Reports of end to the euro zone crisis are premature
The sheer size of the imbalances allowed to build up in the period following the launch of the euro means it will be several years before any commentator can declare an end to the crisis is in sight
MARIO DRAGHI, the European Central Bank’s president, revealed the monetary policymaker’s latest creative response to the rolling euro-zone crisis during the first week of September.
Investors greeted the central bank’s latest manoeuvre, known as Outright Monetary Transactions (OMT), enthusiastically, and pushed stock prices to within touching distance of 52-week highs in the days that followed.
The advance added to the robust double-digit percentage point gains already enjoyed since late July, when Draghi declared that “the ECB is ready to do whatever it takes to preserve the euro. And believe me, it will be enough”.
The stock price reaction was understandable in light of the moves in other financial markets, which suggested the OMT programme will be sufficient “to remove tail risks from the euro area”.
The yield on under-pressure 10-year Spanish sovereign bonds, for example, dropped almost 200 basis points from the summer high of 7.4 per cent to well below the psychologically important 6 per cent level.
The yield on comparable Italian government debt securities declined from 6.6 per cent to below 5 per cent over the same period.
Meanwhile, the single currency appreciated by more than 8 per cent vis a vis the dollar, to the highest level in five months.
The programme has been described as a game-changer by some; others have gone so far as declaring that an end to the monetary union’s woes is imminent.
The idea that the latest liquidity operation is an important step is beyond dispute; the notion that the crisis is almost over is sheer nonsense.
The revelation that the ECB would be willing to engage in the unlimited purchase of troubled-periphery, short-maturity sovereign bonds in the secondary market under certain conditions, and would be prepared to continue the programme until its objectives are achieved, means the monetary authority is ready to accept de facto the role of lender of last resort to governments, even though this was not explicitly stated by the central bank.
In acting as lender of last resort to beleaguered governments in the euro zone, the ECB removes the ability of private investors to precipitate a sovereign default.
The bank’s commitment to purchase government debt securities in the secondary market should ensure that new issuance can take place in the primary market at acceptable yields to the sovereign borrower.
Further, the programme should ease liquidity pressures among the periphery’s ailing bank sectors, as the funds from secondary market purchases replace the funds lost to deposit flight.
However, the monetary authority has stated it will engage in the purchase of a country’s debt securities only after that country has formally asked for help via the European support mechanisms, the European Financial Stability Facility (EFSF) and the European Stability Mechanism (ESM).
That, in turn, is certain to result in the imposition of a stringent fiscal austerity programme upon the recipient country.
The politically intolerable measures a bailout would impose means democratically elected governments are certain to request support only if the financial markets force them to do so.
That assures continued uncertainty and volatility.
More importantly, the ECB’s latest policy manoeuvre should be viewed in its proper context: as a measure designed to create time for governments in the periphery to implement durable solutions that restore stability.
However, monetary policy is no remedy for the structural problems that have laid the peripheral countries low.
The sheer size of the imbalances allowed to build up in the period following the launch of the single currency means it will be several years before any commentator can declare confidently that an end to the crisis is in sight.
Successful resolution of the crisis requires much more than the reduction of fiscal deficits and public debt ratios to sustainable levels.
It must also involve a sufficient deleveraging of overstretched private-sector balance sheets in several member countries, as well as ample investment in the productive capital stock – not only to spur much-needed job creation to bring down unacceptably high unemployment rates but also to boost exports and eliminate structural external deficits in the absence of a fiscal transfer union.
The attainment of these goals is simply not feasible in the short run. A planned reduction in the fiscal deficit at any given level of output – in tandem with a desired increase in private-sector savings relative to investment – must be accompanied by an equal and opposite adjustment in the financial position of the external sector.
In other words, exports must increase by a sufficient amount vis-a-vis imports to offset weakness in government consumption, household consumption and private investment simply to maintain a constant level of output.
Basic arithmetic indicates that rapid adjustment and hence a quick resolution of the euro crisis is not possible in the absence of currency devaluation and robust external demand. This means that high levels of economic, financial and political uncertainty are virtually certain to persist for several years.
Those who believe the monetary union’s travails are close to an end are dreaming.