Has the ECB actually moved closer to QE?

There has been a cacophony of comments from ECB members and ECB watchers over the past few days. However, the overriding view since ECB President Mario Draghi’s press conference last week is that the ECB has now moved a step closer to unconventional action such as Quantitative Easing (QE).

This is mostly down to two factors. First the following statement from Draghi’s presser:

“The Governing Council is unanimous in its commitment to using also unconventional instruments within its mandate in order to cope effectively with risks of a too prolonged period of low inflation…this statement says that all instruments that fall within the mandate, including QE [Quantitative Easing], are intended to be part of this statement. During the discussion we had today, there was indeed a discussion of QE. It was not neglected in the course of what was actually a very rich and ample discussion.”

Second, the FAZ report over the weekend that the ECB has been modelling the impact of a €1 trillion per year (€80bn per month) QE programme. While it suggested that such a programme would only raise inflation by between 0.2% and 0.8% (not a significant amount given the cost), the simple fact it is being modelled has been enough to give markets hope.

We believe QE or similar measures have become a bit more likely, but mostly because the market now seems to expect action and if the ECB is to maintain its credibility it will need to do more than simply talk.

That said, while there may be ‘unanimous commitment’ to using such measures when needed, it’s still not clear what the criteria are for such action and it is even less clear that all members of the GC agree on when such action would be needed. Draghi was pushed on this on the first question during the Q&A session, however, he never provided a direct answer.

Furthermore, much of the coverage has suggested that QE is in fact closer because the ideological opposition to such a measure at the Governing Council (GC) level has crumbled - although we're not sure that such a clear unified opposition ever really existed.

With this in mind then, it’s worth once again pushing the point that, in fact many of the issues with further easing are practical, political and/or legal rather than ideological at the ECB. We have previously analysed each measure in detail, below is a summary and links to all those posts:

Quantitative Easing (purchasing government debt)
We have detailed the issues extensively here (but also here and here). Draghi has hinted of these practical issues before, highlighting that they need time to design the programme and gather more information. Beyond political opposition in Germany and the legal limits to ECB financing governments, there is a clear problem in that the purchases would need to split according to the ECB capital key, meaning little would flow to the periphery where the deflationary forces are strongest. Add onto this the fact that QE in other countries has not been proven to boost the real economy or even bank lending as well as that it may exacerbate the squeeze on safe assets and it becomes clear that practically and technically this would be a very difficult step for the ECB to take and is not well suited to tackling the problem of low inflation.

Quantitative Easing (purchasing private assets)
See our detailed analysis here. The thrust would be to target purchases of assets which would help promote bank lending – the main one discussed is Asset Backed Securities (ABS), particularly ones made up of loans to the real economy. However, these markets in Europe are small and underdeveloped meaning the level of assets available and suitable for purchase would be minimal. The ECB has suggested it wants this market to grow but it’s tough to force such a move, especially in the short term.

Negative deposit rate
We analysed this option here. Since then the ECB seems to have made progress on the technical implementation of such a move. That said, the impact remains very uncertain. It could further reduce excess liquidity, force money market funds to shutter and force banks to pass costs onto consumers. On the plus side it could help weaken the euro.

A targeted LTRO (similar the Bank of England’s Funding for Lending Scheme)
Discussed, with other measures, here. A fairly simply option to take, however, given that there is already full allotment (unlimited liquidity at low rates) and banks have already repaid a lot of the previous LTROs there is no guarantee there would be any significant take up or that it would filter through to the full economy.

Ending sterilisation of the Securities Markets Programme (SMP)
A smaller measure, discussed in this post. While it would stop liquidity being drawn out of the system on a weekly basis, it’s not clear that this liquidity would flow to the real economy.

Further standard measures such as rate cuts and changing collateral rules
We rounded up such options a while ago here. Given that rates are already so low and that the transmission mechanism remains broken, the impact of such moves is likely to be limited to signalling intent rather than hoping for any significant return.

Overall, nearly all of these measures face quite serious practical, technical and/or legal obstacles.

Furthermore, it is unlikely that there is any consensus at the ECB GC level of when each measure is needed or what the triggers for such action are. The obstacles are also probably viewed to be different sizes by each national central bank. All that is to say, while it may have moved slightly closer, don't yet count on QE being much more than a last resort.

