It is often claimed by economists that the central banks have run out ammunition to boost economic activity, but they certainly have not lost the ability to have an impact asset prices. Since the latest round of quantitative easing was signalled back in June (see this blog), global equity prices have risen by 14.5 per cent, and commodity prices are up by 15.4 per cent, despite the fact that economic activity data have shown no improvement whatever over this period.
Clearly, these impressive moves in asset prices have been triggered by a sharp decline in the disaster premia that were priced into markets only three months ago. Mario Draghi and Ben Bernanke have, in a sense, purchased global put options on risk assets, and have offered them without charge to the investing community.
By doing the market’s hedging for it, the central bankers have certainly had an impact. Confidence, while not fully restored, is much improved, which is exactly what was intended. But there is no sign yet from hard data that the downward slide in global GDP growth has been reversed. Until that happens, the market rally will remain on insecure foundations. Read more
Today’s decision from the German Constitutional Court in Karlsruhe is a major victory for Angela Merkel and for Germany’s preferred approach to handling the eurozone crisis. The court has approved the ratification of the ESM treaty, with only minor conditions attached.
It looks like a comprehensive defeat for those trying to mobilise political opinion inside Germany to block the treaty. As a result, the ESM and the fiscal compact can now be safely launched, and any immediate obstacle to Mario Draghi’s bond buying plan at the ECB has disappeared. What has emerged from this messy process is, in effect, an ESM leveraged by the ECB, something which seemed impossible this spring.
This represents a very large building block in the rescue strategy which the eurozone has gradually pieced together in the last three months.
The acute phase of the crisis peaked in mid June with the Greek election, which reduced the probability of a disorderly Greek exit.
Then, the eurozone summit in late June announced a roadmap for the long term reform of the eurozone. Mr Draghi was a co-author of the plan, and in retrospect it was a very important step, not least because he deemed it to be so.
These steps did not immediately settle the markets, and at times during July it seemed that the capital outflow from Spain would reach unmanageable proportions. However, at that point, Mr Draghi crucially said that the ECB considered it to be within its mandate to eliminate “convertibility risks” in the eurozone, and that statement basically turned the crisis around. Since then, for example, Spanish equities have risen by 30 per cent. Read more
Gavyn has made some changes to the presentation of the table due to readers’ comments summarised in the footnote. The argument is not changed.
Another week, another summit. Once again, we are being told, this time by Italian prime minister Mario Monti, that there is only one week left to save the euro. Yet the crisis still does not seem sufficiently acute to persuade eurozone leaders that a full resolution is necessary.
The next summit on June 28 and 29 will unveil a long term road map towards fiscal and banking union, which in better economic circumstances could appear highly impressive. But the market is currently focused on the shorter term. Unless there is some form of debt mutualisation at the summit, resulting in a decline in government bond yields in Spain and Italy, the crisis could rapidly worsen.
Debt mutualisation can come in many forms. The European Redemption Fund, proposed by the Council of Economic Experts in Germany (and discussed here) seems to have receded into the background this week but could still have an eventual role. More immediately, the main option on the table seems to be the use of the eurozone firewall (ie a combination of the EFSF and ESM) to buy secondary government debt, or inject capital directly to the banks. But the problem here is simple: a lack of money. Read more
As the eurozone crisis enters a critical phase, market attention is once more focused on the central banks to contain the crisis. They have promised in advance to provide unlimited liquidity to solvent financial institutions if necessary in coming weeks, which is now their standard response to financial shocks. However, the slowdown in global activity caused by the euro crisis may mean that they are thinking of acting more aggressively than that. A further large bout of unconventional easing is now on the agenda. Read more
Today’s governing council meeting at the ECB marked a return to “business as usual” after the dramatic injections of liquidity into the banking system in December and February. The ECB understandably wants to return to its regular duties, where it focuses on keeping inflation below its 2 per cent long term target, and is desperate to shift the burden for other aspects of managing the eurozone economy back to member governments.
