Gavyn’s blog is taking a break over the festive season and will return in early 2012. Happy holidays everyone.
The explosion in central bank balance sheets continues. As explained in this earlier blog, the ECB, the Fed and others have become the holders of last resort for much of the private sector risk which no-one else is willing to touch. Today’s announcement of a record liquidity injection by the ECB, along with a further rise in the Fed’s balance sheet as part of the dollar swap programme, looks particularly dramatic, but it really just represents a continuation of a process which has been underway for many months now.
Whatever they may claim to the contrary, the ECB is finding that it has no choice but to use the central bank balance sheet to stabilise the euro crisis. I am not complaining about that. The alternative would have been far, far worse. But we should call a spade a spade. This is quantitative easing on a significant scale, and the lines between this form of QE, and the direct monetisation of budget deficits, which is forbidden by the spirit of the eurozone treaties, are becoming increasingly blurred.
The euro fell by 3 per cent against the dollar last week, and it is now 12 per cent below the level it reached in the spring. Many economists have seen the decline in the euro as a symptom of the wider sovereign debt crisis, but actually it could prove to be part of the solution, not part of the problem. The euro is still not “weak” on the foreign exchange markets in any long term sense, and a further significant decline in its real value is not something to be feared. In fact, it would be an entirely normal response to the recession, and to the consequent monetary easing, which is now underway in the eurozone.
The financial markets are becoming ever more dependent on the continuing willingness of the central banks to use their balance sheets to rescue the global economy. The central banks are not flinching from their task. In fact, they are in the process of firing their second barrel of quantitative easing at the global crisis. It could prove to be as large as the first barrel in 2008/09.
Amid all the focus on the UK’s decision to use its veto, it is important not to miss the main economic outcome of the summit, which is that the agreement heralds a new era in European policymaking. The German approach to fiscal policy will now be writ large across the eurozone. This raises three key questions:
My initial take on the deal is that it will be sufficient to dampen the acute phase of the crisis, but that the absence of a clear long-term strategy for growth means that there could still be a long period of chronic problems ahead.
ECB headquarters in Frankfurt. Bloomberg
(Updated with comments, below) For those of us trying to follow the progression of the eurozone’s leaders towards their critical summit on Friday, it has been a fascinating but somewhat bewildering week. However, the critical point is that, so far, the game still seems to be taking place on a playing field mainly of the Germans’ choosing, so the inevitable concessions and bargains which are reached at the summit will still leave the final outcome lying well within their preferred territory. (See an earlier blog.)
What is basically under discussion is a tightening in the fiscal rules which will apply to, and indeed within, the member states, in exchange for a provision of a limited amount of liquidity to allow these countries to reach the point at which they can regain market access for their sovereign debt. With eurobonds now effectively ruled out, any permanent transfers of resources within the enhanced fiscal union are strictly limited in size and scope. However, if the settlement is to prove durable, Germany will need to give some ground in the coming hours. Angela Merkel, the German chancellor who is nothing if not an arch pragmatist, undoubtedly realises that. So where will the bargains be struck?
The leaders of the eurozone have finally reached crunch time. This is the week in which Angela Merkel’s “grand bargain” is due to reach fulfilment at the European summit. On one side of the bargain, the eurozone will be required to accept Germany’s demand for “fiscal union”. On the other side, Germany will agree to the provision of funds to help indebted countries to remain liquid while they reduce government deficits and debt ratios, and thereby regain market access. These provisions of liquidity will come from the EFSF, which will transform into the ESM in 2013, and potentially from the ECB.
Given that fiscal union will play such a central role in this bargain, it is surprising that its exact contents have received such little examination, at least in the financial markets. What might it include, and to what extent is it desirable?
Ben Bernanke. Image by Getty.
The announcement of co-ordinated central bank action to boost foreign exchange swap lines on Wednesday has boosted market sentiment. The central banks have become extremely alarmed about the deterioration in the funding market for eurozone banks, and the consequent deleveraging of bank balance sheets which this is causing, and have decided to inject a great deal more liquidity into the system to bring this back under control. The injection of additional dollar liquidity which the Fed will undertake through its currency swaps with the ECB could potentially involve a very large increase in the Fed’s balance sheet, so it is worth understanding exactly what this initiative involves.
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Gavyn Davies is a macroeconomist who is now chairman of Fulcrum Asset Management and co-founder of Prisma Capital Partners. He was the head of the global economics department at Goldman Sachs from 1987-2001, and was chairman of the BBC from 2001-2004.
He has also served as an economic policy adviser in No 10 Downing Street, an external adviser to the British Treasury, and as a visiting professor at the London School of Economics.
Gavyn Davies is an active investor and may have financial interests and holdings in any of the topics about which he writes. The views expressed are solely those of Mr Davies and in no way reflect the views of Prisma Capital Partners LP, Fulcrum Asset Management LLP, their respective affiliates or representatives. This material is not intended to provide, and should not be relied upon for, investment advice or recommendations. Readers are urged to seek professional advice before making any investments.