ECB preview - ECB may take limited action but shy away from serious intervention

As we noted last month, a lot has been pinned on the March ECB meeting, with the release of new data potentially facilitating further easing action.

But on the eve of the meeting, analysts remain split, although the sense is that the pressure for significant action is easing. February’s inflation data came in above expectations, with core inflation (removing the effect of short-term moves in energy and food prices) actually at 1% - still very low but well above expectations. We’ve also seen positive PMIs (indicators of private sector business activity) across the eurozone and in some of the struggling countries, although France remains behind the curve.

With that in mind, it looks as if the ECB will shy away from taking a major decision on Quantitative Easing or a negative deposit rate. These remain drastic actions which the ECB is clearly unsure about, and with good reason. It’s not clear what the side-effects would be of such action or that it would actually feed through to tackling low inflation in the periphery or boosting lending to the real economy (and therefore economic growth).

There are a few other options on the table. Another, more targeted long-term lending operation (LTRO), or purchases of private sector assets, probably packaged bank loans (asset-backed securities). These are possible and more likely than the above, but for reasons discussed before, would also be quite a big step by the ECB.

The most likely options remain a token rate cut (i.e. one without an accompanying cut to the deposit rate), a further extension of the unlimited fixed rate liquidity provision and the end to ECB sterilisation of the Securities Markets Programme (SMP) bond purchases. We have outlined before that, at this stage, a rate cut makes little difference as the transmission mechanism is broken, at least to the areas where the impact of the cut would like to be felt. Extension of the liquidity provision is also broadly inferred and was always expected to go on as long as is needed, in line with the forward guidance given.

We’ve yet to discuss the end to sterilisation, so we lay out a few points below.

As a recap, the SMP was a programme launched in 2010 to purchase government bonds on the secondary market and bring down borrowing costs for certain countries (which were hampering the transmission of monetary policy). The sterilisation process sees the liquidity introduced by these purchases absorbed by the ECB, through the issuance of corresponding amounts of one week fixed-term deposits with an interest rate of 0.25%.

ECB SMP sterilisation total amount (€m)

Why take this measure?

• The idea is that ending the sterilisation would free up the €175bn in liquidity currently pledged to the ECB. This will counteract the recent decrease in excess liquidity in the eurozone and should encourage banks to lend this money out rather than simply posting it with the ECB.
• From a political perspective, this is also one of the least controversial actions since it has been endorsed by the Bundesbank and should be fairly easy to get support for at the ECB Governing Council.

Will it have any impact?

• It is unclear, but we are not overly hopeful. As the chart to the right (courtesy of Commerzbank) highlights, the earlier tensions in money market rates have eased. This means the impact will be limited.
• Ultimately, it depends on what banks decide to do with this money. The ECB deposits were a very safe investment with a decent return given the ultra low rates around at the moment. Our feeling is that banks will want to continue to search for equally safe assets rather than take on much more risk for a similar return over a short period. This could actually acerbate the demand for quality short term assets, particularly core ones, in the eurozone.
• Despite some failings in the sterilisation (shown by sharp deviations in the graph) demand has been fairly solid, although whether this is due to demand for safety or a decent return is unclear.
• The fixed-term deposits are also eligible as collateral for the ECB’s lending operations. It’s not clear if they have been used for this purpose, but if they were, this could further limit the impact in terms of boosting liquidity.

Ultimately, ending SMP sterilisation would be a token compromise measure. Its greatest use is probably as an indicator of an on-going willingness to ease if needed, and of the ability to compromise on the issue from the Bundesbank side. 

ECB publishes details of SMP purchases

The ECB has just released details on its holdings of government bonds bought under the Securities Markets Programme (SMP) for the first time, see table below (click to enlarge):

To be honest, the figures are much as expected – although the holdings of Greek bonds will have decreased due to a fair amount of the holdings maturing (circa €10bn over the course of the SMP). The holdings of Italian bonds are interesting, given that we knew the ECB purchased almost €145bn of Spanish and Italian bonds, it is possibly a bit surprising that the level of Italian bonds outweighs Spanish so significantly (although it does broadly match the relative size of their debt markets). Still it highlights that necessary intervention to simply keep yields in these countries to below 7% was still very sizeable.

