Tim Duy's Fed Watch

Quick Euro Update

Mostly quiet on the Euro front today, but there are some bits and pieces worth chewing over.  To recap, ECB President Mario Draghi raised expectations that a big plan was in the works to save the Euro.  In short, Draghi's commitment to do everything necessary to save the Euro was interpretted to mean that the ECB was prepared to act as a lender of last resort to bring down yields in struggling periphery nations.

There is an alternative explanation.  Draghi was simply making some off-the-cuff remarks, saying things he thought he largely said before, and not intending to illicit the subsequent market response.  If so, market participants may be set up for a phenomenal dissapointment this week.

With that in mind, Spiegel says that Draghi dropped a bomb on other ECB members:

It was an illustrious meeting that British Prime Minister David Cameron was hosting on the evening before the opening of the Olympic Games in London...

...It was meant to be a day of glamour, but then Mario Draghi, the president of the European Central Bank (ECB), made a seemingly trivial remark -- but one that ensured that the 200 prominent guests were swiftly brought back to gloomy reality. His organization, he promised, would do "whatever it takes to preserve the euro."

The audience treated the remark as just another platitude coming from a politician. But International financial traders understood it as an announcement that the ECB was about to buy up Italian and Spanish government bonds in a big way. So they did what they always do when central banks suggest they might soon be firing up the money-printing presses: They clicked on the "buy" button...

...Meanwhile, experts at the central banks of the euro zone's 17 member states had no idea what to do with the news. Draghi's remark was not the result of any resolutions, and even members of the ECB Governing Council admitted that they had heard nothing of such plans until then.

This doesn't sound like Draghi has much time to build a concensus.  Interestingly, Spiegel claims that the pressure on Draghi is becoming unbearable:

A deep-seated feeling of mistrust has taken hold at Frankfurt's Eurotower, the ECB's headquarters, and even Draghi, who is normally seen as the epitome of level-headedness among central bankers, has recently shown signs of nervousness. At a dinner in early July, the ECB chief and his fellow governors were discussing the question of whether the ECB's loans to Ireland's government-owned "bad bank" were consistent with the bank's current bylaws.

It was a debate among experts, like many before it, but then something unusual happened: Draghi raised his voice. Such questions, he snapped at his opponents, could not always be discussed in exclusively legal terms...

...The ECB president has become thin-skinned and easily irritated by criticism, especially when it comes from Germany.

Sounds like ECB is coming apart at the seems, much like Europe itself.  The story that Draghi was interested in downplaying "legal concerns" is particularly interesting.  It suggests that he increasingly does not believe he can save the Euro in the context of strict interpretations of the ECB's mandate.

As far as the timing of any action, I caught this in a Reuters report:

Both the ECB and the Fed are set to meet this week. The Fed will start a two-day meeting on Tuesday, with many economists believing the central bank will wait until September to provide more stimulus to a faltering U.S. economic recovery. The ECB's policy-setting meeting on Thursday is receiving more of the markets' attention after the bank's chief, Mario Draghi, pledged last week to do everything to save the euro. 

But translating his words into action are particularly important given the threat the long-running euro zone crisis poses to the global economy.

Bold action by the ECB is at least five weeks away, insiders told Reuters.

I would really appreciate a little expansion on that last line.  The longer timeline would not be surprising if the Spiegel report is correct and Draghi failed to build consensus before he spoke.

Finally, on the issue of convertibility and default risk, Joseph Cotterill at FT Alphaville says:

The ECB could now see a risk to its monetary policy — conducted in euros — from market pricing of peripheral bonds which assumes they won’t eventually be paid back in euros. And it could now act on this risk. However it might do this and with whatever facilities, it feels conceptually different to the actions which the market largely expects, which are versions of credit easing or liquidity for sovereign debt (the SMP).

FT Alphaville sees this as more about convertibility than default risk, different than I suggested yesterday.  I think though that we both agree this may be crucial to understanding Draghi's policy intentions.  Cotterill also cites research on quantifying this risk, and thus what the ECB is prepared to do.  maybe less than the market expects.  I think following FT Alphaville on this subject (and many more, of course) is well worth the time.

Bottom Line:  Seems like a lot of uncertainty heading into this ECB meeting, despite financial market participant's understandably crystal-clear interpretation of Draghi's now famous remarks.

Summer

Diamond Peak while fishing for kokanee in Crescent Lake:

Kids running for cold mountain waters:

The Euromess Continues

Excitement is almost guaranteed this week, with both the Federal Reserve and the European Central Bank pondering their next moves.  At the moment, I am more fascinated with the latter, as it represents the more fast moving policy failure for the moment.  In response to that disaster to date, it is now widely expected that the ECB will deliver a significant policy expansion, possibly accepting its responsibility of lender of last resort for sovereign debt in the Eurozone.  I think it is widely believed that this will be the turning point in Europe.  In some ways, yes, as it would keep the threat of imminent dissolution at bay.  But the Eurozone will still be fundamentally hobbled by a devotion to re-balancing via austerity-driven internal devaluation.  This does not offer a promising long-run outcome.

