Macro and Markets

Over the past year, Europe has enjoyed calm financial markets.  At the core of the market’s comfort were two assumptions about policy. First, that the European governments would do just enough to keep the process of European integration moving forward. Second, that the ECB would, in the words of Mario Draghi, do “whatever it takes”  to save the euro. The centerpiece of the ECB’s subsequent efforts was expanded liquidity (through long-term repurchase operations and easier collateral requirements for banks to access ECB liquidity) and a commitment to purchase government bonds to support countries return to market (the OMT program).  Even many pessimists who fear that Europe is trapped on a unsustainable, low-growth trajectory remain optimistic that Europe will do what it takes to navigate the near term risks.  It may be time to question that optimism. As many have noted, there is an increasing sense of adjustment fatigue in Europe, reflected in pressure on governments and the rise of anti-austerity, anti-establishment parties across the Eurozone.  In rhetorical terms, Europe has responded, and fiscal policy looks likely to be broadly neutral in the year ahead.  However, an overall fiscal relaxation that is needed in the euro area as a whole looks unlikely, as peripheral countries can’t afford much additional spending, while the core countries that can spend more seem disinclined to. Monetary policy also falls short of what is needed to establish the conditions for growth.  Unlike the United States, where a decision to recapitalize banks was coupled with strong Federal Reserve easing policies that established the basis of recovery, the ECB has to date resisted quantitative easing or a significant easing of collateral requirements to spur lending to small and medium enterprises (SMEs) in the periphery.  While it’s fair to point out that the ECB faces a more constraining legal and governance framework than the Fed, it’s also hard as a result to be confident in the IMF’s (and others) view that recovery is coming to Europe in 2014.  Even the IMF acknowledges that currently, "centrifugal forces across the euro area remain serious and are pulling down growth everywhere." Finally, there seems to be little political consensus on creating a true banking union (with deposit insurance and a strong pan-European resolution authority), dealing with the legacy sovereign debt, or honestly addressing the scale of the non-performing loan problem.  All these are critical to a long-term solution to the crisis.  All of these are long-term pressures on Spain, France and Italy, on which the future of the Eurozone no doubt rests. However, in the coming months Europe will face tests from a number of smaller countries.  Notably, economic programs in Greece, Cyprus and Portugal are all heading off track.  In the case of Greece, money promised for later years has been moved forward, resulting in a financing gap that will be impossible to ignore at the next review of the program in September.  Cyprus will need expanded ECB access if it is to ease capital controls.  Each of these countries will require new programs with more money, and eventually a debt restructuring.  Reviews of these programs in the fall likely will be too early for Europe to agree to debt official debt reduction, but fresh new money with an unsustainable debt profile may be similarly hard to justify.  Meanwhile, Ireland looks ready to press for better treatment on its debt as well. In each of these cases, the argument has been made that concessions cannot be made to these countries ahead of German elections in September (and  a German constitutional court ruling  on the ECB’s bond-purchase program).  This of course creates expectations that things will be much better for these countries after elections.  There is talk of a December European leader’s meeting being the forum for a “move towards more Europe.” The problem is not the scale of the support needed in each cases.  These are small programs that can readily afford to be expanded within the existing framework.  The problem is that they could become the place where broader battles over the future of Europe–on official sector debt reduction, on banking union, and on fiscal federalism—are fought out.  In that case, will existing ECB liquidity facilities and the threat of OMT be enough to keep markets calm?  If pressures on banks or governments intensify, questions will no doubt be raised on whether the ECB’s threat to buy bonds is a bluff.  It’s hard to imagine countries accepting material new conditionality to access the bond-buying facility, or that the ECB could materially ease its conditions for use.  The period of financial market calm may be coming to an end.

The IMF is out with a global update and a statement on Europe.  Unsurprisingly, it has revised its outlook down (again).  It still, optimistically, expects a return to growth in Europe next year, but it recognizes the risks are on the downside.  A few points to highlight. 1.       We are all in this together. The largest downward revision is to emerging markets (-0.3% revision this year and next).  While there are idiosyncratic factors (e.g., credit squeeze in China, infrastructure in India, lessened policy support in Brazil), the common issue affecting the emerging world is a weaker external environment due to slow industrial country growth.  I’d emphasize here, of course, that these countries can depreciate their exchange rates, ensuring a faster recovery than we will see in the periphery of Europe. 2.      Downside risks dominate.  The reports candidly acknowledge the downside risks, including the upcoming debt-ceiling fight in the United States and deteriorating financial conditions in Europe.  The overall sense is of a Fund frustrated with policies across the major industrial countries (except Japan, where it has revised growth up on Abenomics) 3.      A boost to macroprudential  regulation.  The Fund continues to support  accommodative monetary policies in the G3; thus its not surprising that they emphasize regulatory and macroprudential policies to deal with potential bubbles.  This ties in with earlier Fund work suggesting a more positive view of macroprudential measures and capital controls to address financial imbalances. 4.      For Europe, easier fiscal and monetary policies.   They support further rate cuts from the ECB (including negative ECB deposit rates) and endorse the ECB’s recent forward guidance.  Further fiscal “flexibility” is likely to be needed in Europe, as current targets are unlikely to be met. I don’t think there is much new here, but it’s still the right call. 5.      The path to European union must be accelerated. More aggressive measures to repair bank balance sheets, a faster move to banking union, and stronger ECB efforts to reduce fragmentation are needed.  On the latter, they support new long-term lending (LTRO) coupled with an easing of collateral requirements to provide a greater incentive to lend to the periphery.  This approach mirrors the “funding for lending” scheme in the United Kingdom.  They also would support ECB purchase of private assets, a more full-throated quantitative easing (QE). The Fund clearly is increasingly unhappy with the policy framework in Europe.  The question is what, if anything, they will do about it.  The test will likely come this fall on Greece, Portugal, and Cyprus--all programs that seemed destined to fail without stronger European support.

The Greek government has reached agreement with the Troika (European Central Bank, European Commission, and IMF) on a set of policies putting its program back on track and opening the door for €8.1 billion in tranches over the summer, which should finance the government until September.  To get this done involves moving forward lending originally scheduled for later years.  That means a large financing gap looms for 2014.  But that’s an issue for after the summer break. Under the agreement, the Greek government will take a number of fiscal measures to meet their fiscal targets (closing a €2 billion gap) and achieve primary balance this year.  This includes a luxury tax, a unified property tax, reduced pensions for military personel, and other social safety net reforms.  The government also has agreed to move forward with plans to reduce government employment by up to 25,000 through a mobility and reallocation scheme.  These were tough measures, which for a while looked like they could destabilize the government.  The government will get credit from European leaders for getting this done, even as it becomes apparent that prospects for recovery remain distant.  (The IMF forecasts a fall in activity in excess of 4 percent this year followed by positive growth of just 0.6 percent in 2014.) Austrian Finance Minister Maria Fekter summarized the optimism:  "I’m convinced that Greece is making every effort to meet these goals…The summer break is coming up and I really don’t fancy coming to Brussels during that period." My concern here, as in Cyprus (where the program is going off track) and Portugal (where an agreement to preserve the government appears predicated on a request for a relaxation of their program) is that flaws in these countries’ programs are being papered over on the hope that easier times—additional financing and/or debt relief—will come after German elections in September. It’s a big ask, and sets us up for disappointment this fall.  But summer vacations are saved.