This year, the critical question in Europe has changed from whether policymakers could find the required policy instincts – they have – to whether they are moving fast enough to get ahead of the deleveraging by the private sector.
By announcing a new conditional bond purchase program on Thursday, the European Central Bank took a major step to close what, at one time, seemed a near-insurmountable deficit in this race. It now needs the support of other policymaking bodies to fully eliminate the gap.
European policymakers and politicians were very slow in 2009-10. Insufficient understanding of regional debt dynamics, together with widespread denial that Europe could be on the receiving end of a typical “emerging market crisis,” made it even harder to coordinate policy in a monetary union with very different initial conditions among its 17 member countries. The longer this persisted, the more policies fell behind the exiting of private capital.
As the regional crisis deepened in 2011, governments and the ECB adopted a policy approach more commensurate with the complexity of the crisis. Namely, seeking to break the link between sovereign credit deterioration and banking sector weakness, trying to change the policy mix for struggling countries and, at the regional level, addressing design flaws in the original monetary union through banking and fiscal unions and closer political integration.
But words came easier than actions. As implementation lagged, private capital outflows broadened and accelerated. Outflows took two distinct forms. Firstly, out of an expanding universe of peripheral eurozone countries and to a very small inner eurozone core. Secondly, out of the eurozone as a whole to the rest of the world, in particular Switzerland and the US.
These outflows did more than increase market volatility, raise financing costs for struggling economies and ration funds to their governments and (especially) companies. They also put in place the seeds for a fragmentation of the single financial market, threatening structural damage to the very idea of investment in Europe.
The danger to the single financial market and the related increase in “convertibility risk” were cited in the historic remarks made by Mario Draghi, in London on July 28th. They set the stage for a much bolder policy response that, after a summer of intense work and consultation aimed at reconciling debtors’ demand for financing and creditors’ emphasis on policy conditionality, culminated in what the ECB announced on Thursday.
According to MrDraghi, the ECB will start buying short-dated (up to three-year maturity) bonds issued by government subjecting themselves to appropriate policy conditionality. It will do so with no pre-specified limit, thereby seeking to sustainably lower borrowing costs while removing concerns about these countries’ refunding prospects. According to preliminary information, the policy component of this more transparent new programme will strike a better balance between conditionality and financing – one that, critically, may be more agreeable to both creditor and debtor countries.
Returning to the race analogy, Thursday’s ECB actions can significantly close the gap between private capital outflows and what, until now, have been lagging official policy reactions. They would reduce the tail risk of immediate fragmentation. But it remains to be seen whether this latest policy sprint can totally eliminated the gap, thus putting in place conditions for a reversal in capital outflows.
Our analysis of the underlying drives of financial flows suggests that policy still needs a further nudge to get ahead of the de-leveraging. Specifically, exploiting the window offered to them by bold ECB actions, national and regional policy entities need to implement – rapidly, comprehensively and simultaneously – the list of corrective measures that have been widely discussed in official circles but languish on the drawing board.
If they fail to do so, the ECB will find that it has mis-timed its impressive sprint. Within a few months, policies will again fall further behind the de-leveraging process, and the credibility of Europe’s policymaking process will be dented further. This is a possibility that should be avoided – not just for Europe’s sake but also for that of the global economy.