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Emergency manoeuvres -
August 16th, 2011
COMETH the hour, cometh the central bankers. On August 8th the European Central Bank (ECB) began buying Italian and Spanish bonds in an effort to stop the sovereign-debt crisis from crippling two of the continent’s largest economies. And a day later America’s Federal Reserve made an unprecedented commitment to keeping interest rates at more or less zero for two more years to keep a stalling economy out of recession.
In both cases the dramatic steps were taken in the face of political failures to get to the heart of the problems at hand. The fact that they took both banks well outside their normal zones of operation was underscored by the internal dissent both moves faced, dissent rarely seen in the consensus-driven world of central banking.
The initial market reaction was positive, at least on one side of the Atlantic. Yields on Italian and Spanish bonds fell sharply relative to Germany’s. In America Treasury yields fell and stocks rose—but not for long, as equity markets fell again on August 10th. No one should see this as a fundamental turnaround. The ECB’s earlier bond-buying hasn’t saved smaller countries from punitively high government-bond yields; the Fed’s previous interventions haven’t spurred a robust recovery. The big issues of America’s stagnant economy and Europe’s debt crisis remain in the hands of elected politicians who still seem inadequate to the task. But at least central banks have shown themselves ready and able to act.
Although the dramatic sell-off in equity markets over the past week had many causes, the most important was the darkening outlook for the American economy. The jobs report for June, released on July 8th, was shockingly weak. On July 29th it was capped by a stunning report on first-half GDP that portrayed the recovery since the recession ended in mid-2009 as far weaker than had been widely realised. Finally, on August 5th Standard & Poor’s, a ratings agency, lowered America’s credit rating from AAA to AA+.
The economic significance of the move was small, in that almost no investors had to sell Treasuries because of the downgrade. The downgrade was not taken as adding any new information to the question of America’s creditworthiness. Treasury-bond yields fell on the news. Tim Geithner, the treasury secretary, accused S&P of “a stunning lack of knowledge about basic US fiscal-budget math,” because it at first overestimated America’s future debt by $2 trillion, inflating its value in 2021 by 8% of GDP. (Unfortunately for Mr Geithner, even correct figures paint an unflattering profile of America relative to other AAA countries; see chart right.)
Regardless of all this, the downgrade spooked the markets and unleashed yet more name-calling among politicians, increasing the pressure for austerity that will make significant new stimulus still less likely. Republicans greeted the decision as vindication for their insistence on steep spending cuts, while saying little of S&P’s view that their threat of default had had a real effect on the country’s creditworthiness. By raising questions about that creditworthiness, the downgrade also threw doubt on the Treasury’s ability to stand behind the financial system. As a result bank stocks were particularly hard hit in the wake of the announcement, which will make bankers even more guarded about how much they lend.
Rummaging through the toolkit
Bad though the situation is, America isn’t yet back in recession. On August 5th the government reported that non-farm employment rose 117,000 in July, or 0.1%, which was better than some had feared; the unemployment rate edged down from 9.2% to 9.1%. Car sales also rose in July, and initial claims for unemployment insurance have been on a downwards trend. What’s more, commodity prices are falling. But at best the economy may be growing at around 2.5%, which is about its long-term potential growth rate. That is too low to make a significant dent in unemployment. And that, the Fed signalled with its actions, is unacceptable.
Citing “downside risks” to a much-reduced economic outlook, the Fed said its short-term interest-rate target, near zero since the end of 2008, will probably stay there until at least mid-2013. This, at first blush, doesn’t seem like much; markets hadn’t expected a move before early 2013 anyway. And the Fed can abandon the commitment if growth or inflation perk up. But by largely eliminating uncertainty about when it will next move, it encourages investors to take on debt and buy riskier assets such as equities, noted Peter Hooper of Deutsche Bank. That should stimulate overall growth and investment.
The Bank of Canada pioneered the use of “conditional commitments” when it said in 2009 that it expected to keep its rate target at 0.25% until July 2010 (it actually tightened sooner, because economic conditions had changed). But such commitments remain rare. Central banks dislike binding their hands, and they dislike giving markets any reason to lever up even more. Indeed, three of the ten officials at the Fed who get a vote dissented, the largest number to do so in almost 20 years.
The Fed also said it was prepared to try other tools. These could entail chopping the interest it pays banks for the reserves they keep on deposit at the Fed, which is now 0.25%; altering the mix of bonds it owns to favour longer-term securities; or targeting bond yields, not just short-term interest rates.
