Simon Nixon suggests that the ECB is ready to step up to the plate

The second task is to stabilize sovereign debt markets to ease solvency concerns, cut interest costs and shore up confidence. The ECB is considering a big increase in its Securities Markets Program including targeting explicit government bond yields. The hope is that, by setting a credible target in conjunction with a long-term bank liquidity facility, it can ensure governments retain access to bond markets; banks will borrow to buy bonds at attractive yields knowing any losses are capped.

Obviously I have long advocated this as the only way to stem the crisis.

At this point, however, I am not sure it will work. The ECB may have a larger problem if the marginal cost of cash is diverging across countries.

The irony is that assuming basic market theory and fully integrated and liquid markets, this program can’t work as advertised. Targeting rates on bonds should cause the bonds – at least at the very short end – to collapse towards the same yield.

If not, then that tells us something about the integration of the money markets which in turn tells us something about the ECB’s ability to stem the crisis with this type of action alone.

To be sure, a credible cap can keep the Eurozone from flying apart but if short yields maintain their spread that is evidence of different effective monetary policy in different countries and possibly cripplingly tight monetary policy in the periphery.

I say that with the full recognition that it is not even clear what it means to say that there is different monetary policy under the same currency. What I mean is that there are differing marginal costs of funding. Some questions

  1. Does this extend up into the commercial paper markets?
  2. How many firms have access to credit from outside their country?
  3. How many households have access to credit from outside their country?

Of these questions I would usually consider (1) the most important but the prevalence of small and medium sized business in the periphery may mean that (2) is the most important.

More when I get the chance.