The sequence of events of last week is becoming clearer.  Last Monday, Spanish Economy Minister Luis de Guindos met with his German counterpart.  Initial reports indicated no new initiatives were in the works.  Subsequent reports suggest otherwise.  Friday we learned, via Reuters:

Spain has at last conceded it may need a state bailout and policymakers are considering writing down Greek debt to their central banks, European officials said on Friday, as markets anticipated radical new action to pull the continent out of its debt maelstrom...

...A euro zone official said Economy Minister Luis de Guindos had brought up the prospect of a 300 billion euro bailout this week at a meeting with Germany's Finance Minister Wolfgang Schaeuble. The official spoke on condition of anonymity because he was not authorized to brief

"De Guindos was talking about 300 billion euros for a full program, but Germany was not comfortable with the idea of a bailout now," the official said.

He said the question would be put off until the euro zone's new, permanent bailout fund, the European Stability Mechanism, is up and running. He also said that Germany appeared to be softening its opposition to giving the ESM a banking license, which would allow it to borrow money and deploy more firepower if called upon to rescue an economy as big as Spain's.

So it sounds like de Guindos went to Schaeble with hat in hand, only to be told that at best Spain would need to wait its turn.  Meanwhile, market participants, sensing Spain is teetering on the brink, were pummeling the nation's stock and bond markets, sending yields soaring, thus ensuring a bailout was necessary (Interesting aside - at what interest rate does Spain not need a bailout, and would that rate become an ECB target?  Sounds like a good project for an investment bank research team.)  ECB President Mario Draghi, smelling disaster in the wind, breaks down and delivers some now famous remarks in London, including this line:

To the extent that the size of these sovereign premia hampers the functioning of the monetary policy transmission channel, they come within our mandate.

This indicates Draghi has finally found away around the mandate prohibiting monetizing sovereign debt, laying out the justification for bond purchases as necessary to implement appropriate monetary policy.  This generates a massive global relief rally, as everyone and their brother, expect of course apparently everyone at the ECB, knows that only the ECB has the firepower to stop the repeated cycle of panic endured by Europe.  It seems like a real, promising plan is in the works. Via Bloomberg:

Draghi’s proposal involves Europe’s rescue funds buying government bonds on the primary market, flanked by ECB purchases on the secondary market to ensure transmission of its record low interest rates, the officials said. Further ECB rate cuts and long-term loans to banks are also up for discussion, one of the officials said.

I don't think Draghi has publicly stated this as a proposal, but instead reporters have pieced this together from contacts within the Eurozone.  In any event, to the extent that their exists any substantial opposition to such a plan, that opposition rests with - caution, spoiler alert! - Germany.  But you guessed that already, didn't you?  Via Reuters:

Germany's Finance Minister dismissed reports Spain is about to ask the euro zone bailout fund to purchase its bonds, and talked down fears about its spiralling borrowing costs in an interview with Welt am Sonntag newspaper made available on Saturday.

"Spain's financing needs in the short-term are not so high. High interest rates are painful and they create a lot of uncertainty, but it is not the end of the world, if you have to pay a few percent more at a few bond auctions," Wolfgang Schaeuble said.

Asked if there was any truth to speculation that Spain would shortly ask the euro zone rescue fund for help via buying its bonds, Schaeuble answered: "No. There is nothing to these speculations."

And from the FT:

Germany’s powerful Bundesbank issued a reminder that it still opposed sovereign bond purchases by the European Central Bank, dampening market optimism after ECB president Mario Draghi hinted he could act more decisively in the eurozone debt crisis.

This, I think, is the state of play heading into Monday morning. Basically, Spain is in all-liklihood on the brink of disaster, threatening to drag the rest of the Eurozone with it, Draghi sees this and has made some very, very big promises to deliver imminent action to keep the ship afloat, but he may face internal resistance that necessitates watering down his plans.  

Now, at what levels will such a plan work?  The short-game here is pretty obvious.  It is tough to bet against Spanish or Italian debt if you think the ECB is set to cap borrowing rates.  Now think about the long-game.  Does it, by itself or in concert with other plans floated in Europe, put the Eurozone economy on firm footing?  In my opinion, no.  To understand why, one needs to read the full text of Draghi's market-moving remarks.  

I struggled with the remarks, and was happy to see that I was not alone.  Paul Krugman describes them as strange.  I found them downright incomprehensible.

Draghi begins with the analogy that Europe is like a bumblebee.  No one believes it should be able to fly, but it did.  Then people stopped asking the question of why it should be able to fly until the financial crisis.  Now the job is too restore confidence in the Eurozone so that is become a bee, which everyone believes flies.

