That, at least, is UniCredit’s interpretation of the latest rheotoric from the European Central Bank and its officials, a stance which the bank’s chief economist Marco Annunziata describes as a “peculiar reversal of logic”.
Notes Annunziata (emphasis ours):
The ECB is telling us “No, we can’t”: we can’t lower interest rates to zero (for fear of the liquidity trap–Trichet); we can’t implement a true Quantitative Easing policy (because it is not so easy when you have so many government bond markets–Mersch); we can’t bail out [governments] in Europe (Mersch again). From this it then seems to follow that the corresponding risks simply will not materialize: there can be no deflation, no credit crunch, no sovereign default.
This is a peculiar reversal of logic: it would be more advisable to have a sober assessment of the risks and then publicly discuss the feasible policy options. And it seems to me that the risks cannot simply be ruled out a priori. A famous TV commercial once used the very effective oxymoron “Foreseeing the unforeseeable can save your life”. After a number of seemingly impossible events have materialized in the last eighteen months, spelling out contingency plans for identifiable tail events would be much more reassuring than simply playing down the risks.
And while Annunziata stresses that he does not believe there will be either a sovereign default in or a break-up of the eurozone, he is much less sanguine about the macroeconomic health of the whole (emphasis his):
For the last ten years, European policymakers have tended to dismiss the inherent tensions between a single currency and completely decentralized political decision-making and fiscal policy. Now those tensions have surfaced. For the US, a massive fiscal stimulus package has a confidence-boosting impact on the markets, with concerns on financing relegated to the backburner. In Europe…we have a fallacy of composition where the whole is less than the sum of the parts: individual fiscal deficits are large enough to raise default concerns, and yet the eurozone-wide fiscal stimulus is insufficient to instill confidence in a recovery.
The bottomline, however, is that the crisis has drawn attention to the fact that the eurozone does not have a common fiscal policy, does not have a homogenous government bond market, does not have a fully coordinated financial supervision. The most-cited argument as to why the eurozone will not break apart is that exit costs are way too high—hardly a ringing endorsement, and probably an excessively harsh one, given that potential new members seem to see eurozone membership as much more attractive than they once did.
The still fragmented nature of the eurozone is constraining the fiscal policy stimulus, limiting the monetary policy options, and fuelling dangerous temptations of beggarthy- neighbor measures. The biggest risk is not that the eurozone could break up, but that a hamstrung policy reaction might result in much more prolonged downturn than elsewhere. Already many observers, including ourselves, project a deeper recession and a weaker recovery in the eurozone than in the US, where the crisis originated. The dangers of an insufficient policy response are clearly illustrated by the Japanese example.
Most forecasts envision a bottoming out of the European and world economy in the first half of this year, with a moderate recovery in the second half. Unless during Q2 we start seeing signs that the downturn is losing momentum and activity stabilizing, confidence in this baseline scenario might quickly evaporate, opening room for more serious concerns of a prolonged recession. Further policy action is urgently needed.
Dispiriting reading, but we would argue that Annunziata does not go far enough. As the collapse of the Icelandic government shows, the crisis has moved rapidly from a shakeout in the US housing market to one that threatens the political stability of countries on the other side of the world.
The ECB needs to change its tune – and fast.
Related links:
Roubini on the UK vs Iceland – FT Alphaville
Does a single European bond hold the answer? – FT Alphaville
ERM, convergence might not work – FT Alphaville