Not just hot air

Psy Ops

Psychological operations, also known as psychological warfare, have been used effectively since ancient times. In a nutshell, a psy op is the attempt to influence your adversary’s, or your target audience’s, behaviour to your own advantage, usually sparing you the need of engaging in shooting warfare.

Mario Draghi’s announcement fifteen months ago that the ECB would do “whatever it takes” to preserve the euro could easily be considered a psy op—and, to judge by the way it calmed the markets, a highly successful one. It gave lenders investment safety, and borrowers the possibility of continued borrowing at lower rates, as if the crisis had never occurred. And all that, so far, without having had to spend one cent to back up the pledge.

After all, the euro crisis, despite its dismal figures, is allegedly at heart a crisis of confidence. If investors’ confidence were restored, goes the thinking, the crisis would be over at once: credit and investment would flow again, yields on government bonds would come down, growth would pick up, and unemployment would drop. Mr Draghi’s nifty psy op has gone a long way towards accomplishing all that, and hasn’t cost a cent. Still, the job is not yet quite done, and the crisis is not yet quite over.

Understandably, this has increased the pressure, in particular on the German government, to go whole hog and undertake the next logical step in this sort of psy ops, namely embrace the mutualisation of Eurozone debt and pledge “whatever-it-takes” sort of support for a full banking union, with common deposit insurance and a bank resolution mechanism. That would do wonders to fully restore confidence and wipe away the largest obstacle to declaring the crisis over for good. And it wouldn’t cost a cent.

Hold it right there. Was Mr Draghi’s psy op really that magical and cost nothing? Good that it were so. The markets were calmed because his announcement assured investors that, no matter what, they would get their money back. The liability would be ultimately assumed by the unsuspecting taxpayers. And, if the money-printing press is cranked up to meet the pledge, by everyone through higher inflation.

But that is exactly the kind of solid assurance investors would have obtained if they had purchased insurance against default, an instrument long and widely available known as credit default swaps (CDS). CDS risk premiums for IPSIC government debt (Italy, Portugal, Spain, Ireland and Cyprus) had started to fall before Mr Draghi’s announcement, thanks to the various rescue measures, but were still sizeable. Then the announcement came and gave investors this kind of insurance without them having to pay any insurance premiums at all, saving them billions. No wonder they were so thrilled.

But the problem of why investors were jittery to start with has not been addressed at all: namely, that the debtor countries’ lack of competitiveness dims their growth prospects considerably, and their weak growth will likely make them unable to repay their debts. Worse, the risk of misallocation of resources, i.e. the excessive credit flows that gave rise to the crisis in the first place, would still be there, since investors would have no qualms about sending their money to places they would shun in the absence of the insurance provided by the taxpayers.

So, the Draghi psy op may well have been highly effective. But free-of-cost it isn’t. History will tell whether that cost was lower than that of pushing through reforms to make the debtor countries more competitive.