Martin Wolf’s column on Wednesday and his subsequent blogpost have once again focused attention on the importance of trade flows in the eurozone. Martin’s argument is that the German strategy of fiscal austerity and internal reform to fix the imbalances needs to change. I would like to ask a different question, which is what happens in the likely event that it does not change?
Investors, ever more optimistic that the worst of the euro crisis is over, are asking whether the German strategy might actually work. Largely unnoticed by some, eurozone trade imbalances have in fact improved dramatically in recent years. But this has happened mainly for the wrong reasons, ie recession in the south rather than any large narrowing in the competitiveness gap. The eurozone is engaged in a race between the gradual pace of internal devaluation and the mercurial nature of democratic politics. It is still not obvious how this race will end.
When the euro was launched in 1999, its supporters believed that the balance of payments crises which had plagued its weaker members for decades would become a relic of the past. The crisis revealed this view to be entirely complacent. The current account imbalances which were generated by the peripheral economies during the boom of the 2000s soon became impossible to finance after the crash. It was only the growth of so-called “Target2″ imbalances on the ECB’s balance sheet which provided the official financing which held the system together. No Target2, no euro.
However, some of the contingent credits which the Bundesbank has acquired against the rest of the ECB in the course of this process might become worthless under certain break-up scenarios, and this has become a political hot potato inside Germany. The solution, many in Germany believe, is to foster an improvement in the balance of payments positions of the troubled economies so that no further rise in the Target2 imbalances will be needed. Read more
Market expectations about Thursday’s ECB meeting had become quite bullish in the past couple of weeks (see this blog), and Mr Draghi went just far enough to justify those expectations by cutting the main repo rate by 0.25 per cent and the marginal lending rate by 0.5 per cent. This is a clever way of directing more help to those banks which need it most in the south.
Adding to his dovish tone, he talked about cutting deposit rates at the ECB into negative territory, as Denmark has already done (with moderate success), and he hinted that the ECB still has one further repo rate cut in the locker. At the less dovish end of the spectrum, he said that the ECB will not buy government bonds, which does not sound promising for Fed-style QE, should the eurozone economy continue to weaken. Read more
The recent rise in eurozone equities, along with a sharp further decline in peripheral bond spreads, has occurred in the face of continuing disappointing data on economic activity. Real GDP in the eurozone seems to be declining at a 2 per cent annualised rate in the current quarter, and the pivotal German economy is showing worrying signs of being dragged into the mire with the troubled south (see this earlier blog).
Markets are in one of those periods (which usually prove temporary) where they interpret bad economic news as being good news for asset prices, because weaker growth will result in easier policy from the central banks. In the eurozone, expectations are high that the European Central Bank will deliver lower interest rates on Thursday, and specific measures designed to address the provision of liquidity to small and medium sized enterprises (SMEs) in the south seem probable.
But a more radical easing in monetary conditions may prove necessary to drag the economy out of recession, and prevent inflation from falling further below the target, which is defined as “below but close to 2 per cent”. In March, the ECB staff forecast for inflation in 2014 was 0.6-2.0 per cent, which seems barely consistent with the mandate, especially as the recession shows no sign of ending and fiscal policy is still being tightened. Any other major central bank would be urgently reviewing its options for aggressive easing, and the markets could become very disillusioned if they sense that the ECB is unwilling to do the same.
So what, realistically, can the ECB do? The following table gives a fairly comprehensive list of the options which are definitely available within the mandate [A], those which might be available if the ECB chose to interpret its mandate more widely [B], and those which are clearly unavailable under any circumstances [C]:
The IMF on Tuesday repeated its call for the ECB to reduce policy rates in the eurozone, and Mario Draghi came fairly close to promising action in May at his press conference after the governing council meeting on April 4. But no-one really believes that the expected 0.25 percentage point cut in the main refinancing rate will do very much to solve the eurozone’s most pressing problem, which is the lack of bank lending to small and medium sized enterprises (SMEs) in the troubled economies.
Monetary conditions in the eurozone are fragmented. Bank lending rates are, perversely, much higher in the weakest economies than they are in the core. Unless this is solved, the eurozone economy will remain in trouble.