Mario Draghi’s main message in recent weeks has been that “the ball is in the court of governments” in three different ways: the need for fiscal consolidation, bank recapitalisation and a “growth strategy” involving labour and product market reform. Assuming satisfactory progress on these three objectives, the ECB would retire to the relative obscurity of inflation control, a place where it is always happy to find itself. “Non standard” monetary measures, which involve the use of the ECB balance sheet to finance troubled banks and sovereigns, would no longer be needed.
Unfortunately, it is improbable that the ECB will be granted its wish to remain on the sidelines for very long. The key question is how, when and where it will be called back into action. Read more
Spanish workers demonstrate in Madrid during a national strike, 29 March 2012. Image by Getty
It was always likely that Spain would prove to be the key battleground in the eurozone crisis this year, and so it is proving. If the eurozone’s austerity strategy, based mainly on the imposition of fiscal contraction in the peripheral economies, works in Spain, then it will probably work elsewhere. But if it fails in Spain, the long term outlook for the eurozone would seem ominous.
The EFSF/ESM “firewall” announced last week was at the low end of market expectations, providing new funding for future crises of only €420bn by July 2013, and €500bn a year later. A medium sized Spanish crisis, involving both the sovereign and the banking sector, would comfortably absorb most of that, leaving nothing over for the many other potential calls on the eurozone’s bail-out funds. That is why the market was so focused on the Spanish budget announcements on Friday. Read more
The initials LTRO, barely ever discussed prior to last December, now form the most revered acronym in the financial markets. Before the first of the ECB’s two Longer Term Refinancing Operations in December, global equity markets lived in fear of widespread bankruptcies in the eurozone financial sector. Since LTRO I was completed on December 21, equities have not only become far less volatile, but have also risen by 11 per cent.
With LTRO II completed last week, over €1tn of liquidity has been injected into the eurozone’s financial system. Private banks were permitted to bid for any amount of liquidity they wanted, the collateral required was defined in the most liberal possible way, and the loans will not fall due for three years. Any bank that might need funds before 2015 should have participated to the hilt, thus eliminating bankruptcy risk fora long time time to come. Read more
A large and important change is underway in global economic policy. This change will determine whether the developed economies can grow their way out of recession. Although the new strategy has been tried before by individual economies, this is the first time it has been adopted on such a global scale. If it fails, it is far from clear that policy-makers have a ready-made alternative plan waiting in the wings. Read more
Talks in the eurozone about the intended €130bn bail-out package by the EU and IMF have become more convoluted than ever this week. The latest deadline for a final decision by the eurozone is now said to be Monday, and there is no certainty that the deal will be ratified even then.
However, assuming that the Germans, Dutch and Finns are willing to sanction the deal, which on balance seems likely, the package will produce a further large increase in the exposure of eurozone taxpayers to Greece, without reducing the overall burden of Greek indebtedness very much at all.
The deal would therefore involve a further big step towards the “socialisation” of Greek debt to other eurozone sovereigns, while reducing the exposure of the private sector to any further Greek default. From now on, the burden of Greek debt will either by borne by Greek taxpayers, or by eurozone/IMF taxpayers, depending on whether additional defaults occur in future. It will be a simple head-to-head between sovereign governments, which is why the debate is becoming so heated. Read more
In 1951, an epic struggle between a US president who stood on the verge of a nuclear war, and a central bank that was seeking to establish its right to set an independent monetary policy, resulted in an improbable victory for the central bank. President Harry Truman, at war in Korea, failed in a brutal attempt to force the Federal Reserve to maintain a 2.5 per cent limit on treasury yields, thus implicitly financing the war effort through monetisation. This victory over fiscal dominance is often seen as the moment when the modern, independent Fed came into existence.
The idea that the central bank should place a cap on the level of bond yields is firmly back on the agenda, at least in the eurozone. This week, Italian prime minister Mario Monti said that he was increasingly optimistic that his country’s bond yields might soon be capped. Although he stopped short of saying that this would be done by the European Central Bank, there really are no other viable candidates to achieve this. Furthermore, many economists are arguing that this is the right policy, since Italy is now following a sustainable budgetary policy which deserves to be rewarded by ECB action in the bond market. Read more