The move is positive for the transparency of the ECB (if a little late). Let us hope this is the start of a trend rather than a one off…

A big week for Greece - but still few answers

As we noted in our press summary today, this week is lining up to be another big one for Greece.

The Greek government faces two crucial votes in parliament – first on Wednesday to push through the latest package of structural reforms (as demanded by the EU/IMF/ECB) troika and second on Sunday to approve the latest and, according to Greek PM Antonis Samaras, the last austerity budget for next year.

Since the governing coalition was formed after the second summer elections, such votes have usually passed without much fanfare. However, this time around the Democratic Left (which holds 16 seats in parliament) has said it will not vote with the its coalition partners. Pasok (which holds 31 seats) is also facing a period of internal strife with one MP already leaving and up to five others threatening to at least vote against the government. New Democracy (127 seats) should have an easier job pulling its MPs together.

The votes should pass but the margin for error is tiny, possibly only two or three votes, notably provoking unrest amongst financial markets and other eurozone leaders. In the end, given that the end of the government would very possibly signal the end of Greece as eurozone member, the (perceived) fear factor is likely to be enough to once again push the vote through.

This clears the way for the release of the next €31.5bn tranche of bailout funds and a potential two year extension to the Greek bailout. Today’s FT notes that the extra funding for the extension is likely to come from an increase in short term debt issuance by Greece and possibly a reduction in interest rates on eurozone loans to Greece – exactly as Open Europe predicted in its recent flash analysis on the issue.

The FT article also includes a potential plan for the ECB to return profits from its purchases of Greek bonds to Greece via eurozone governments to avoid the thorny issue of the central bank directly financing a state. This sounds plausible on the surface since the returning of profits to national governments should happen naturally anyway under the ECB rules. The only issue being that this can only happen overtime as the profits accrue as the bonds are paid off, so its unlikely to be paid out in a single chunk at one time (as is needed here).

One final point on the cost of the extension. We put it at around €28.5bn, although estimates range from €15bn to €40bn. We didn’t include a delay in Greece’s return to borrowing from the markets, which is looking increasingly likely. If Greece doesn’t return to borrowing until after 2016 it could add a further €10.6bn to the cost of an extension.

So although this is a big week for Greece, even a clear government win in both votes will do little to answer questions over Greece’s future in the eurozone.

Has Draghi really saved the universe?

So it continues.

During a highly anticipated press conference, ECB head Mario Draghi - the man tasked with saving the universe after eurozone leader's consistent failures - announced today that the ECB will buy 'unlimited' government debt, albeit short-term.

So the central bank that once wouldn't touch government debt with a bargepole, has now said it's willing to underwrite governments, in theory indefinitely. In fairness, we're talking short-term, sterilised bonds from countries who enter an EFSF/ESM bailout programme - so there are several catches. Still, this is a big move, which is why markets have reacted positively.

How long it'll last is, as ever, an open question. You can read our full take on the decision (and all the technical details) here. The key concerns / questions:

• Purchases of short term debt don’t tackle the rising cost for Spain and Italy of refinancing long-term debt, and may force countries to focus more short term funding, making them more susceptible to higher borrowing costs.
• Despite all the talk of conditionality, can the ECB really cut off bond purchases from a country when it is already in trouble? We doubt it, at least not without causing huge problems in the markets (which the policy is meant to avoid).
• The sterilisation (removal of the money created) is almost irrelevant given the already unlimited lending provided by the ECB.
• Although it claims to no longer be senior to other bondholders, would the ECB really take losses, meaning that it crosses the mark for directly financing governments, if push came to shove?
• With the interbank lending market still dead and buried will a few sovereign bond purchases really restore monetary policy to ‘normality’?
• These purchases tackle a symptom not a cause of the crisis, lack of competitiveness, poor growth prospects, unsustainable debt and undercapitalised banks still weigh down the struggling countries.

The markets might be buoyed, but this one will drag on for much longer.

Finland and Netherlands raise doubts over summit conclusions

As we expected, doubts are already arising over the package agreed at last week’s summit. In particular, Finland and the Netherlands have today expressed strong reservations about the plans to allow the EFSF and ESM to purchase the debt of struggling countries.

