Speeches by Bernanke and Trichet at the ECB’s Central Banking Conference today grabbed most of the attention, but developments on the eurozone’ periphery seem of far greater import. Most importantly, the fact that the EU is stonewalling IMF proposals to extend the duration of loans extended to Greece is troubling. It is becoming obvious that unless repayment obligations are smoothed more evenly, Greece will not be able to make it even if it meets all the program targets. Refusing to consider an extension virtually guarantees that Greece will not regain market access, and therefore makes no logical sense if the objective is to restore debt sustainability. Meanwhile, negotiations on a comprehensive IMF/EU program with Ireland have barely started, and we already have a fight on the corporate tax rate, seen in Dublin as the cornerstone of Ireland’s long-term growth strategy and a potent symbol of sovereignty—leaving the unfortunate impression that some EU countries might be mostly concerned with seizing the opportunity to push for greater harmonization of tax policy. Overall, this unfortunately confirms that EU politics might become the greatest source of volatility in the eurozone’s financial markets, and the biggest obstacle to the normalization of the ECB’s monetary policy.
Bernanke mounted a vigorous defense of QE2 and an equally forceful counterattack on China and other emerging markets. His argument can be summarized as follows. First, with weak growth, stubbornly high unemployment and declining core inflation, further stimulus is appropriate, and given evidence that QE1 worked, there is a strong case for QE2 (although Bernanke notes that quantitative easing refers to targeted increases in bank reserves, and is therefore a misnomer for the Fed’s securities purchases). Second, emerging markets which keep their exchange rates undervalued are fuelling market expectations of future appreciation, and thereby attracting capital inflows: they should not blame the Fed for this. Third, this pursuit of export-driven growth by emerging markets creates a number of inefficiencies and policy challenges and ultimately, by preventing some rebalancing of growth towards advanced economies, makes the global recovery more fragile and less sustainable. Conclusion: while recognizing that an early shift to flexible exchange rates is not feasible for all countries, Bernanke argues that current account surplus countries should still try to bolster domestic demand to help this rebalancing.
I find Bernanke’s argument not fully convincing — although he is right in arguing that everybody should start now to work towards rebalancing. There is no doubt that a more balanced global growth is desirable, and that while US consumers carry out the needed deleveraging, global growth depends more on overall demand in other countries. However, Bernanke recognizes that “the internal rebalancing associated with exchange rate appreciation-that is, the shifting of resources and productive capacity from production for external markets to production for the domestic markets— takes time”, which sounds closer to China’s position, and suggests that the US should not expect significant quick help from this rebalancing in any case. Moreover, while there is no doubt that expected exchange rate appreciation is an important attractor of capital flows, it seems equally clear that the Fed’s policy of increasing the overall amount of liquidity in the global financial system while depressing yields on US assets also plays a major role in determining both the size and direction of capital flows.
Bernanke stressed the role of emerging markets and of managed exchange rates, which would seem to leave the eurozone off the hook, as the euro floats freely. However, if we transpose the same arguments to within the eurozone, the reference to Germany is obvious: with artificially fixed intra-eurozone exchange rates accompanied by major current account imbalances, Bernanke’s argument implies that Germany should boost domestic demand.
Trichet reiterated very explicitly that the ECB could well decide to hike interest rates while keeping some of the non-standard liquidity measures in place. It seems increasingly likely that they will indeed do so late next year.
In my view, however, hiking the Refi rate while maintaining exceptional liquidity provisions would be an awkward way of hiding two inconvenient truths: First, that widening structural divergences across countries make a single monetary policy more and more difficult to run; and second, that the overall monetary policy stance remains hostage to localized troubles in the banking sector and the sovereign bond markets. With growth at potential and inflation slowly normalizing towards the 2% target, the ECB should in theory be moving faster to reduce liquidity provisions and then raise rates. But full allotment liquidity provisions are still needed to cushion the financial sector from the ongoing debt crisis at the periphery, and thereby insulate the real economy from the shock.
Troubles at the periphery risk getting worse rather than better. The arrival of an IMF team in Dublin might be bringing some relief, but this is unlikely to last long—after all, investors already knew the script, given the Greek precedent and the fact that the EFSF is in place.
Going forward, volatility is likely to increase, for at least three connected reasons. First, as long as discussions on debt restructuring remain unresolved, IMF/EU programs can only offer limited relief—again Greece is a case in point; Second, EU politics are injecting additional sources of conflicts: it is remarkable that when discussions on an comprehensive program with Ireland have barely started, other EU countries have already picked a fight on the Irish corporate tax rate, which is seen in Dublin as the cornerstone of Ireland’s long-term growth strategy and therefore also a symbol of sovereignty. The inevitable impression is that some EU countries are more concerned with seizing the opportunity to push for greater harmonization of tax policy rather than with stabilizing the situation. Third, and most importantly, the fact that the EU seems to be stonewalling IMF proposals to extend the duration of loans extended to Greece is troubling. It is becoming more and more obvious that unless repayment obligations are smoothed more evenly, Greece will not be able to make it even if it meets all the program targets. Refusing to consider an extension virtually guarantees that Greece will not regain market access, and therefore makes no logical sense unless the objective is to push the country to default. It is understandable that extending the terms of the loans is a difficult political decision for the creditor countries, but it would not be an unreasonable step if Greece continues to keep its part of the bargain, and keeping the door open on this would reduce the risk of further market instability. Overall, this unfortunately confirms that EU politics might be the biggest obstacle to stabilization in the eurozone’s financial markets, and to the normalization of the ECB’s monetary policy.