No, it is not an easy analogy to decipher.  But the bottom line seems to be this:  There is not anything fundamentally wrong in the Eurozone that prevents a fully functioning economy, it is only a crisis of confidence.  

It's not me, it's you.

Draghi then starts the comparisons:

The first message I would like to send, is that the euro is much, much stronger, the euro area is much, much stronger than people acknowledge today. Not only if you look over the last 10 years but also if you look at it now, you see that as far as inflation, employment, productivity, the euro area has done either like or better than US or Japan.

I wish he would quantify these comparisons. Putting that aside, as well as the low bar of Japan and the US in the midst of the most significant economic downturn since the great Depression, Draghi does not seem to realize the importance of capital flows from the core to the periphery.  If you don't understand this, you don't understand you need a full on reversal of these flows to keep the Eurozone economy flying.  See Paul Krugman.

Not understanding internal capital flows.  Strike one for Draghi. He continues:

Then the comparison becomes even more dramatic when we come to deficit and debt. The euro area has much lower deficit, much lower debt than these two countries. And also not less important, it has a balanced current account, no deficits, but it also has a degree of social cohesion that you wouldn’t find either in the other two countries.

So many things wrong here, beginning with the obvious morality play:  Debt and deficits are bad, and therefore the Eurozone is stronger than the US or Japan.  Again, he fails to recognize the importance of the internal divergence in debt and current account deficits is a driving factor in this crisis.  Or, more accurately, that the Eurozone economies are too disparate to function under a single monetary policy.  

I don't even know what to say about the social cohesion story.  Granted, it has been a decade since closely followed Japan, but, really, Europe has more social cohesion than Japan?  The combination of morality play, focusing on the aggregate rather than lack of economic cohesion among the underlying desegregate, and the bizarre appeal to social cohesion is strike two for Draghi.

Draghi anticipates my criticism:

The second point, the second message I would like to send today, is that progress has been extraordinary in the last six months. If you compare today the euro area member states with six months ago, you will see that the world is entirely different today, and for the better.

And this progress has taken different shapes. At national level, because of course, while I was saying, while I was glorifying the merits of the euro, you were thinking “but that’s an average!”, and “in fact countries diverge so much within the euro area, that averages are not representative any longer, when the variance is so big”.

But I would say that over the last six months, this average, well the variances tend to decrease and countries tend to converge much more than they have done in many years - both at national level, in countries like Portugal, Ireland and countries that are not in the programme, like Spain and Italy.

So now you are on pins and needles.  What exactly is he talking about?  What convergence?  Convergence to Ireland's unemployment rate?  The answer:

The progress in undertaking deficit control, structural reforms has been remarkable. And they will have to continue to do so. But the pace has been set and all the signals that we get is that they don’t relent, stop reforming themselves. It’s a complex process because for many years, very little was done – I will come to this in a moment.

No problem with convergence of structual reforms, although I sense he expects a more rapid positive economic response than is reasonable.  More important is his focus on deficit convergence.  This persistent belief in expansionary austerity will remain the Achilles heal in any European forecast.  It guarantees the public sector will continue to deleverage as the private sector deleverages.  This is a long-term negative for the Eurozone.  

Failure to recognize the the negative weigh of austerity.  Strike four.  More:

But a lot of progress has been done at supranational level. That’s why I always say that the last summit was a real success. The last summit was a real success because for the first time in many years, all the leaders of the 27 countries of Europe, including UK etc., said that the only way out of this present crisis is to have more Europe, not less Europe.

A Europe that is founded on four building blocks: a fiscal union, a financial union, an economic union and a political union. These blocks, in two words – we can continue discussing this later – mean that much more of what is national sovereignty is going to be exercised at supranational level, that common fiscal rules will bind government actions on the fiscal side.

Then in the banking union or financial markets union, we will have one supervisor for the whole euro area. And to show that there is full determination to move ahead and these are not just empty words, the European Commission will present a proposal for the supervisor in early September. So in a month. And I think I can say that works are quite advanced in this direction.

Failure to understand that "fiscal union" in the European context is an "austerity union," not the supernational agency with broad tax and transfer powers that represents a real "fiscal union."  Strike five.  Failure to understand that the time it takes for Europe to reach a decision is vastly different than the speed at which markets react.  Strike six.

Draghi than appeals to the permanence of the Euro:

But the third point I want to make is in a sense more political.

When people talk about the fragility of the euro and the increasing fragility of the euro, and perhaps the crisis of the euro, very often non-euro area member states or leaders, underestimate the amount of political capital that is being invested in the euro.

And so we view this, and I do not think we are unbiased observers, we think the euro is irreversible. And it’s not an empty word now, because I preceded saying exactly what actions have been made, are being made to make it irreversible.

