“Whatever it takes”

This is the bold pledge made by the governor of the European Central Bank (ECB), Mario Draghi, in reference to what the Europe’s central bank is willing to do to help stop countries leaving the euro.  This statement of intent was made at the end of July but investors had to wait until the beginning of September for the details of how far the ECB was willing to go.  And the ECB has brought out the big guns to prove its resolution but it remains to be seen whether the full might of the ECB will be enough.

The central part of the new policy was that the ECB would purchase an unlimited amount of bonds of indebted countries suffering from high interest rates.  The fact that the ECB has set no limit on funds available for bond purchases is meant to stop investors selling bonds of European governments in the expectation that the interest rates will rise (interest rates get higher if bonds are sold off and their price falls).  If the ECB is always ready to buy bonds, the price of bonds is less likely to fall and this will create an environment where other investors will be motivated to also buy. 

And in theory, it is a good time to buy.  The worries that a breakup of the Eurozone will prompt governments to default on their debt have prompted investors to sell off the bonds of countries such as Spain who are expected to have difficulties in paying their bills.  If the fears of default can be soothed, the prices of bonds will seem cheap.  So, the ECB is betting on its ability to calm the nerves in the market and could actually make a profit on its buying of bonds.

This new stance is not without its problems.  The help for troubled countries from the ECB is not unconditional and governments must agree to reforms to the economy which would be supervised by the EU and the IMF for the ECB to buy their bonds.  Spain is seen as a prime candidate for this support but the harsh reality of having to submit to orders from others has made the government reluctant to seek assistance. 

 

The ECB could be caught in a dilemma if a country does not toe the line after having their bonds propped up by the ECB despite having signed on for reforms.  If the ECB stops its bond purchases for such a country, default would be highly likely and this is exactly the result that the policy is intended to stop.  There are concerns with the ECB along with the EU and the IMF having control over governments which have been democratically elected by their citizens.  While an undesirable outcome of the sovereign debt crisis, the greater power of these unelected bodies is the result of governments being unable to sort out the problems themselves. 

But perhaps the biggest concern is the slim possibility that that the unlimited firepower of the ECB will not have enough punch.  Pessimists may bet against the ECB to test its resolve.  There are numerous parties which are unhappy with the new position taken by the ECB.  In particular, policies makers in Germany have made public their displeasure and this will grow with the amount of funds which the ECB uses to buy up bonds increases.  Investors will also second-guess the efforts of countries receiving support as to whether they will stick to what is expected of them by the ECB.  The policy of the ECB has been compared to a bazooka – if you have a big enough gun, no one will mess with you.  But there is the smallest chance that even a bazooka may not be big enough faced with an army of doubters.  

Another dose of medicine but will it help…

Vital signs suggest that the global economy in 2012 is not healthy.  Europe is the main cause of concern as politicians argue about the right course of action with regard to the sovereign debt crisis.  But problems in other major economies such as the United States and China are also adding to the ailments of the global economy.  This deteriorating outlook for the global economy has also sapped the willingness of many firms who operate on a global level to spend and invest.  The typical economic prescription in cases where a lack of optimism dents spending by firms and consumers is Keynesian – the government is to step in and increase spending to cover the drop in demand from elsewhere.

But governments in many countries such as the United States have their hands tied due to large amounts of government debt which limits further spending.  Central banks have also tried the textbook response to a weak economy by cutting interest rates to close to zero.  But this has had little effect as business will not borrow even at low interest rates if the prospects for the economy are dim. 

So central banks have been pushed to try less conventional medicine.  The new prescription is referred to as quantitative easing and involves the central banks printing money and using this to buy bonds issued by their government or by businesses.  This acts to further lower interest rates on the bonds and the lower return for investors in bonds prompts some of them to move their money to other investments such as shares which acts as a shot in the arm for the stock market.

Growing concerns that the global economy is on its sick bed have jolted the central banks in the United States, Europe, and Japan into ordering a further dose of medicine.  The European Central Bank released plans to buy as many bonds of indebted countries as necessary to help out the sick patients of Europe after its pledge to do “whatever it takes” to support the euro (more on this in a future posting).  The Federal Reserve in the United States followed suited and announced it would buy an unlimited amount of bonds until unemployment began to come down.  The Bank of Japan also jumped on the bandwagon with its own plans to buy up bonds.