Finland suggested today that it will not support any bond purchases by the bailout funds, while the Netherlands took a less stringent line simply saying that it would assess each purchase on a case by case basis (although behind the scenes it is widely thought not to be keen on the idea).

However, as has been noted, the countries may have backed themselves into a corner here with one of the previous summit amendments to the ESM treaty, which says:

“An emergency voting procedure shall be used where the Commission and the ECB both conclude that a failure to urgently adopt a decision to grant or implement financial assistance, as defined in Articles 13 to 18, would threaten the economic and financial sustainability of the euro area. The adoption of a decision by mutual agreement by the Board of Governors referred to in points (f) and (g) of Article 5(6) and the Board of Directors under that emergency procedure requires a qualified majority of 85% of the votes cast.”

It is worth remembering though that under the EFSF unanimity is still needed so in the short term they can block any attempt to purchase bonds. However, once the ESM comes into force, in around a week’s time if done on schedule, the countries could well be outvoted, since they control less than 8% of the votes combined. It is obviously not completely clear cut, the ‘emergency procedure’ would need support from the ECB and/or the Commission, although it is unlikely that the purchases would be started up in a non-emergency situation. At the very least it should make for an interesting vote on the ESM in the upper house of the Dutch parliament tomorrow and even though ratification is likely (especially since the lower house has already approved it) we’d hazard a guess that this isn’t the last we’ve seen of this issue.

Are the rumours of a new(ish) eurozone backstop true?

The press have got very excited over suggestions from European leaders at the G20 meeting in Los Cabos, Mexico, that they will activate the EFSF to buy eurozone government bonds from the secondary market in an attempt to reduce borrowing costs for Italy and Spain - a function which the fund has always had but has never been used (since the ECB has filled this role with its bond buying programme). Berlin has already moved to deny this, but there could be truth in it - not least because it's legally possible but also because we've seen over the past few weeks that the ECB has refused to buy bonds despite the persistent rise of Spanish borrowing costs. It has become increasingly clear that Spain cannot withstand these interest rates for long - something needs to  be done.

If true, this could prove a important change. Despite always being possible, bond buying from the EFSF has up until now only been theoretical. When it comes to the unenviable task of backstopping Spanish and Italian government debt, the ECB has now officially passed the buck to eurozone governments. Over the last two years, the ECB has effectively managed to manipulate government bond yields by buying a limited amount of government bonds – some tens of billions a month at its peak (although with mixed success). In August last year, for example, the mere willingness of the ECB to buy Italian government debt may have prevented a full-scale run on that country as political uncertainty ran wild. But there’s a key difference between the ECB and the EFSF – while the former has deep enough pockets to move markets, the EFSF’s lending capacity is inevitably limited, meaning that making it into a lender of last resort for a country the size of Spain (let alone Italy) could prove risky. The ECB could stand behind Spain and Italy with, at least in theory, the ability to massively expand its balance sheet and thereby quarantine these problem countries. But the EFSF only has €250bn left to lend – to top up its lending capacity, it will need to pass 17 hostile national parliaments, which ain’t gonna happen anytime soon.

This is to say that, if the buck has indeed been passed from ECB to the EFSF, then the Eurozone’s firewall just became a lot weaker - many have rightly previously questioned its capacity to purchase bonds and fund lending programmes to struggling countries simultaneously. Furthermore, the EFSF treaty states that secondary market intervention can only take place at the request of the recipient country and will come with some conditions (although probably not a full reform programme). Clearly this will come with significant stigma (once you go down the path of any external aid it is hard to return, as Spain is now finding out), while it is hard to imagine a country signing up to extra conditions just to manage its secondary bond market (especially since the ECB was previously doing this without any clear conditionality).

There are additional questions over what this means for the permanent eurozone bailout fund, the ESM, which is meant to be up and running this summer. Presumably, it will have to take over this bond buying role once it comes into force. The same problems apply here as do with the EFSF, but the ESM is also senior to other debt, meaning that as it buys up debt of a country other holders of this country's debt become subordinated - this can result in further market uncertainty making it counter productive. Ultimately, if the ESM is to serve as a lender of last resort in any way, it almost has to be equipped with a banking license in order to allow it to lend and borrow freely, without being hostage to national parliamentary politics or very limited in size. Giving the ESM a banking license is a hot potato in Germany, but will Berlin have any choice if the markets start to question the firepower of the fund?