I find this hilarious because it seems to me that the most vocal advocate of the idea that the Eurozone is not permanent is the force behind the Euro, the Germans, who so frequently voice the opinion that Greece is a lost cause.  But I don't think it should be a strike against Draghi; he really sees the project is irreversible, which speaks, in theory, to his willingness to ultimately embrace the role of the ECB as a lender of last resort.  With that in mind:

Within our mandate, the ECB is ready to do whatever it takes to preserve the euro. And believe me, it will be enough.

The "within our mandate" condition is strike seven.  The 2% inflation target is another factor that will be a weight on the European economy.  See Paul Krugman.  Draghi continues:

There are some short-term challenges, to say the least. The short-term challenges in our view relate mostly to the financial fragmentation that has taken place in the euro area. Investors retreated within their national boundaries. The interbank market is not functioning. It is only functioning very little within each country by the way, but it is certainly not functioning across countries.

And I think the key strategy point here is that if we want to get out of this crisis, we have to repair this financial fragmentation.

There are at least two dimensions to this. The interbank market is not functioning, because for any bank in the world the current liquidity regulations make - to lend to other banks or borrow from other banks - a money losing proposition. So the first reason is that regulation has to be recalibrated completely.

The second point is in a sense a collective action problem: because national supervisors, looking at the crisis, have asked their banks, the banks under their supervision, to withdraw their activities within national boundaries. And they ring fenced liquidity positions so liquidity can’t flow, even across the same holding group because the financial sector supervisors are saying “no”.

So even though each one of them may be right, collectively they have been wrong. And this situation will have to be overcome of course.

I see the financial fragmentation as a longer-run challenge.  Indeed, this is really the factor that is preventing the effective transmission of monetary policy, not the interest rate on Spanish debt.  And the history of financial crisis is that you cannot simply flip a switch and normal lending activity will resume.  Moreover, ECB actions have almost certainly aggravated the challenges.  Tying the banks to sovereign debt via the LTRO funding and then failing to serve as a lender of last resort to eliminate default risk certainly didn't do the banks any favors.  More to the point, the ECB encouraged the financial fragmentation by letting the crisis fester to this point and not recognizing the lack of social and economic cohesion in the Eurozone (see above). If the collective action was wrong, it was because the individual actions were reacting to poor ECB policy. 

Failure to understand their role in perpetuating the crisis.  Strike nine.

And then there is a risk aversion factor. Risk aversion has to do with counterparty risk. Now to the extent that I think my counterparty is going to default, I am not going to lend to this counterparty. But it can be because it is short of funding. And I think we took care of that with the two big LTROs where we injected half a trillion of net liquidity into the euro area banks. We took care of that.

Then you have the counterparty recess related to the perception that my counterparty can fail because of lack of capital. We can do little about that.

Then there’s another dimension to this that has to do with the premia that are being charged on sovereign states borrowings. These premia have to do, as I said, with default, with liquidity, but they also have to do more and more with convertibility, with the risk of convertibility. Now to the extent that these premia do not have to do with factors inherent to my counterparty - they come into our mandate. They come within our remit.

I am going to focus on the sovereign debt issue.  Draghi breaks it into two parts, default and convertibility.  Presumably, convertibility is the risk that Euro-denominated debt will be converted into debt denominated in a revived national currency.  He seems to be saying that that can deal with the convertibility risk because it represents the willingess of investors to believe the Euro is not permanent.  But is is permanent, he just said so.  But I don't think it is the convertibility issue is at play.  I think that investors genuinely fear default, and that such default will be driven by the ECB's failure to serve as lender of last resort.  So that Spanish default is possible even if Spain remains in the ECB.  Much like Greek default was possible.  

I think the commitment to serving as lender of last resort might be different than commitment to the Euro alone.  In other words, what Draghi is thinking of delivering may fall short of what markets are expecting at this point.  Which would be consistent with European policy to date, and with the tone of Draghi's remarks - policymakers always think they are taking big steps, but they are so far behind the curve market participants see baby steps at best.

Draghi needs to deliver big this week.  If Draghi overpromised, possible strike ten.

Bottom Line: Yes, I am a Euroskeptic, so feel free to take my comments with a grain of salt.  Discount as appropiate.  But when I read Draghi's remarks, I see a policymaker in denial, not wanting to understand the root causes of the crisis.  Thus he sees the crisis in terms of simply lack of confidence rather than one with important fundamental factors.  Moreover, he is trapped by the austerity framework, not seeing that this is a failing strategy.  I don't think he sees the ECB's complicity in supporting the crisis.  And I think Draghi is representative of the average policymaker in Europe.  Which leaves me still convinced that Europe's future is either Depression or continued recession/stagnation.  The ECB can prevent the former, but lacking a complete overhaul of the implications of protracted fiscal austerity and a "fiscal union" the cements such austerity in place, coupled with a serverely damaged financial system, I am challenged to see how the latter can be overcome.

Draghi Blinks. Maybe.

