotate back to stage 1 (capital flows from the periphery to the core) in a vicious circle.
This circular toxic debt loop of death merely leaves a real-money investor questioning everything as fundamentally we all know the problem at the sovereign and financial system (even more tied together due to LTRO's encumbrance - another unintended consequence) is one of solvency and not liquidity.
By 'enabling' banks and sovereigns to delay addressing the insolvency issue, creditors will simply reduce exposure to manage risk - forcing the ECB to intervene further.
Charts: IMF