These interventions, though, seem relatively minor compared with the possibility of a third bout of “quantitative easing” (QE): buying bonds with newly created money. Powerful as it might be, though, QE is a tool the Fed is loth to reach for again. The last round, completed in June, provoked a political firestorm. Republicans accused the Fed of monetising fiscal profligacy; officials abroad said it was debauching the dollar at the expense of America’s trading partners. The Fed has little appetite to endure that again. It has bought plenty already (see chart right), and a major goal of the last round, preventing deflation, has been accomplished.
Developing economies fear that more QE in America will inflate prices and speculative bubbles in their own countries. Today policymakers in emerging Asia and Latin America are trying to rein their economies in, not spur them on. The Chinese are grappling with an inflation rate that rose to 6.5% in the year to July, the highest for three years. In Brazil it rose to 6.9%, the highest in six. Last month India’s central bank raised interest rates for the eleventh time since March 2010.
But a weaker dollar need not push up prices elsewhere, as long as policymakers outside America do not try to follow the dollar down. By allowing their currencies to move more freely against the greenback, emerging economies can insulate themselves from the Fed’s decisions. The only danger is that these currency appreciations begin to feed on themselves, tempting “carry-traders” to make money by stoking the process for as long as they can. Modest controls on capital inflows are one way to keep such speculators in check.
Over the past year most countries in emerging Asia (with the exception of Vietnam) have allowed their currencies to strengthen somewhat against the yuan, even as China has allowed the yuan to rise against the greenback. The rise in Latin America’s exchange rates has been more dramatic—indeed excessive. Brazil’s currency, the real, appreciated by 6% against the dollar in the first seven months of 2011 before falling a bit this month.
In principle, these stronger currencies can help the emerging economies fight inflation and also contribute to the rest of the world’s recovery. Dearer currencies act as a brake on exports. That makes them unpopular, but also helps to contain wage pressures, dampening inflation. Dearer currencies also encourage people to switch their spending from domestic goods to foreign goods. That could help revive demand in the rest of the world, without contributing to domestic overheating.
This rebalancing will help the global economy to some degree. But few forecasters see it adding more than $100 billion to demand in the rest of the world this year, a modest contribution compared with the spending required to restore the world economy to full employment. America alone suffers from a shortfall in demand of $880 billion a year, according to the Congressional Budget Office.
How not to save the euro
The political failings that led to the ECB’s intervention in the bond markets are even more worrying than those that spurred the actions by the Fed. The debt problem tying America in political knots lies in future medical and pension costs. Europe’s debt problem is clear and present. And it cannot be solved without overcoming the deep reluctance of the leaders of the main creditor nations in the 17-country euro area—above all Angela Merkel, the German chancellor—to shore up the rickety single currency with greater fiscal integration.
The original conception of Europe’s monetary union saw no need for such integration. The Maastricht treaty of 1992 proscribed bail-outs of improvident member nations, which was meant to avoid such issues ever arising. The tension between such a rule and the admission of countries with poor public finances, such as heavily indebted Italy and Greece, was brushed aside. Fiscal discipline was supposed to come from budget-deficit limits in the stability and growth pact, but this buckled early on when Germany and France breached the thresholds but wriggled out of sanctions.
Once Europe decided to ditch the no-bail-out rule in May 2010, when it rescued Greece, a new mechanism of fiscal underpinning was clearly needed. There would have to be much tighter constraints on countries to prevent them from running unsustainable public finances in the future. And Europe would need to create a shared fiscal capacity to support countries that ran into trouble.
But European leaders have consistently fallen short of what is required. The doleful pattern has been to do as little as possible as late as possible after prolonged and often heated diplomacy that spills out messily in public, sowing confusion rather than delivering reassurance. A German-led initiative set hopes flickering when mooted early this year, but reforms finally agreed in March proved a damp squib. They focused on preventing future bail-outs resulting from fiscal slippage and economic vulnerability, with euro-area countries (and others in the wider European Union) signing up to commitments, binding under national law, that would ensure sound public finances as well as measures to improve competitiveness.
The more pressing need was to bolster the euro area’s main rescue fund, the European Financial Stability Facility (EFSF), set up last year. And on this front too little was done. European leaders did pledge to increase the EFSF’s lending capacity to the original target of €440 billion ($625 billion); the reserves needed for a AAA rating meant that the original commitments allowed it to lend only €250 billion. But German opposition knocked back hopes that it would be made bigger and more flexible. Instead it remained confined to its original role of providing funding only for countries that had formally been rescued.