Global equity markets surged this today on the back of supportive comments from ECB President Mario Draghi.  Borrowing from FT Alphaville, who borrowed from Bloomberg:

Draghi Says the Euro Is Irreversible

Draghi says ECB will do whatever needed to preserve the euro – Draghi Says ECB Ready to Do ‘Whatever It Takes’ to Preserve Euro

*DRAGHI: YIELDS DISRUPTING POLICY TRANSMISSION ARE IN ECB REMIT

*DRAGHI SAYS ECB WILL DO WHATEVER NEEDED TO PRESERVE THE EURO

*DRAGHI SAYS `BELIEVE ME, IT WILL BE ENOUGH’

*DRAGHI SAYS THE ECB IS READY TO DO WHATEVER IT TAKES FOR EURO

*DRAGHI SAYS THE EURO IS IRREVERSIBLE

*DRAGHI SAYS DON’T UNDERESTIMATE POLITICAL CAPITAL IN THE EU…

*DRAGHI SAYS FIREWALLS `READY TO WORK MUCH BETTER THAN IN P…

Draghi Says Euro-Area Much Stronger Than People Acknowledge

*DRAGHI SAYS LAST SUMMIT WAS `REAL SUCCESS’

It looks like Draghi finally found that panic button.  This is crucial, as the ECB is the only institution that can bring sufficient firepower to the table in a timely fashion.  His specific reference to the disruption in policy transmission appears to be a clear signal that the ECB will resume purchases of periphery debt, presumably that of Spain and possibly Italy.  The ECB will - rightly, in my opinion - justify the purchases as easing financial conditions not monetizing deficit spending.

So far, so good.  But there is enough in these statements to leave me very unsettled.  First, the claim that the Euro is "irreversible" should send a shiver down everyone's backs.  Sounds just a little too much like "the crisis is contained to subprime" and "Spain will not need a bailout."  Second, the bluster that "believe me, it will be enough" is suspect.  The ECB always thinks they have done enough, but so far this has not been the case.  Moreover, he is setting some pretty high expectations, and had better be prepared to meet them with something more than half-hearted bond purchases.  

Also, note that despite Draghi's bluster, the rally in Spanish debt send yields just barely below the 7% mark.  A step in the right direction, but also a signal that investors still worry that Spain will need a bailout despite additional ECB action.  

More distressing to me was Draghi's clearly defiant tone, reminiscent of comments earlier this week from German Finance Minister Wolfgang Schäuble.The message is that Europe has done all the right things, it is financial market participants that are doing the wrong things.  What we have here is a failure to communicate.  European leaders believe they have made remarkable progress in the context of the political realities they face, and want credit for that expended "political capital."  Financial markets are saying the the progress politicians see as "remarkable" barely moves the needle compared to what is necessary to resolve the crisis. 

The classic breakup line is "it's not you, it's me."  It is a classic line because everyone knows it's a lie.  I suppose at least Draghi is living up to the lie, essentially saying that "it's not me, it's you."  European policy makers simply will not accept what financial markets are telling them.  As a consequence, Draghi doesn't act until is back is against the wall, they engage in some half-hearted program, conditions ease temporarily, and then the ECB drifts back into the woodwork, claiming they have done all they can do.  Lather, rinse, repeat.  Why should we believe this time is any different?

As to the claims of Euro-area strength, Izabella Kaminska has this to say:

The second thing we think is interesting is Draghi’s point that the euro area is much stronger than people realise. This *we think* is very encouraging indeed. And whilst many might disagree, we actually don’t think it’s a bluff at all. Not only does it tie very much with Draghi’s previous comments about how well Ireland is doing, it suggests Draghi feels the market may be over focusing on the wrong metrics.  Or, in other words, that there may be other economic gauges that are much more reflective of what’s really going on.

I don't usually disagree with the FT Alphaville staff, but I disagree on this point.  I don't find it encouraging at all.  I think it is exactly the kind of delusion that leads to spectacular policy failure.  I can't wait for the ECB to pull out the statistics that explain exactly how we don't get it.  I want to see the explanation of how this reflects the strength of the European economy:

 

Call me crazy, but I get a little disconcerted when unemployment rates exceed 11%.  And, is it just me, or isn't the gap between the Eurozone and EU27 rates increasing, suggesting that being a member of the Eurozone is on net a negative?

And what about the lasting impact of this crisis?  I get unnerved by the structural damage due to Washington's acceptance of 8+% unemployment rates in the US. That is absolutely trivial compared to Europe.  Spain is at 24.6%, with a a youth unemployment rate of 52.1%.  We called this a Great Depression in the 1930's, not a sign of strength. Greece was at 21.9% in March.  France and Italy are in the double digit range.  And the "remarkable" Ireland has an unemployment rate at 14.6%.  Simply put, the mindless pursuit of fiscal consolidation is scarring a generation of workers, perhaps irrevocably.  There will be a cost that offsets the benefits of the structural change European leaders seem intent on pursuing in the absence of fiscal stimulus.

