At the gloomy IMF/World Bank meetings in Washington this weekend, everyone seemed to agree on one thing, and one thing only. The European debt crisis is now by far the most urgent matter facing the world economy. Not only has it already taken the eurozone to the brink of renewed recession, but it threatens to envelope the rest of the world as well. ”The threat of cascading default, bank runs, and catastrophic risk must be taken off the table, as otherwise it will undermine all other efforts, both within Europe and globally”, said Tim Geithner, US treasury secretary. He is right. But there is still no unanimity on what exactly should be done to take take this catastrophic risk off the table.
In the last week, there were unmistakable signs that Europe’s financial crisis is now developing into an economic crisis as well. The PMI business surveys for September fell below 50 in the eurozone, and consumer confidence dropped ominously. Although the business surveys still seem to be consistent with a positive out-turn for real GDP growth of around 0.3 per cent in the third quarter, the downward momentum in the forward-looking components now seems strong enough to threaten negative growth in the fourth quarter.
Significantly, JP Morgan has broken ranks with those forecasters who merely warn of “increased downside risks”, and they now show a European recession as their main case forecast for the next 12 months. This also breaks with long-standing economic tradition. Cyclical downturns in Europe normally follow several quarters behind those in the US, but this time it is the other way around.
What has caused this sudden drop in eurozone economic activity only a matter of weeks after the ECB actually felt confident enough to raise interest rates in July? After all, oil prices have been dropping, and financial conditions have barely tightened, despite what now seems to have been a mistaken 50 basis point increase in interest rates by the ECB. One factor has been that fiscal policy has tightened by about 2 per cent of GDP in the eurozone this year – a warning to the US that a premature fiscal tightening can cause trouble, especially if it is not accompanied by monetary easing. But this can hardly explain the sudden weakening in activity around the middle of this year. Clearly, the “crisis of economic competence” surrounding the sovereign debt crisis has been largely to blame.
Market turbulence of the extreme variety we have seen in recent weeks in the eurozone can, on its own, cause a recession. Eurozone equity markets have fallen by 30 per cent since June, and financial stocks have fallen by twice this amount. European policy makers have a tendency to pour scorn on the short termism of financial markets, but this study of the inter-connectedness of banks’ share prices by Kamil Yilmaz clearly shows that a severe contagion has gripped the financial sector. And this study by Nicholas Bloom argues that uncertainty shocks of the type we have just seen tend to cause consumers to postpone purchases, and employers to postpone hiring decisions. On average in earlier episodes, this reduces real GDP be around 2 per cent over six months, which in current circumstances would be enough to cause a recession.
Press reports suggest that policymakers in Germany and France are now waking up to the urgency of this situation. One report suggests that they may be thinking of a much more dramatic package of measures than anything contemplated so far. This might include the acceptance of a much bigger Greek default on its sovereign debt, with the private sector taking a large part of the losses.
The resultant losses in the European banking sector would necessitate capital injections to recapitalise the banks, and there would also need to be massive official purchases of Italian and Spanish government bonds to prevent contagion to those economies. The question is not whether such a strategy can, in principal, be designed. Clearly, it can be. Ever since the 21 July summit, it has been apparent that the EFSF provides the necessary pipelines to make this work, and the structure should be ratified by member states very soon. No, the real question, as usual, is whether the stronger economies in the eurozone are willing to sanction fiscal transfers in sufficient scale to calm the markets. To judge from comments by German Finance Minister Schauble over the weekend, nothing much has changed on that front.
That leaves one other idea, which is to use the ECB balance sheet to increase the size of the EFSF without directly spending a great deal more government money to get this done. Tim Geithner flew to Europe last week to suggest that this should happen, following the precedent set by the TALF in the US in 2009. The method would be to inject equity into a new bail-out fund from the EFSF, and to ask the ECB to inject several times this amount in the form of debt to the fund. The much bigger fund would then be able to buy Italian and Spanish bonds in much greater size. For example, if the equity in the EFSF were used to cover the ECB for potential losses of up to one-fifth on its sovereign debt holdings, the total fund could be leveraged up to E 2 trillion, which would be more than enough.
In principal, this sounds like a sensible idea, which would probably fly if the eurozone were a true nation state. But it does have two large drawbacks. First, it certainly involves the potential for future fiscal transfers, even though these would be very heavily disguised. Second, it would involve using the balance sheet of the ECB to buy sovereign debt, which would be very close indeed to the direct monetisation of fiscal deficits, something which Bundesbank President Weidmann specifically rejected last week.
So far, I have seen very little to persuade me that Germany is ready to contemplate such a drastic measure.
We have updated this piece to include the word “tightening” in the fourth paragraph.
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