On the current path, presenting the EFSF/ ESM as lender of last resort – for Spain in particular – but without equipping it with the cash to actually allow it to fulfil this function, could set the stage for a showdown between markets and the funds - in that scenario we can only see one winner.

Decoding the ECB bond swap

As Die Welt reported yesterday, it now looks as if the ECB will swap it’s circa €55bn (nominal) holdings of Greek debt into newly issued Greek bonds provided by the Greek state. Below we attempt to summarise what this actually means. It’s a bit techie – so bear with us.

There are basically three options for Greece: a debt write-down that creditors agree to voluntarily, coercive restructuring (where Athens uses contract-based provisions to not pay back its creditors) or disorderly default (all hell breaks loose). Today’s deal has reduced the risk of the latter while increasing the chance/risk of the first two. However, it still hasn’t answered the question whether the ECB will actually itself take losses – or participate in some form – in a Greek restructuring.

Why is the ECB swapping its current holdings of Greek bonds for new ones?

Under this arrangement, the new bonds will be distinguished from the old ones in some way (possibly through different serial numbers) allowing Greece to pass legislation which retroactively imposes collective action clauses (CACs) on the rest of Greek debt held outside of the ECB. (This is sort of like the government hiking the tax rate today and then trying to claim 10 years of back tax at this higher rate). While a number of bondholders could agree to take write downs voluntarily, the remaining ones could be forced to do under these CACs. But the ECB is now safe. This matters tremendously since, if Greece went for a coercive restructuring without any special protection for the ECB, the institution could be faced with major losses and huge dents to its credibility – since it continually denied that it was taking too much risk since it saw a Greek default as impossible. The Eurozone and Germany in particular is keen to avoid this (see here for a whole range of political reasons why).

Open Europe take: While we have sympathy with the ECB for trying to avoid losses, this is a rather strange move (and a result of their flawed policy approach we might add). The preferential treatment it now has on Greek debt, suggests that the ECB’s wider holdings of eurozone debt from its bond purchase programme (around €220bn) are senior to eurozone debt held elsewhere. This could create uncertainty in the bond markets of the southern eurozone states, as bonds held by private creditors are much more likely to be next in line for a write down. More importantly, it also opens the ECB up to legal challenges, since some bond contracts will have clauses protecting them against subordination (negative pledge clauses). Importantly this worrying precedence is reported to be the reason why Bundesbank President Jens Weidmann objected to the move, further highlighting the fundamental disagreements within the ECB itself.

Doesn’t this increase the prospect of a voluntary restructuring?

The swap seems to have gone down well with markets. The perception is that private creditors – those that still hold out – will be much more likely to now accept voluntary losses, which – finally – can bring a conclusion to what has seemed like endless talks between creditors and the Greek government.

Open Europe take: The risk of a disorderly default on the 20 March has radically decreased, which must be considered a good thing. The Greek threat of forcing a coercive default using CACs is now much more credible (it can be done with fewer legal complications) which should force private sector bondholders to pull their finger out since they could face far greater losses under a coercive restructuring. At the same time, Greece now actually has the tools to push through a coercive restructuring (via the CACs) and a larger write-down, meaning that this option is still very much a possibility. So perhaps the markets are getting ahead of themselves.

Does this provide any additional debt relief for Greece?

No. There has been some confusion over this point. Currently the swap is 1:1 meaning the ECB will not take any losses or provide any monetary benefit to Greece. The ECB does seem to have agreed to distribute its ‘profits’ (revenues from the interest payments) on the new holdings so that they can be used to aid Greece.

Open Europe take: As we have noted before, the official sector will take losses in Greece, now or in the future (better now). The ECB should not take direct losses but forgoing the difference between the purchase and nominal price of its holdings of Greek debt would be beneficial. On a side note this episode highlights the lack of transparency surrounding the ECB's actions in the eurozone crisis. Despite purchasing the bonds at a discount the ECB holds the bonds at nominal value on its balance sheet, therefore selling them at purchase price means the ECB would still book a loss on paper. This is not an argument against the ECB providing some debt relief to Greece in of itself (by selling the bonds at purchase price), but more that the ECB does not correctly display risk on its balance sheet and did not create enough safeguards against such an event when it first decided to purchase eurozone government debt.