Also, how much damage is being done to the European financial system?  Gillian Tett reports on the fracturing of banking along national boundaries:

The bankers, however, were alarmingly precise: amid all the speculation about Grexit, they told me, banks are increasingly reordering their European exposure along national lines, in terms of asset-liability matching (ALM), just in case the region splits apart. Thus, if a bank has loans to Spanish borrowers, say, it is trying to cover these with funding from Spain, rather than from Germany. Similarly, when it comes to hedging derivatives and foreign exchange deals, or measuring their risk, Italian counterparties are treated differently from Finnish counterparties, say.

The halcyon days of banks looking on the eurozone as a single currency bloc are over; cross-border risk matters. To put it another way, while pundits engage in an abstract debate about a possible break-up, fracture has already arrived for many banks’ risk management departments, at least when it comes to ALM in their eurozone books.

The way this is heading is toward a continent with limited cross-border capital flows with a fiscal policy regime that limits members ability to use fiscal policy, all under a single monetary policy.  This is a recipe for long-term recession, not economic strength.  And it is also a system that will become increasingly susceptible to asymmetric shocks.

Finally, note that we are well past the point where just bringing down interest rates in peripherial economies is enough to turn the ship around.  The 10-year UK bond yield stands at 1.48% today.  And despite low rates, the UK economy continues to struggle:

The UK’s double-dip recession has deepened sharply and unexpectedly, leaving the economy smaller than it was when the coalition government took office two years ago....

...critics of Mr Osborne’s austerity programme, which aims to eliminate the structural current deficit in five years, said the data showed his efforts were self-defeating.

“As we warned two years ago, David Cameron and George Osborne’s ill-judged plan has turned Britain’s recovery into a flatlining economy and now a deep and deepening recession,” said Ed Balls, shadow chancellor for the Labour party.

In short, it's not just about interest rates.  

Bottom Line:  Draghi has his back up against the wall, and is now forced to step back into the crisis.  A near-term positive, to be sure.  It might be a longer-term positive if the ECB would commit to an open-ended purchase program based on macroeconomic objectives (sound familar?).  But that is likely too much to ask, as he has yet to admit that the entire policy approach is failing the Eurozone, not just in the short-run, but in the long-run as well. Until policymakers fundamentally rethink their approach to the crisis, expect the optimisim-pessimism cycle to continue.  Right now, the best case scenario I see is that the ECB will act to hold the Eurozone largely together, but at the cost of protracted recession.  

Why Europe Matters to the US

Last month I identified this error in the logic of St. Louis Federal Reserve President James Bullard:

Bullard also dismisses financial market distress as an artifact of the European crisis: 

The global problems are clearly being driven by continued turmoil in Europe. 

China might be a bigger driver than we realize, but I digress.  Given that this is a European problem, the Fed is helpless:

 A change in U.S. monetary policy at this juncture will not alter the situation in Europe.

This is one of those things that makes you shake your head in the wonder of it all.  The point of further easing would not be to alter the situation in Europe - THE POINT IS TO PREVENT THE SITUATION IN EUROPE FROM WASHING UP ON US SHORES.

Via today's Wall Street Journal:

Europe's deepening economic crisis is cutting into corporate earnings, with the continent's woes threatening to exert a drag on multinational corporations around the world into next year...

...The corporate alarm bells highlight how the miserable economic conditions in much of Europe are spilling onto the global stage. With much of Europe in recession and unemployment soaring, spending is sliding on everything from big-ticket items like cars to everyday staples like yogurt...

...Companies also are growing concerned about 2013 as government austerity measures eat into sales. The Ifo Institute survey of business sentiment released on Wednesday shows business confidence in Germany, Europe's largest economy, falling to its lowest level in over two years.

And note the trend in capital goods orders:

Flat growth year-over-year.  Not necessarily a recession, but a clear warning sign as well.  It is starting to look like firms satisfied their pent-up demand and don't see the underlying growth that justifies further spending.  And clearly Europe is only aggravating that situation.  

The recent softness in manufacturing is a warning sign that usually prompts Fed easing.  That might be next week, or next month - there remains considerable uncertainty on the timing of their next move.  But one thing is looking more certain day by day:  The Fed should have been hitting their own panic button six weeks ago when it became clear their forecasts were well off the mark.  

Asked and Answered

Yesterday I asked:

In my view, the lack of panic is downright scary.  Is Europe completely devoid of new ideas?  Or is everyone simply on vacation?

The former might be true, but Bloomberg confirmed the latter is definitely true:

German Finance Minister Wolfgang Schaeuble declared bond traders all wrong in driving up Spanish borrowing costs to unsustainable levels.

After issuing the statement late yesterday, Schaeuble, 69, went off duty for a three-week vacation.

It’s summertime in Europe, and like last year, borrowing costs are rising as investors fret over the fate of the 17- nation euro area. Most government leaders are heading to their favorite beaches, mountains and lakes to take a break from a crisis that U.S. Treasury Secretary Timothy Geithner said July 23 requires “immediate, short-term” measures to help Spain and Italy.

