Mountains to climb
August was a nerve-racking month for the world economy. September and October will be no better
Sep 3rd 2011 | JACKSON HOLE, WYOMING | from the print edition
CENTRAL bankers are not known for seeking solace in the heavens. But at their annual symposium in Jackson Hole, organised by the Federal Reserve Bank of Kansas City, the world’s leading monetary mavens could be found, after dinner, peering enthusiastically into telescopes set up by the local astronomy club. As he spied the M82 galaxy, 12m light-years away, one central banker remarked: “That puts our problems into perspective.”
On the ground, though, those problems are as big as ever. Christine Lagarde, the new managing director of the IMF, voiced a collective sentiment when she said the world economy found itself in a “dangerous new phase”. Things could get riskier still in the coming weeks.
In America, the worry is dashed expectations. The Federal Reserve’s policy-setting committee next meets on September 20th and 21st and has scheduled an extra day’s discussion on its arsenal of unconventional monetary weapons. Wall Street hopes it will mark the onset of “QE3”, another big bout of bond-buying. The mood in Jackson Hole suggested that any action will be modest and incremental.
Many central bankers, including Ben Bernanke, the Fed’s chairman, think it is time for fiscal policy to do more. He gave Congress a scolding at Jackson Hole, arguing that politicians need to address the medium-term fiscal mess while leaving room to cushion the economy now. Barack Obama is working on a jobs plan but the chances of a political rapprochement on issues like America’s payroll-tax cut, due to expire soon, remain uncertain. No deal implies sharply tighter fiscal policy.
Far more serious danger lies in Europe. Policymakers there put great faith in an agreement they struck on July 21st, which promised more money for Greece as well as more resources and a broader remit for the European Financial Stability Facility (EFSF). That expanded role is due to be ratified by euro-zone parliaments in the next few weeks. The European Central Bank (ECB) regards its recent decision to buy Spanish and Italian bonds as a stopgap until the expanded EFSF is up and running.
But three shadows hang over the EFSF. First, the political timetable for its ratification could slip. Potential causes include Finnish demands for collateral against its contribution to the Greek bail-out and a vote by Germany’s constitutional court, due on September 7th, on the legality of the rescue package (see table).
Second, there is growing confusion about what the revamped rescue fund should do. Europe’s central bankers are desperate for it to take over the bond-buying duties if markets stay skittish over Italy and Spain. Ms Lagarde is pushing another priority. She thinks Europe’s banks urgently need more capital to “cut the chains of contagion” and wants a mandatory recapitalisation, using public funds if necessary and the EFSF in particular. In effect, the IMF wants a repeat of what America’s Treasury did in 2008, when it bullied big banks into taking capital injections.
Many Europeans were furious at Ms Lagarde’s comments, denying any serious capital shortage and arguing instead that if there is a problem, it is one of attracting funding from skittish wholesale markets. Jean-Claude Trichet, the ECB’s president, tried to damp down even that concern, pointing out that banks could tap unlimited liquidity at the ECB and that they had ample collateral left to post in return.
Mr Trichet is right, but only up to a point. The sheer scale of European’ banks’ funding needs (about €1.7 trillion, or $2.5 trillion, in the next three years) is daunting: an idea from Morgan Stanley, to use the EFSF to offer European guarantees on new bank debt, has gained traction recently. And illiquidity is a symptom of concerns about solvency. So Ms Lagarde is right that strengthening banks’ buffers is important. The July stress tests, which did not allow for sovereign defaults, offer scant guidance. Using the market price of sovereign bonds, the IMF thinks that European banks could have unrecognised losses of €200 billion, meaning lots more capital would be needed. The EFSF is one sensible source.
The third and biggest reason to worry is that the EFSF is too small. The fund is being increased to €440 billion. But subtract the money already committed to bail-outs as well as the extra Greece might need if “voluntary” private debt-restructuring falls short (see article), and only around €200 billion may be left. At the ECB’s current pace of bond-buying (€6 billion-22 billion a week), that will not last long, especially if some is also set aside for banks.
European politicians are unlikely to cough up more, so much discussion behind the scenes is about how to lever up the rescue facility. Daniel Gros of the Centre for European Policy Studies and Thomas Mayer of Deutsche Bank think the EFSF should be registered as a bank and allowed to borrow from the ECB, using the government bonds it buys as collateral. That kind of arms-length arrangement, they argue, would be much better than having the ECB buy bonds itself, and would give the EFSF huge firepower. Conservative central bankers worry that it would still break the rule that bans direct purchases by the ECB, in spirit at least.
An alternative, quietly touted by some North American officials, is to tempt investors into buying bonds by giving them access to non-recourse loans from the ECB. The model is another American innovation from the financial crisis—the Term Asset-Backed Securities Loan Facility, or TALF. Soft loans from the Fed were designed to tempt investors into buying securities; the Treasury promised to take the first tranche of any losses, thus protecting the Fed. In a European version, cheap, non-recourse loans would encourage investors to buy Italian or Spanish bonds and bring down yields. The ECB would provide leverage, but any initial losses would be borne by the EFSF. The facility’s resources would be magnified, private investors would be drawn in and the price of bonds would still be set by the market.
Dusting off America’s crisis-management ideas makes sense: they were effective. But Europe’s task is far harder, not just because there are many more parties involved but because the end goal is so unclear. American officials were battling the temporary collapse of a financial system. European politicians need to create a new one, either with a more integrated fiscal union or a break-up of the current euro area. Without political leadership, the technocrats cannot solve the problem.