Furthermore, the concept of redistributing ECB ‘profits’ is flawed. The ECB already pays out any profits it makes to eurozone member states. It is then up to them to use the money how they see fit – it is a political decision, meaning the ECB’s comments about profits being used to aid Greece in this sense are more or less irrelevant.

Is this the end of the discussion with the ECB and Greece then?

Not quite. Once the switch to the new bonds has occurred there could still be scope for the ECB to offload them and sacrifice the difference between the purchase price and nominal value of their Greek holdings. The voluntary restructuring will move ahead and if it does not provide enough debt relief the pressure on the ECB to provide some additional relief will increase again.

Open Europe take: As we note above, Greece will probably need help from the ECB at some point. The Greek negotiating position is now significantly weakened since the ECB has greater protection. The ball is firmly in the ECB’s court – not exactly desirable given the opacity and stubbornness which it has presented so far in the eurozone crisis.

ECB sterilisation fail

The ECB yesterday failed to fully sterilise its purchases of government bonds under the Securities Markets Programme (SMP).

A quick recap - the sterilisation is designed to remove the same amount of liquidity from the financial system as the ECB introduces from its purchases. This stops the ECB from engaging in Quantitative Easing (QE) and allows it to stay in within its mandate by avoiding financing member states directly. This is done by taking on one week fixed term deposits.

This is definitely a strange occurrence and may have some important follow on impacts, especially if it happens again in the near future. Here are a few of our key thoughts:

- ECB failed to absorb the necessary liquidity to sterilise its purchases of sovereign debt. Its target was €203.5bn but it only succeeded in taking on deposits of €194.2bn.

- The shortfall of €9.3bn is not huge but is large enough to be worrying, especially since it basically amounts to the level of bond purchased over the past week.

- This is not the first time the sterilisation has failed. It did so previously (and to a larger extent) but was able to get back on track. At that time the failure was likely due to banks preference to place liquidity/deposits elsewhere to gain higher returns.

- This failure is more surprising, since in times of uncertainty banks are keen to stash funds within the safety of the ECB.

- So why might it have failed? It could be that liquidity is so short and times so uncertain that banks prefer to keep the funds on hand than commit them to a fixed term deposit of one week. This makes sense given the eurogroup and ecofin meetings today and tomorrow as the situation could change with the outcome of those meetings.

- It is also concerning that given the amount of liquidity that banks are draining from the ECB lending operations, there is still not enough demand for the one week fixed term deposits.

- This all raises questions over whether the ECB is reaching some technical limit for sterilisation. It has long been rumoured that there is a limit to the amount of liquidity which the ECB can suck out of the system at reasonable rates. There could come a point where the banks simply do not have the liquidity at hand to fill such huge need for deposits, especially given that their funding is already spread so thinly during the crisis.

- Future sterilisations will be interesting, since previously the ECB has always rebounded quickly and managed to meet its target.

So, in itself this is not a huge event but it definitely raises some interesting questions. Not least on the debate surrounding the role of the ECB. If some technical limit is reached (from the failure of sterilisations) it will force the issue of whether the ECB can engage in unsterilised bond purchases, essentially QE. At that point, as we have pointed out before, it is likely that the ECB and Germany will have to make a fundamental decision over whether to either continue the bond purchases, abandoning their core monetary principles, or stick to their guns and wind down the purchase programme altogether.

Just another small indication that the endgame for the eurozone may be approaching, as if we didn't have enough already...

Greater intervention by the ECB raises more problems than it solves

Over on the FT A-list we've got a response to a piece by George Soros and Peter Bofinger, who are calling for the ECB to act as full lender of last resort to struggling eurozone member states. As regular readers of our blog and comment pieces will know, we're firmly against this course of action, as we believe it would throw up huge questions over the credibility and independence of the ECB (both vital if the eurozone has any hope of surviving). It would also likely make Germany question its membership in the eurozone. See below for our full response (we'd recommend reading the Soros and Bofinger piece here as well):

George Soros and Peter Bofinger present a measured approach for the intervention of the European Central Bank in eurozone bond markets, essentially envisioning it as a temporary liquidity provider of last resort. However, the ECB is already playing this role to a large extent. It has along with the eurozone bail-outs bought European politicians 18 months in which to devise the fiscal rules and growth strategy the authors call for. Unfortunately, leaders have repeatedly failed to reach any semblance of consensus on a lasting solution to the crisis.