This upshot of the article is that, like last summer, leadership will be hard to come by in Europe for the next month.  

Is There Even a Panic Button in Europe?

I didn't think it was possible, but my confidence in the ability of European policymakers to pull the Continent out of crisis continues to fall.  This is saying a lot because I had virtually no confidence to begin with.

Consider where we are at today.  Greece once again is making the headlines, as it is increasingly evident that they have made virtually no progress on the last bailout package, and will therefore need another.  This should have come as no surprise; it was increasingly politically impossible to engage in additional austerity with the Greek economy plummeting into the abyss.  But bailout fatigue will finally hit this time, as there appears to be no more appetite to limp Greece along.  Evan Ambrose-Pritchard argues that Germany is leading the drive to finally force Greece out of the Eurozone.  Ambrose rightly places at least some, if not the lion's share, of the blame for this outcome at the feet of the Troika:

This was entirely predictable – and was predicted by many critics – since Greece faced an IMF-style austerity package without the usual IMF cure of devaluation. The Troika's ideology of "expansionary fiscal contraction" – which the IMF has to its credit since abjured, but the fanatics in charge still swear by – is breaking a whole society on the wheel.

The Greeks were never given a bailout plan that had any hope of success.  And they deserved such a bailout, given the rest of Europe's culpability in this crisis for letting Greece into the Euro in the first place.

Whether or not Greece can be forced from the Euro with little impact elsewhere remains to be seen.  I doubt we will need to wait much longer to learn the outcome of Grexit.  But the devastating train that is the debt crisis keeps rolling right along, currently crashing through Spain's economy.

And make no mistake, European policymakers have learned nothing from the Greek experience.  One gets the sense that policymakers think the prescription was correct, but that the patient was simply unwilling to take the medicine.  Where Greece failed, Spain will succeed, or at least so it is hoped.  Indeed, today Spanish Finance Minister Luis de Guindos met with his German counterpart, and the FT reports:

Germany on Tuesday threw its considerable weight behind the reform and austerity programme of the Spanish government, in the face of a continuing surge in the cost of borrowing for Madrid, and strong protests against its spending cuts.

 Spain is doing the right thing, apparently.  It's just the markets that have it all wrong:

A joint statement by Wolfgang Schäuble, German finance minister, and Luis de Guindos, Spanish economy minister, condemned the high interest rates demanded for the sale of Spanish bonds as failing to reflect “the fundamentals of the Spanish economy, its growth potential and the sustainability of its public debt”.

The truth is exactly the opposite - market participants have looked at Spain's fiscal and economic situation, including the issue of provincial bailouts, and concluded that another sovereign bailout is coming, complete with private sector involvement.  The "voluntary" kind of involvement, of course.  And in return for this bailout, Spain will be pushed further down the same path of never ending recession as Greece.  Because if once you don't succeed, try, try again.  European policymakers will pursue the same path because they know of no other:

But after talks in Berlin last night on the eurozone crisis, the two gave no hint of any new initiatives to try to calm the markets, or prevent contagion from Spain affecting any other members of the eurozone, such as Italy.

This comes as Spanish 10 year yields hit 7.62% and the Italian equivalent lurches up to 6.60%.  And unbelievably, the ECB is apparently out of the game, no longer willing to buy sovereign debt either to avoid being a victim of "public sector bailout" or because they believe that restrictions against monetizing the debt of member states trump imminent financial collapse.  Meanwhile, the crisis is increasingly bleeding through to the supposedly immune German economy, with the Markit PMI continuing to fall.  The deeper Europe slides into recession, the harder it will be to find solutions. 

And it is already almost near impossible to find solutions, a fact proved by the seemingly pointless European summits that always seem to come too late and offer too little.

Yet despite what is obviously clear and present danger to the Eurozone project, and, more importantly than the project, but to the economy on which millions depend for their livelihood, there doesn't seem to be any panic in official circles.  No sense that policies need to be fundamentally reassessed.  No sense that time is of the essence.  No one is even bothering to leak unsubstantiated and false rumors of some "Grand Plan" in the works.

In my view, the lack of panic is downright scary.  Is Europe completely devoid of new ideas?  Or is everyone simply on vacation?

Bottom Line: Still a Euroskeptic, and an increasingly pessimistic one at that.  I really, really want to believe that Europe will quickly coalesce around a solution to the crisis, and I hope to see a move in that direction soon.  At a minimum, the ECB should throw in the towel and backstop sovereign debt.  But all I see are the same failed policies again and again.  Worse, no one is running for the panic button.  Maybe there isn't a panic button;  I guess it was another piece of the necessary institutional framework forgotten during the creation of the Euro.

A Missing Ingredient

Ryan Avent makes a good point about San Francisco Federal Reserve President John Williams' recent FT interview.  