 

This new consensus among central banks has not pleased everyone.  There are concerns over the new roles for central banks who have traditionally been bastions against inflation.  Inflation is seen as a negative influence as it reduces the value of money which hurts savers.  Central banks have killed off inflation by increasing interest rates but this has been possible due to the targeting of inflation by central banks.  But attempts by central banks to revive flagging demand through quantitative easing also could result in the resurrection of inflation.  As quantitative easing also involves central banks creating money for nothing, it also acts to drive down the value of the currency (as will be described in a future posting) and this is controversial as a weaker currency boosts exports at the expense of other countries. 

Even if the quantitative easing by central banks is seen as a necessary evil, there are further fears about whether the policies themselves are having the desired effect.  Because quantitative easing involves buying bonds in the hope of influencing investment decisions of other buyers of assets for investment, the effects are not clear and the continuation or even worsening of economic problems suggests that the policies are not a cure-all.  This is reinforced by the fact that, for example, this will be the third round of quantitative easing in the United States (hence the abbreviation “QE3” in the newspapers). 

In effect, there are few differences from when Your Neighbourhood Economist first started this blog in November 2011 (So what is going on…???).  The problems that central banks are grappling with are beyond the scope of the current understanding and available tools.  It remains to be seen if the unlimited resources now being tapped by the central banks will in fact be enough to resuscitate the major economies.  There is not much else that can be done.  Even Your Neighbourhood Economist does not know what to expect in twelve months’ time.

Back from Vacation in Greece

Upon returning from holidaying in Greece, Your Neighbourhood Economist typically has gotten a quizzical look from people when the choice of holiday destination comes up in conversation.  “How was it?” would be a standard response with the expectation of tales of squalor coupled with rebellion being rampant amongst the locals.  But except for stories of idyllic islands and endless sunshine, there was nothing much else to tell.

While there are stories of hardship coming out of Greece, for many life goes on.  While 17.7% of the working population are unemployed, there are still 4.1 million workers in jobs who generate GDP worth 215 billion euros giving Greece a per capita income which is higher than Portugal, Croatia, and the Czech Republic.  Much of the hurt that the country is experiencing comes not from absolute poverty which does exist as it does in many other richer countries.  The real pain comes from what has been lost due to the debt crisis and from a future that looks considerably different now than would have been the case five years ago when the entry to the euro had seemingly ushered in a new era of prosperity.

Some readers with a sympathetic disposition toward the people of Greece may consider the stance of Your Neighbourhood Economist to be harsh.  But the trouble that Greece is in will require pain to be inflicted on someone and it is essentially the Greek people that ran up the bill.  Blaming an irresponsible and unrepresentative government only goes so far when considering that the Greeks have left these politicians in power.  Investors who hold Greek debt have endured a portion of the pain in the form of the debt write-off that was part of the previous bailout (see Another Bailout for Greece).  But the Greek people are even now living beyond their means considering the small primary budget deficit in 2011 which means that government spending still exceeds its income even when interest payments on its debt are excluded despite the austerity measures already implemented. 

The cash and the solutions are available to solve the debt problems in Greece and elsewhere but sharing out the pain is the issue that politicians are negotiating.  To let Greece off the hook too easily would create a moral hazard – setting a precedent whereby costs of bad decisions are borne by others.  Despite the rioting and protests, Greeks have shown a willingness to accept a considerable share of the burden after a small majority voted for parties which supported the bailout and the accompanying austerity in elections in June 2012 (which was a bit of a surprise to Your Neighbour Economist - Greece Set to Rebel and Dump the Euro).  And even Angela Merkel has shown some flexibility in allowing the European Union to move toward a banking union whereby funds will be available to prop up the banks in the different countries.  But taxpayers in Germany are still loath to stump up cash for the Greeks who are seen as proliferate when German workers have made do with limited wage increases to maintain competitiveness. 

But these negotiations have dragged on for too long as the leaders in Europe hope that minimal measures will suffice.  The trials and tribulations that Greece is being put through to ensure that it bears its share of the pain are causing the problems to fester such as delays in a possible bailout to Spain as well as sluggish economic growth in the Eurozone acting as a drag on the global economy.  Europe’s leading politicians and its central bank have been more proactive of late (more on that in a future posting) and hopefully the end of austerity is not too far away with the Greek government hoping that cuts to spending in 2013 and 2014 will be the last of it.  If the country pulls through without much more turmoil, it will be the Greeks that will have earned themselves a holiday.