Therefore, the exit strategy envisioned here for the ECB is dubious. Without a clear mechanism for winding down the ECB bond purchases, it becomes impossible to imagine a situation where the ECB could end its bond buying programme without causing huge market distortions.

The authors approvingly cite the example of the unlimited liquidity provision given to banks. However, this could equally be used as an illustration of the risks mentioned above. Although the ECB’s unlimited liquidity provision for the banking sector may have avoided a bank run, it simultaneously created a set of so-called ‘zombie banks’. Precisely because of the absence of an exit strategy, these banks have now become reliant on ECB liquidity to survive, while stripping them of the incentive to reform the bad practices and mismanagement which got them into this situation in the first place. The cost of this is now becoming clearer, with some banks on the precipice of failure, forcing a widespread recapitalisation of the banking sector – of which some cost will undoubtedly fall onto taxpayers. Against this backdrop, it becomes a huge risk for the ECB to stake its independence and credibility on the hope that such a solution will be achieved in the near term.

Targeting the spread between German bunds and other eurozone bonds would also significantly undermine the ECB’s independence. Ultimately, the spreads are reliant on the fiscal policy and domestic politics of each member state. Any failure or uncertainty in either area spooks markets. As such, the level of ECB bond buying could become almost directly influenced by the political and policy decisions in member states. The ECB is already treading perilously close to this line. One step further and it would cease being the independent central bank that is so essential to future monetary stability, and instead become a fiscal actor highly susceptible to political wrangling.

This also raises questions over the definition of the bond run. It’s true that the yields may not currently accurately represent the economic fundamentals of each nation, however they are a result of the markets trying to price in the domestic and European political risk as well as the structural flaws in the eurozone exposed by the current crisis. Using the ECB to try to ‘correct’ these issues not only damages the price determination mechanism in markets but takes the ECB far beyond its mandate.

Moreover, the German fears over hyperinflation cannot be seen as an anomaly – it is a political reality that goes to the heart of the German post-world war settlement. The day the ECB is turned into a politicised lender of last resort, may also be the day when the Germans start to seriously question whether they wish to be a part of the single currency.

The struggling eurozone countries need to press ahead with economic and institutional reform. But in the longer term it has now got to the point where the eurozone will have to reassess its structure and membership if it is to survive. Having the ECB act as a full lender of last resort will detract from these requirements and may throw up more problems in the longer term; making it ultimately self-defeating.

Why the ECB saving the euro is anything but simple

Our ongoing conference today in Frankfurt, on the current and future of the ECB in the eurozone, could hardly be more timely. We're posing two questions: should the ECB act as the eurozone's lender of last resort, and has the ECB acted within its mandate in this crisis?

In fact, all eyes are now on Frankfurt, as new ECB President Mario Draghi - an Italian and former banker - is faced with a quite awful dilemma: should he shore up his credentials with the German monetary establishment (which would involve hard money policies, staying well clear of any major ECB intervention on the bond markets), or appeasing markets by buying large amounts of Italian government bonds, described by some as a 'silver bullet' (which it isn't).

Draghi's decision the other week to cut the ECB's interest rate has already raised suspicion in some German quarters that the Italian can't be trusted. FDP MP Frank Schäffler - the most vocal critic of current ECB policies - simply stated:

"The hawk has become a dove on his first day in office."

At his first press conference, Draghi went out of his way to insist that its government debt-buying scheme - the Securities Markets Programme (SMP) was “temporary” and “limited”. But since then Italy has been sucked deeper into the crisis, and Draghi may not escape making a tough call on radically extending the SMP, which would lead to many in Germany asking for his head on a plate. Though the pressure on Italian bonds have eased slightly over the last two days - ten years bonds were at 6.7% this morning - and there's talk of the 'Monti effect', markets remain extremely nervous about the complete absence of a fire wall around Italy should the smelly stuff really hit the fun. With EU leaders unable to agree a top-up of the eurozone's temporary bailout fund, the EFSF (they cannot get more loan gurantees through their Parliaments), and with the IMF out of the picture, the ECB would basically stand alone.

