Now comes the latest deal over eurozone fiscal rules, presumably the deal that ECB President Draghi asked for last week. It is a deal about sovereign budget discipline. But if I read Draghi's speech right, we should not expect him to be buying sovereign debt. (That will be the IMF's job, if anyone's, and with strict conditionality; details to be sorted later.)
Instead, he'll be buying bank debt, specifically the debt of the banks that hold the sovereign debt. Banks currently borrowing from their own national central banks will therefore be able to repay, and consequently the national central banks will be able to repay the ECB. This takes national central banks out of the picture on the asset side.
So, in terms of the two-drunks model, the fact that the European Central Bank will buy bank debt rather than sovereign debt means that the ECB will support only one of the drunks. Of course, this drunk (the banks) will in turn be trying to prop up the other drunk (the deficit-spending governments). Thanks to our wise technocrats, the two drunks will continue to lean on one another and stagger along.
The challenge for the imminent Eurozone summit is to come up (once again!) with an agreement that sounds definitive to the markets and yet is not truly binding on current political leaders. The markets want maximum certainty. The politicians want maximum vagueness. As for the outcome of the summit, my money is on the politicians. (Actually, if I were really putting my money on that outcome, I would be shorting the stock market. Instead, I am just trying to maintain a portfolio with a low beta.)
"One of the central pillars of the Basel III framework is the notion of a risk-free asset class," said Matthew Czepliewicz, a banking analyst at Collins Stewart Hawkpoint Plc in London. "That central pillar is disintegrating. Basel is quite clearly going to have to be revised."
Remember my view of financial intermediaries. The nonfinancial sector wants to issue long-term risky liabilities and hold short-term riskless assets. The financial sector accomodates that by doing the reverse. The problem now is that the financial sector has gotten too big. The amount of supposedly risk-free liabilities that have been issued far exceeds what is actually possible, given the real investment opportunities that are available. If the regulators do not want to shrink the financial sector, then they have to try to prop it up, in part by labeling securities as low risk when they are not.
Which is how the financial sector got to be to big in the first place. The regulators labeled mortgage securities as low risk when they were not. Then they labeled sovereign debt low risk when it was not.
Since 2008, it has seemed to me that it is imperative for the financial sector to shrink. Instead, the world's bank regulators have managed to maintain the size of the financial sector. In the technocrats' view, they have saved us from an awful cataclysm. I worry that they are mistaken.