Avent is less impressed than me on Williams' conversion to open-ended QE as a policy tool because it by itself does not communicate a willingness to allow inflation to exceed 2%.  I think that Avent is on the right path.  While Williams did make what I think is a big step, he could go one step further and not only call for open-ended QE, but to do so in the context of Chicago President Charles Evans' suggestion for explicitly tolerating inflation up to 3%.  That said, I also think this is too much to hope for, as I haven't seen any indication that Williams would be willing to deviate from the 2% target.

Also, you can interpret open-ended QE as a higher possibility that the Federal Reserve will not be able to pull-back the increase in the money supply, thus one could expect higher inflation in the future.  And by leaving the program as open-ended, you remove the uncertainty created by arbitrary end dates and purchase amounts.  So I do think that Williams is making a significant shift in the right direction.  But I agree with Avent that a clear communication of tolerance for higher inflation would be even more effective.

Ultimately, I think the Federal Reserve made a huge policy error in committing to an explicit 2% inflation target.  I think policymakers were under the impression that such a commitment would give them more flexibility by removing concerns that QE would be inflationary.  In reality, I think it had the opposite effect - it eliminated a policy tool, thereby reducing their flexibility.  And that commitment stands as a barrier to Evans' suggested policy path.  I think the rest of the Fed would loathe accepting inflation as high as 3% given they just committed to 2% at the beginning of this year.  In doubt, they would view such backtracking as a threat to their much-cherished credibility.

Interestingly, they don't see Treasury rates below 1.4% as a threat to their credibility.  They really should.

John Williams Gets It

Better late than never.  San Francisco Federal Reserve President John Williams continues to make the case for another round of quantitative easing in an interview with Robin Harding at the Financial Times.  I came away from the article with five takeaways:

1.) There will be little progress in the labor market in the absence of additional policy.  Not surprising, given that the Fed's forecasts were never exactly exciting to begin with, and the recent weakness in the data flow is leading economists to downgrade Q2 growth to the 1% range, putting even the Fed's anemic forecasts into jeopardy.  

2.) Williams believes the Fed should shift the focus to mortgage backed securities:

 “There’s a lot more you can buy without interfering with market function and you maybe get a little more bang for the buck,” he said.

He sees MBS as an avenue around the potentially disruptive effects of additional Treasury purchases, acknowledging one of the concerns about additional QE.  

3.) Importantly, Williams realizes that the arbitrary end-dates for policy actions are disruptive and counterproductive.  Instead, he argues for open-ended purchases:

“The main benefit from my point of view is it will get the markets to stop focusing on the terminal date [when a programme of purchases ends] and also focusing on, ‘Oh, are they going to do QE3?’” he said. Instead, markets would adjust their expectation of Fed purchases as economic conditions changed.

This is a big step, and, in my opinion, this is exactly where the Fed needs to go.  Shift the focus from the policy itself to the macroeconomic outcomes the policy is trying to achieve.  After two years of stop-start policy, Williams gets it. 

4.)  Eliminating interest on reserves is pretty much off the table.  I never thought the Fed was too excited about the this option.

5.) Despite delivering a strong argument for QE, Williams himself is not convinced the FOMC will follow his lead:

But he declined to call directly for a Fed move. “I think the argument against further action is the question of uncertainty around the effects, the costs and the benefits of doing so,” he said.

This uncertainty was evident in the minutes of the last FOMC meeting, as well as Federal Reserve Chairman Ben Bernanke's trip to Capitol Hill last week.  While I would like to think that his generally dour outlook was in and of itself a signal that he was prepared to ease further, he made clear that QE was not the only option on the table.  As quoted by the FT:

“We haven’t really come to a specific choice at this point, but we are looking for ways to address the weakness in the economy should more action be needed to promote a sustained recovery in the labour market.”

This makes me think that there is not broad support at the FOMC for additional QE, or, what I increasingly think is likely, that Bernanke himself is sufficiently uncertain about the impact of additional QE that he would prefer to find another tool, perhaps with the idea of reserving QE for a more dire situation.  If Bernanke wanted to push the FOMC in the direction of QE, he could have done it well before now.  Thus, the fact that such internal uncertainty remains about what the Fed would do next reveals something about his preferences.

Bottom Line:  Williams again telegraphs his belief that the Fed should engage in additional quantitative easing, and makes a big step in calling for an open-ended program.  It is not, however, clear the Bernanke has come to the same conclusion.  It's really Bernanke, not the Fed hawks, that has been the impediment to further easing.

Thanks to CR for spotting this article tonight. 

Travel

I have been silent the last few days.  A stack of work built up while I was on vacation, and I have a heavy travel schedule during the first full week back.  Driving all over the state is seems with trips to Bend, Salem, and Pendleton.  I haven't been to Pendleton in a long, long time, so I am looking forward to the drive.  Unfortunately, too early for the round-up. 

Things will clear up in the next couple days and I can get back to a regular schedule by next week.