Do you believe in Father Christmas? This is the key question for global financial markets hoping for a temporary solution to the €uropean Sovereign Debt crisis. All their Christmases would come at once if the ECB commits to unlimited purchases of peripheral government bonds. This would immediately solve the liquidity problems and relieve the pressure on peripheral government to rapidly consolidate their budget deficits and undergo painful and politically divisive restructuring of their economies.
This unfortunate consequence of more active ECB largesse highlights the prisoners’ dilemma that the central bank finds itself and the inevitability of a sub-optimal outcome. More importantly, the crisis is not one of liquidity but solvency and the ECB does not have a mandate for unlimited funding of insolvent governments.
More importantly, the single currency is the modern day equivalent of the Gold Standard and the lack of currency and monetary flexibility ensures its particular vulnerability to global imbalances. Indeed, the single currency has contributed to the build-up of these imbalances within the €urozone by encouraging the expansion of current account deficits within the periphery over the past decade that paced the deterioration in competitiveness in these economies. In the wake of the global credit crunch, private sector investors have become increasingly reluctant to fund these persistent current account deficits.
This reluctance has been amplified in the wake of Greek private sector involvement, a euphemism for debt devaluation, and France and Germany threat to eject recalcitrant countries from the single currency. This raises the probability of currency devaluation and debt default. This default risk is currently a tail risk, but we believe that these risks will grow over the next year as austerity and deleveraging drive the €uropean economy into recession.
The simultaneous deleveraging of consumer, government, corporate and financial balance sheets within Western Europe will force recession and deflation in the region and cause contagion for Eastern Europe. The savings-investment identity suggests that unless there is a compensatory increase in some other balance sheet within the system, then there will be a rapid contraction in domestic demand and imports, which in turn will lead to deep domestic recession.
Consequently, we have no doubt that the ECB will increase its balance sheet to provide significant additional liquidity to banks and peripheral sovereigns. This provision of liquidity to sovereigns will be carried out via Security Market Purchases but under the principles of lender of last resort, lending to solvent banks/governments at the penal rate of interest. Press reports suggest that the ECB has set a weekly limit of €20bn on these purchases and the average weekly rate since the central bank began supporting Italian and Spanish government debt in early August has been €8.3bn.
These purchases are the monetary equivalent of a sticking plaster. As Sir Mervyn King, Governor of the Bank of England and our choice for central banker of the year (for the fourth consecutive year) noted; “I’m all in favour of sticking plaster; it’s just not a substitute for having proper medical treatment. So if you find yourself with a wound, by all means use sticking plaster, but use the time which it gives you to deal with the underlying problem”.
King’s brilliant exposition of the underlying problem lays the blame on global imbalances and fixed exchange rates. It is not the role of the central bank to fund these imbalances. These imbalances must be addressed by politicians. Central banks must resist pressure from governments to cover up for unpalatable decisions. As the Governor points out, Europe’s current account deficit in aggregate is small but it only becomes operative if the governments and their electorates can agree to pooling of fiscal resources and surrender of sovereignty. At this point, the central bank would be able to play lending of last resort to the common sovereign as the Bank of England has done for the UK sovereign government.
The consequences of this outlook for European government bonds is that benchmark Italian and Spanish government yields are likely to remain above 6% for the foreseeable future and semi-core yields for France, Belgium and Austria are expected to rise further over the next few months while German yields are expected to fall further as the shortage of safe haven assets continues to drive demand.
The €uro has held up remarkably well in the absence of supporting flows from mercantilist central banks. The current tight market range represents an unstable equilibrium between recapitalisation flows by European banks from the rest of the world and the run on banks and sovereigns by investors in the rest of the world. We believe that this equilibrium will resolve itself in a significant weakening of the €uro against the Dollar and Sterling during 2012.
And finally, Germany has been unfairly described as acting like the first class passengers on the Titanic, locking the third class passengers below decks as the ship sinks. We disagree, Germany is the Captain of the ship and the ECB is the band. And the band played on, but safety lies in another ship, RMS Political Union, which is just over the horizon. It remains to be seen whether the third class passengers of the peripheral economies and the second class passengers of the semi-core will be willing to decamp from their current luxury liner to this cramped tramp steamer. What is clear, however, is that the Titanic and the single currency cannot continue in its current form and this is the current tune being played by the band of brothers at the ECB and their friend at the Bank of England.
Chief Economist, Co-Fund Manager
Nov 22, 2011 at 4:06pm