Daily Archives: February 16, 2012

Wednesday’s release of the minutes from the January Federal Reserve meeting was one of the most anticipated ever. The wait proved worthwhile as the minutes did not only help explain historic Fed decisions (which was surely needed given the scale and scope of recent policy innovations). They also shed light on the future of its balance sheet operations and some of the challenges that its unusual policy activism faces in this fluid economic and political environment.

The central bank made history in a number of ways last month. It took transparency to a new level by publishing the policy rate forecasts of the individuals serving on the Federal Open Market Committee, and told us their expectations regarding the next rate hike. In addition, the FOMC members signalled that, collectively, they expected interest rates to remain “exceptionally low” (defined as under one per cent) all the way out to the end of 2014, if not beyond.

Each of these steps would have been deemed unthinkable not so long ago. Together they constituted a major historical evolution in how far this central bank is willing to go in its attempts to influence economic outcomes at a time when its rates are floored and its balance sheet has already expanded to an astounding 20 per cent of gross domestic product. Thus there is great interest in the official thinking underpinning all this.

Given the various views expressed in the minutes (ranging from “almost all” participants to “one” member, with lots of “several,” “some” and “a few” in between), this is clearly a group with diverse opinions. It tries hard to reach a consensus that, most likely, is heavily influenced by chairman Ben Bernanke himself.

It is difficult to avoid the impression that members are navigating, to use some Bernankisms, an “unusually uncertain” outlook with a less than robust assessment of the balance of “benefits, costs and risks”. They are also having to use imperfect policy tools.

Based on the information available to them, they did not wish to infer too much optimism from the recent improvement in US economic data. Indeed, and despite the inevitable uncertainties that accompany unusual policy activism, they seem inclined to do even more.

A few FOMC members already see a need for QE3 or “the initiation of additional securities purchases before long”. Others would go along with this if the economy were again to lose momentum or if inflation remains well behaved. The majority is keen to be even more transparent, with several seemingly interest in providing numerical inflation and unemployment thresholds that would govern the timing of future policy moves.

You should have no doubt. Wednesday’s minutes confirm that the Fed remains one of the most activist, imaginative and audacious central banks in the world. Motivated by the uncertain economic outlook and the reticence of other policymakers who are much better placed to remove impediments to growth and job creation, it feels compelled to do even more to boost the US economy. Yet its ability to deliver good outcomes is tempered by the fact that it is experimenting, deploying untested tools with inadequate support from other policymakers.

The bad news is that we will not know for a while whether the Fed’s unusual activism will work. However, when the time finally comes – and here is the good news – historians will have an unusual amount of information to understand the content in which innovations and important decisions were made.

The writer is the chief executive and co-chief investment officer of Pimco

When discussing Greece, some policy officials and market participants have suggested that ‘the markets are now better prepared to deal with a default’. When was the other time such statements were being made? Probably in mid-September 2008, a few days before the collapse of Lehman Brothers.

If there is one thing to learn from the past five years, it’s that financial contagion operates in unexpected ways, especially after a major shock such as the failure of a major financial institution or the default of a country.

Even if markets have prepared for the possibility of a default by Greece, the practical consequences of such an event can be of a much higher order of magnitude.

First, Greece would most probably have to exit the euro, as it would have no other way of financing its current expenditures other than to print its own money. Capital controls, bank holidays and nationalisations would be required to try to counter a run on the banking system. Litigations between creditors and debtors would rise exponentially. The social and political stability of the country would be in grave danger.

Second, the political crisis would spread to European institutions because of their inability to solve the problem. The losses experienced by taxpayers in other countries would fuel opposition against financial assistance to cash-strapped countries. The prospects for further strengthening the European Financial Stability Facility and the European Stability Mechanism would be weakened, and the safeguards against contagion seriously undermined.

Third, creditors would be further discouraged from investing in the eurozone, given its inability to manage its debt problems. Contagion could extend to the core of the euro system.

Fourth, the financial tensions around the euro would produce a serious blow for the economic recovery not only of Europe but also the US and Japan, and possibly in emerging markets. Public finances would further deteriorate in several countries, increasing the risk of a sovereign default. The world economy could plunge back into recession, as after the Lehman Brother’s bankruptcy.

So what should be done to prevent such a scenario from occurring?

Greece does not suffer from a typical balance of payment problem that can be dealt with short to medium-term adjustment and financing. It has a major structural problem that can be resolved only through a combination of macroeconomic, structural and social measures. It also needs prolonged technical assistance to be consistently implemented over the next decade. Even if it follows the agreed programme in full, Athens is unlikely to be able to access the markets for several years.

What is required is much more similar to the kind of programme that the International Monetary Fund applies to low-income countries, under the Poverty Reduction and Growth Facility (recently renamed Extended Credit Facility), with official financing provided for several years, at concessional terms to ensure debt sustainability. Strong conditionality has to be implemented, in line with the IMF practice for this type of programme, but not under the threat of continuous default that alienates the political support in Greece for the right policies and fuels instability in financial markets.

This avenue raises three fundamental issues. First, it is costly. But the alternative is even more costly, for everyone. Second, other debtor countries may be tempted to seek the same concessional conditions as those granted to Greece. But European authorities have stated that Greece is unique. They should stick to that commitment. In addition, other countries are unlikely to want to get into the dire situation Greece is in, just for the purpose of obtaining more concessional conditions. Third, at this stage of the negotiation, it might be too late to introduce such a game changer. But it’s never too late to try to avoid a disaster.

The writer visiting scholar at Harvard’s Weatherhead Center for International Studies and former member of the ECB’s executive board

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