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ECB not the ‘white knight’ Eurozone envisions

Now that financial markets refuse to continue financing rising government debts, the fiscal authorities are being forced to take a step back and announce plans to reduce deficits. Yet the frugality trend that has defined the Western consumer of late is still going strong and global exports are showing no indication of a dramatic comeback. This means the only way to boost growth is via monetary stimulus measures – that is the theory. But will this work in practice?

A more accurate picture of the ECB’s apparently ineffective policy of recent years can be seen on closer examination of the circumstances from which its measures arose. A prolonged period dubbed ‘the Great Moderation’ had delivered high growth and low inflation. Extrapolating this trend, many households started borrowing – not only for investments in housing and education, for example, but increasingly for general consumption too. Governments, on the other hand, expanded the social safety net ever further. Both trends promised only to be sustainable, however, if growth (in incomes and tax revenues) remained high. Unfortunately, the Great Moderation suddenly came to an end when housing prices in the US plummeted in 2007. Mortgages of dubious quality had to be written off, and the chaos that this created in the US banking sector quickly rippled throughout the financial markets worldwide. It became clear that both the public and the private sector in many Western economies, especially in the Eurozone’s periphery, were contending with excessive debts.

Chart 1: Bank credit to Spanish private sector is declining, undermining economic growth
Chart 1: Bank credit to Spanish private sector is declining, undermining economic growth

Source: ThomasonReuters Datastream/ECR

From moderation to deleveraging

The consumer retreated. Households started to deleverage (ie increase net savings by cutting expenditures sharply) and consumption dropped quickly. Governments stepped up to the plate and ramped up spending to prevent economies falling over the financial abyss. Simultaneously, the ECB and the Fed lowered interest rates and provided banks with ample liquidity. This should have made it more attractive for the private sector to continue spending and borrowing, rather than saving. However, five years later, following numerous rounds of fiscal and monetary stimuli in the US and the EU, economic growth remains disappointing, not least because the private sector is unwilling and unable to borrow.

Governments are now finding it more difficult to sustain high deficits with financial markets breathing down their necks. And Spain and Italy are the most recent examples of countries threatening to go under. The few remaining AAA rated euro countries naturally want to avoid the fate of Greece, and so deficits have been lowered – albeit reluctantly. (For the rate of growth, what matters is not the size of the government deficit, but the direction in which the deficit is going; that is, ramping up deficits boosts growth, while cutting deficits subtracts from growth – even if it remains at, say, 6% of the total economy.)

Many market players have been looking to the ECB to provide stimuli for the ailing economies, as they opine that not enough has been done to tackle the economic crisis. Various studies have shown that the ECB’s liquidity-providing measures and purchases of peripheral sovereign bonds have avoided a credit and a liquidity crunch. Yet, banks in the periphery continue to shrink their lending books – and credit activity is tepid in the core countries also. Without an increase in credit, however, the affected economies will not be able to climb out of the deflationary spiral of economic decline. This will result in increasing government deficit (as a percentage of the total economy), more necessary austerity measures, rising unemployment, further downward pressure on growth, falling asset prices and collateral values, more losses for banks, even less credit extension, a larger drop in economic growth, and so on.

Alternative measures

While (short-term) policy rates cannot be lowered much further, non-standard monetary policy measures have been tried and are being implemented yet again, the most recent being the ‘Outright Monetary Transactions’. Through this initiative, the ECB buys government bonds from countries that have applied for financial aid from the EFSF/ESM and are meeting all the conditions imposed (with regard to reducing deficits and structural reforms to make their economies healthy again).

The motive for the government bond purchases is, of course, to bring down interest rates in the respective countries. High rates on government bonds for the weak countries not only reflect the risk that the country defaults but also a risk that the country exits the Eurozone, whereby creditors get repaid in the newly introduced but substantially weakened currency. The latter risk premium is what the ECB wants to eliminate.

A necessity for countries such as Spain and Italy to stay afloat is that the interest rates are reduced. It will not be the sole necessity, however, which is why the core countries demand the harsh conditions mentioned above in return for the financial aid and ECB’s bond-buying.

Nevertheless, it is uncertain whether the combination of bond-buying and structural reforms will be successful. After all, debts in the weak countries remain far too high, and these are highly inefficient economies with rigid labour markets. Structural reforms can solve this issue, but only if they are not watered down – as is happening currently – and they will only have a positive effect in the longer term. This means that the underlying economic growth rate (the pace at which the economy grows when it does not rely on debt accumulation) will no doubt remain low or negative for the coming years. The core euro countries will then have to continue financing the weaker countries; something which faces ever more political resistance.

Active ECB policy is not enough

ECB bond-buying cannot do anything to lift the underlying growth rate, nor can it generate a reduction in debt levels. This is the domain of politicians who, unfortunately, can be expected to do ‘too little, too late’. At most, the central bank can buy some time for politicians to implement reforms in an attempt to move the Eurozone closer to a banking, fiscal and eventually a political union (probably the only way the Eurozone would be able to stay together). What the ECB should optimally strive towards is getting credit flowing again in the periphery. But purchasing bonds is unlikely to achieve this.

Chart 2: As long as periphery’s competitiveness lags, growth remains low, government deficits high
Chart 2: As long as periphery’s competitiveness lags, growth remains low, government deficits high

Source: ThomasonReuters Datastream/ECR

An additional difficulty with the current bond-buying plan is that it only allows the ECB to step into the government bond markets if interest rates of the countries seeking financial assistance are under upward pressure. However, as we have seen in recent scenarios, this typically only occurs when bond holders question the respective government’s ability to adhere to the fiscal austerity programme and fulfil future interest and principal repayments. In other words, if countries meet the EFSF/ESM conditions and stay on track with the reform programme, interest rates are not expected to rise and so the ECB does not have to buy their bonds. Yet, if governments digress from the austerity programme and private bond holders flee to safe havens, this is when bond purchases are most necessary. But this is also when the ECB – according to current intentions – must step out of the bond market.

Despite this central bank ‘activism’, the underlying economies of the Eurozone periphery remain weak. The ECB should not be expected to address their structural illness or to eliminate all the underlying symptoms; at most, it can ease some of the pain. This also means that tensions are bound to mount every so often – with credit spreads widening, investors fleeing the Eurozone and the euro rate sliding – until the situation is on the verge of escalating and leaders are forced to take action yet again.