In order to address this issue, the ECB needs to think in ways which are unconventional, and therefore unpalatable for many of the conservatives on the governing council. However, both Mario Draghi and his colleague Benoît Cœuré have recently hinted that they view measures to eliminate fragmented lending rates as essential to fulfil the mandate of the ECB. This is how they justified the introduction of the Outright Monetary Transactions (OMT) programme, which saved the euro last autumn.
They have also said that the power of the ECB in this area is limited, and have argued repeatedly that effective action will require co-operation from member governments and from the European Investment Bank (EIB). It is therefore probable that discussions are under way between the ECB and member states to decide what can be done. There are two options which could have significant beneficial effects. Read more
The eurozone is reluctant to admit formally that it is changing its austerity strategy, but in fact it is searching in every corner of national budgets to alleviate the squeeze on its troubled economies, and rightly so.
Recently, member states which have missed their budget targets (and that has been most of them) have been given more time to reach their objectives, implying less fiscal tightening in the near term. It is not all plain sailing, as Portugal’s latest tribulations demonstrate, but the eurozone has recognised that it should not be piling even more short term fiscal contraction on declining economies. It is reported today that the troika will suggest that the average duration of official loans to Ireland and Portugal should be extended by seven years at a meeting of EU finance ministers on April 12-13. Read more
The calmness of the financial markets in the face of the deteriorating Cyprus crisis in the past week has been remarkable. Although Cyprus is tiny enough to be completely overlooked in most circumstances, its economy and banking system have characteristics similar to other, much larger, eurozone countries. Cyprus is certainly at the extreme end, but an over-leveraged banking system, with insufficient capital and reliance on foreign funding, is familiar territory in the eurozone.
Cyprus is therefore, in some respects, a microcosm of the entire eurozone crisis, if a microcosm on steroids. The manner in which the crisis has been handled by the Eurogroup and the ECB will have demonstration effects on other economies, for good or ill.
At the time of writing, the outcome of this weekend’s negotiations remains uncertain. However, assuming that there is no catastrophic breakdown in the talks, leading to the exit of Cyprus from the euro area, the broad outline of the settlement seems to be taking shape. It is reported that the Cypriot government will accept a “bail in” of depositors in one or both of its troubled banks, allowing the release of eurozone financial support, while still keeping the government debt/GDP ratio under 150 per cent. Read more
When David Marsh wrote his definitive biography of the Bundesbank in 1993, he chose the following sub title: “The Bank That Rules Europe“. Feared and revered in equal measure, the Bundesbank was the model on which the ECB was built. Imitation was not, however, the sincerest form of flattery for Germany’s central bank. The arrival of the ECB removed most of its direct authority over monetary policy, leaving it with only one out of 23 votes on the governing council of the new central bank.
Recently, the Bundesbank’s President Jens Weidmann has been in a minority of one on the question of whether to launch the ECB’s new programme of Outright Monetary Transactions, to which he is fundamentally opposed. He views the proposed purchases of government debt in the troubled eurozone economies as a thinly disguised monetary bail-out of profligate governments, something which the Bundesbank had believed from the very beginning to be outside the intention of the treaties. Read more
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
In the second half of 2011, the US economy appeared to buck the impact of the eurozone crisis, with American economic data surprising on the strong side in the final quarter of the year. But, as the new year begins, it seems improbable that economic activity in the US and the eurozone can remain so divergent for much longer.
Will the weakness in the eurozone eventually bring the US economy to its knees? Or will the greater resilience of the US win the day? The answer to these questions will determine whether the global economy will experience a double-dip recession in 2012.
The data released over the holiday period seem to be pointing in a more optimistic direction than markets have recognised. A year of above-trend growth certainly looks like a stretch in the present environment of fiscal tightening and global deleveraging. But the risks of a global double-dip recession appear to be receding, at least for now. Read more
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. Read more
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:
- How different will this prove to be in practice from the old status quo?
- Is it a good idea from an economic point of view?
- Does it allow the European Central Bank in future to play the same role in the eurozone as the Federal Reserve and the Bank of England have been playing in the US and the UK?
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. Read more