The ECB has sometimes appeared to define itself in opposition to the Fed, and after the onset of the “made in the USA” subprime crisis many European politicians and policymakers have been particularly keen to distance themselves from their US counterparts. Lately, the ECB seems to have set its sights higher: its latest rhetoric sounds like a direct contradiction to US President Obama’s “Yes, we can” message. 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.
I do not believe that we will see a sovereign default in the eurozone, and I do not believe the eurozone will break up. This crisis, however, has cruelly exposed the vulnerabilities of a common currency area that is still a work in progress. 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, as I argued in my last note, 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 widening of spreads on eurozone sovereign bond markets is in my view exaggerated. Part of the widening reflects a return to a more appropriate pricing of fundamentals, but this has been exacerbated by the current excessive degree of risk aversion. Spreads will eventually drop well below current levels. They will not narrow, however, as long as financing concerns dominate and guide financial markets’ assessment of sovereigns, corporates, and financial institutions—in the near term, spreads will likely widen further.
The widening of spreads is meanwhile providing a powerful marketdriven disciplining device for governments, forcing them to adopt a more cautious fiscal stance—a long-term desirable effect, even though it’s been triggered at the worst possible time.