To date, the ECB has bought €183bn of government debt through the SMP, including Spanish and Italian bonds. However, for the ECB to act as an effective lender of last resort for the eurozone, and to back stop Italy's €1.8tr bond market, it needs to go far beyond current levels of purchases. We're talking hundreds of billions - if not trillions - worth of government bonds (RBS, for example, estimates that €700bn could be needed to contain Italy).

So why doesn't the ECB step in and save the day? Its pockets are deep enough (it can massively expand its balance sheet as it controls the future supply of money) and doesn't have to go through slow-moving and unpredictable parliaments for approval (that pesky thing called democracy).

Well, there are at least three problems.

Economically: Whilst it clearly comes with some immediate benefits, ECB intervention would not deal with competitiveness gaps in the eurozone or actually solve the eurozone's debt structure in the long-term (as it would merely be passing debt from one balance sheet to another). All ECB intervention does is deal with short-term market jitters and liquidity issues. The ECB could also run into some problems if its financial position is compromised by taking on even more risky debt.

Politically: Large-scale ECB intervention would require nothing short of a major cultural and psychological shift in Germany. As we've noted repeatedly, an independent, strong central bank that stays well clear of any policy that might trigger inflation (read monetising debt) is one of the very founding principles of modern Germany. A central bank that serves as a tool for politicians to paper over cracks in the economy, by flooding the markets with cheap money, remains a hugely frightful prospect in Berlin, for well known historical reasons.

Much like in the internal CDU debate, the German discussion about the role of the ECB reflects a head-on clash between two vital German post World War II objectives: an unambiguous commitment to price stability, on the one hand, and an unambiguous commitment to 'Europe' on the other.

So for UK PM David Cameron to say that he does not 'understand' why some people in Germany are so opposed to the ECB playing a major role in propping up governments, is a bit like Angela Merkel saying that she does not understand why the sovereignty of the British Parliament is so important for the British (for example).

In essence, this would involve messing with some pretty fundamental principles here. Taking the ECB down such a slippery slope towards large-scale debt monetisation could mean that German support for the entire euro project would start to diminish.

Legally: According to the ECB's and the EU's rulebooks, can the ECB really engage in debt monetisation? Despite being limited in comparison to what would be needed for the ECB to shoulder the role of lender of last report, German President Christian Wulff has dubbed the ECB's actions "legally questionable".

German Professor Markus C. Kerber Kerber has already launched a complaint against the ECB with the EU's General Court in Luxembourg (the former Court of First Instance). In his booklet "Die EZB vor Gericht" (The ECB in the dock) he sets out his arguments. In addition to the SMP itself (established on 14 May 2010), Professor Kerber also challenges the ECB's decision to drop its quality requirements for the collateral that Greek, Irish and Portuguese banks can post with the ECB in return for loans (The decisions made on 6 May 2010, 31 March 2011 and 7 July 2011). He claims these that articles violate articles 123 till 125 of the EU Treaty, saying:

Here are the main legal arguments why Kerber thinks the ECB's actions are illegal:

- Art 123.1 bans the ECB and national central banks from buying bonds of member states, either directly or from secondary markets, when the purpose is not mere monetary policy but amounts to fiscal policy (propping up insolvent governments). Kerber cites several economic analyses (as for example this one by DB Research) to back up this claim that the SMP is driven by fiscal policy and therefore illegal.

-The suspension of requirements specifically Greek, Irish and Portuguese government bonds to be accepted as collateral for banks which want to obtain ECB funding is in breach of the ban on privileged access to ECB funding of art. 124. It also goes against the legal rationale behind art. 125 (the famous ban on bailouts).

- The fact that the ECB and its President Jean-Claude Trichet have consciously taken on all this exposure, endangers art. 127, which orders that the primary objective of the European System of Central Banks shall be to maintain price stability. As an example, he cites the purchase of €45 billion of Greek government bonds at the end of 2010, and the emergency liquidity assistance programme, which allows the Irish or Greek Central Banks to rescue their own banks. He claims that because this exposure to European citizens has been taken on consciously by the ECB and its President Jean-Claude Trichet art. 127 which prescribes price stability has been violated.

This is pretty chunky stuff but it does show why large-scale ECB intervention could come against some serious challenges.