Not until the bond vigilantes homed in on Italy and Spain in July did European leaders see a need to make their main firefighting vehicle more effective. At an emergency summit on July 21st, at which the second Greek bail-out was also sorted out, they announced that the EFSF would be empowered to extend lines of credit to troubled but not yet rescued economies and to intervene in secondary markets by purchasing the government debt of vulnerable countries.
European leaders no doubt hoped that they had done enough to keep markets calm while they went on holiday; once again they had done too little, too late. The package of measures announced in late July calmed nerves about Greece, Ireland and Portugal, with the long-feared restructuring of Greek debt not as traumatic as had been feared. But Italian and Spanish bond markets focused on the fact that although the EFSF had a wider remit it did not have deeper pockets—and that the remit could not be acted on until the 17 euro-area countries had ratified the changes.
So when Italian and Spanish bond yields jumped up again (see chart right) there was only one institution with the capacity to act: the ECB. It had already crossed the Rubicon of principle in May 2010, when it started to buy Greek government bonds in the secondary market. Subsequently it has also bought Irish and Portuguese bonds, though no purchases had been made since early this year, leaving the book value of its portfolio at around €75 billion.
On August 4th Jean-Claude Trichet, the bank’s president, said that the ECB had started to buy bonds again. But market sources revealed that this had been confined to Irish and Portuguese bonds. And even this limited foray had been opposed by some members of the bank’s 23-strong governing council, notably Jens Weidmann, the president of the powerful German Bundesbank.
This hesitant, cavilling approach was overturned in an emergency conference call over the August 6th-7th weekend. Under heavy pressure from European politicians (in their holiday getaways), the bank’s governing council indicated that it would after all intervene in the Italian and Spanish bond markets. That decision brought each country’s ten-year yields down by around a percentage point on August 8th and narrowed their spreads over safe German Bunds.
The ECB’s initiative provides a temporary palliative until the EFSF can take responsibility for such interventions, as envisaged in the July summit. Inaction risked a buyers’ strike that could have turned fundamentally solvent public finances insolvent by pushing up yields to unsustainable levels. In this sense, intervening in the Italian and Spanish markets was more defensible than the earlier support operations for Greece, which had been clearly insolvent. And a crisis in Italy or Spain would matter a lot more, since both economies are far bigger than those of Greece, Portugal and Ireland, the countries rescued so far. Their failure would have stretched even a beefed-up bail-out fund.
Yet the ECB dissenters had respectable reasons for caution. For one thing, buying bonds is risky; the ECB’s purchases of Greek bonds would have burned a hole in its accounts if they were valued at market prices. More worrying, buying government debt for selected countries compromises the bank’s credibility by dragging it into what is in effect fiscal rather than monetary territory.
None of this speaks to the most widely criticised ECB position: its aggressive stance on standard monetary policy itself. Alone among the big central banks of the rich world, the ECB has started to tighten policy this year, raising its main interest rate in quarter-point steps from 1% at the beginning of April to 1.5% in July. That stands in marked contrast not just to the Fed’s behaviour but also to that of the Bank of England, which has kept the base rate at 0.5% and looks set to leave it there until 2013, judging by its quarterly report on the economy published on August 10th.
The tightening looked premature when the ECB embarked on it this spring. It looks worse still now. True, the euro area expanded fast in the first quarter of this year, growing by 0.8%, with Germany in particular springing forward by 1.5% (6.1% annualised). But that burst followed two quarters of sluggish activity, and looks unlikely to be sustained.
The ECB’s monetary tightening was all the more uncalled for as countries on the periphery had to undertake fierce austerity programmes. Adding salt to the wound, the higher interest rates will hurt the most where anti-inflationary pressure is least needed, in the troubled economies of southern Europe and Ireland. This is because mortgages in those countries are predominantly variable-rate, whereas they are generally fixed in Germany and France. One ray of hope is that, responding to the economic slowdown and falling commodity prices, the ECB seems not to be in such a rush to raise rates higher, judging by Mr Trichet’s remarks on August 4th, when the bank announced that it was keeping its main rate unchanged.
Although the central bank’s monetary tightening is an own goal, the broader malaise in the euro area has a clear resemblance to those of America and Britain—and that which has gripped Japan since the 1990s. As Kenneth Rogoff, co-author of a recent 800-year history of financial crises, has pointed out, the recovery of debt-laden Western economies was bound to be slow and halting. Central banks may be the last people standing, but they cannot produce better growth out of nowhere. The emerging markets which provided a cushion during the financial crisis look less helpful now, especially if they put up capital controls in the face of a new round of QE. The sharp equity declines in August suggest investors understand the grim reality of a long period of slow growth.