Mario Draghi, the European Central Bank’s President, revealed the monetary policy maker’s latest creative response to the rolling euro-zone crisis during the first week of September. Investors greeted the central bank’s latest maneuver, known as Outright Monetary Transactions (OMT), enthusiastically, and pushed stock prices to within touching distance of 52-week highs in the days that followed; the advance added to the robust double-digit percentage point gains already enjoyed since late-July, when Draghi declared that, “the ECB is ready to do whatever it takes to preserve the euro. And believe me, it will be enough.”
The stock price reaction was understandable in light of the moves in other financial markets, which suggested the OMT programme will be sufficient “to remove tail risks from the euro area.” The yield on under-pressure, ten-year Spanish sovereign bonds for example, dropped almost 200 basis points from the summer high of 7.4 high to well below the psychologically-important six per cent level; the yield on comparable Italian government debt securities declined from 6.6 per cent to below five per cent over the same period. Meanwhile, the single-currency appreciated by more than eight per cent vis-à-vis the U.S. dollar, to the highest level in five months.
The OMT programme has been described as a game-changer by some, and others have gone so far as declaring that an end to the monetary union’s woes is imminent. The idea that the latest liquidity operation is an important step is beyond dispute, but the notion that the crisis is almost over is sheer nonsense.
The revelation that the ECB would be willing to engage in the unlimited purchase of troubled-periphery, short-maturity, sovereign bonds in the secondary market under certain conditions, and would be prepared to continue the programme until its objectives are achieved, means that the monetary authority is ready to accept the de facto role of ‘lender of last resort’ to governments, even though this fact was not explicitly stated by the central bank.
In acting as ‘lender of last resort’ to beleaguered governments in the euro-zone, the ECB removes the ability of private investors to precipitate a sovereign default; the central bank’s commitment to purchase government debt securities in the secondary market should ensure that new issuance can take place in the primary market at acceptable yields to the sovereign borrower. Further, the programme should ease liquidity pressures among the periphery’s ailing banking sectors, as the funds from secondary market purchases replace the funds lost to deposit flight.
However, the monetary authority has stated that it will only engage in the purchase of a country’s debt securities, after that country has formally asked for help via the European support mechanisms, the European Financial Stability Facility (EFSF) and the European Stability Mechanism (ESM), which in turn is certain to result in the imposition of a stringent fiscal austerity programme upon the recipient country. The politically-intolerable measures that a bail-out would impose, means that democratically-elected governments are certain to request support only if the financial markets force them to do so, which virtually assures continued uncertainty and volatility.
More importantly, the ECB’s latest policy maneuver should be viewed in its proper context; it is simply a measure designed to create time for governments in the troubled periphery to implement durable solutions that restore stability. However, monetary policy is no remedy for the structural problems that have laid the peripheral countries low, and the sheer size of the imbalances that were allowed to build-up in the period that immediately followed the launch of the single currency, means that it will be several years before any commentator can confidently declare that an end to the crisis is in sight.
Successful resolution of the euro crisis requires much more than just the reduction of fiscal deficits, and public debt ratios to sustainable levels. It must also involve a sufficient deleveraging of overstretched private-sector balance sheets in several member countries, as well as ample investment in the productive capital stock to not only spur much-needed job creation to bring down unacceptably-high unemployment rates, but also to boost exports and eliminate structural external deficits in the absence of a fiscal transfer union.
The attainment of these goals is simply not feasible in the short-run. A planned reduction in the fiscal deficit at any given level of output – in tandem with a desired increase in private-sector savings relative to investment – must be accompanied by an equal and opposite adjustment in the financial position of the external sector. In other words, exports must increase by a sufficient amount vis-à-vis imports to offset weakness in government consumption, household consumption, and private investment simply to maintain a constant level of output.
Basic arithmetic indicates that rapid adjustment and hence, a quick resolution of the euro crisis, is not possible in the absence of currency devaluation and robust external demand. This means that high levels of economic, financial, and political uncertainty are virtually certain to persist for several years. Those who believe the monetary union’s travails are close to an end are dreaming.
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