Yet Another Year of the Central Banker
2012 was the year that Mario Draghi saved the euro. There is no doubt that it was the European central banker’s simple statement that the ECB was ready to do “whatever it takes” to save the euro that altered the dynamic of the euro crisis. Draghi, the Financial Times’ man of the year, built a protective shield around the common currency and was successful in discouraging speculators from making further attacks against Europe’s periphery.
Sebastian Mallaby of the Council on Foreign Relations recently pointed out that if the Italian Draghi rightfully earned the highest reward, Ben Bernanke, the chairman of the Federal Reserve, deserves the second spot on the podium. By launching a new round of quantitative easing in September of this year, and by promising in December that the FED would continue to pump liquidity into the economy until unemployment falls below 6.5 %, Bernanke opened a new chapter in the FED’s history.
Draghi’s decision was bold because it was a political move that challenged the Bundesbank’s orthodoxy. It also corrected the widespread misperception that the German central bank still wields a de facto veto power in the Eurotower, and that the ECB would therefore not be able to stop the euro area from breaking up.
Bernanke’s decision was just as bold because it abandoned the 30 year-long consensus among central bankers that had emerged from the turbulent nineteen seventies, also known as the age of stagflation. The FED effectively decided to ignore inflation, thus ignoring its dual mandate. The U.S. economy is now entering unchartered waters. Will the vulnerable U.S. engine manage to burn all the additional fuel provided by the FED or will it choke? Could it overheat? Nobody really knows.
Similar questions abound in Europe. Has Draghi really saved the euro or merely delayed the inevitable breakup that doomsayers have predicted for years now? Whatever the answers, there is no question that Draghi and Bernanke’s actions confirmed that once again 2012 was a year of central bankers. This spurred some commentators to point out that as long as central banks remain “the only game in town,” we will continue to live dangerously close to a precipice.
2012 was also the year when the combined effects of fiscal austerity and the financial fragmentation within the euro zone caused a severe credit crunch and made the recession in parts of Europe much harsher than previously anticipated. This forced the International Monetary Fund to reassess the impact of fiscal retrenchment on the real economy, what is known among economists as the fiscal multiplier. As a consequence, the IMF has begged Europe to go a little easier on austerity — so far to no avail.
For 2013 to be truly different from 2012, the banking system in Europe needs to get back on its feet and reduce its dependence (particularly in the periphery) on cheap ECB loans for its funding needs. Despite recent progress on that front, in its December Financial Stability Review the European Central Bank clearly stated what it is still worried about. According to the ECB, “a further deterioration in bank profitability and credit quality owing to a weak macro financial environment” coupled with “fragmented financial markets amplifying funding strains in countries under stress” still pose a serious risk going forward. In other words, despite the recent narrowing of spreads between yields of peripheral sovereign bonds and German bunds, lower interest rates on sovereign bonds have yet to translate into easier access to credit in most countries under stress. A prolonged credit crunch in already weakened economies is poison for businesses and for individuals who face liquidity shortfalls, need to refinance loans, or who want to make new investments. The longer austerity bites, the higher the percentage of non-performing loans. Banks might become even more reluctant to lend money to consumers and businesses. It is a vicious cycle. In order to repair banks’ balance sheets, peripheral economies need to start growing again, and soon. However, as long as credit is scarce, growth will remain elusive.
These challenges are particularly concerning in the case of the Spanish banking sector, which has been granted a total of 37 billion euros in fresh capital from the European Stability Mechanism (ESM). Spain is quickly becoming the biggest poster child for the German style European overhaul. While its financial sector still faces significant challenges, the seeds of a tentative recovery are starting to yield results. As labor per unit costs fall dramatically, the country is quickly regaining competitiveness. Spain is already experiencing a surge in exports and foreign direct investment. Spain is also quietly turning a large current account deficit into a surplus without devaluing its currency. It is through internal devaluation, often described by Keynesian economists as an almost impossible goal (because of the so-called wage stickiness as well as the slowness of the pace of adjustment), that the Spanish economy is regaining lost ground. However, if Spanish progress comes at the cost of other euro area economies — corporations might redirect planned investments from one country to another — Europe as a whole will not profit from Spanish developments.
Not surprisingly, Europe is now focused on becoming a giant current account surplus area. The goal is not merely for countries to regain competiveness within Europe, it is to become stronger globally. If growth in the euro area returns in the second half of 2013, as projected by the ECB, strains on the financial system would ease and Europe could even enter a virtuous cycle.
Nevertheless, a quick recovery mainly rests on two key assumptions: the improved health of the U.S. economy and a more robust growth in emerging economies, neither of which should be taken for granted. Add to the mix the effect of monetary easing (particularly in the U.S.) on exchange rates and things could turn sour very quickly. Europe can ill afford for its currency to appreciate substantially in the coming year.
Exchange rates matter. Given that the German consumer is not willing to come to the rescue of Europe’s periphery, southern Europeans will have to rely for the most part on non-European demand to spur their growth. While the periphery undergoes a painful adjustment, others (including, but not limited to, the U.S.) could wipe out any European competitive advantage by simply manipulating their currencies. Europe’s challenges could quickly turn into a Sisyphean task, like the Greek mythological figure condemned to roll a huge boulder up a hill, only to watch it roll back down. Avoiding that fate could very well end up being the biggest challenge for Europe’s economy.
On the political front, the two biggest hurdles are the Italian and German elections, for completely different reasons. The former has the biggest potential to disrupt not only Italy, but the whole of Europe. That is, however, only if the controversial billionaire Silvio Berlusconi returns to power. His announcement of a return to the political stage already had the effect of throwing a firework into euro area crisis management. The outcome of Germany’s election will not have an impact on the European crisis management. The effect of the political campaign will be felt before Germans even cast their vote, as the risk-averse German Chancellor is likely to become even more cautious. She will religiously stick to her slow step-by-step approach in addressing European challenges. Greece’s problems will probably make a come back, but only towards the end of the year. A majority of euro area countries will wait until then to resume their push to mutualize at least some parts of national sovereign debts. The German government will attempt to avoid facing these two problems for as long as it can.
Europe as a whole, following the make or break end of June summit in 2012, will probably continue to move at a steady, yet moderate pace towards the goal of a banking union, with significant progress already achieved on this front. In particular, the euro area will attempt to edge closer to tighter fiscal and political integration, which remains a much more elusive goal. Meanwhile, Ireland and Portugal will try to return fully to bond markets in 2013. It would be a huge symbolic success if they did (while also helping Merkel make her case to German voters), but no catastrophe if they did not.
The German Finance Minister, Wolfgang Schaeuble, is confident that in 2013 investors will finally give Europeans the benefit of the doubt and show more patience than in the past three years. He thinks that it will be the turn of other world trouble spots to draw speculators’ attention. But if things turn sour once again, guess who will intervene? It could be yet another year of the central banker.