30 augustus 2011
Austerity Is Not EnoughArticle Introduction

By: PIMCO’s Andrew Balls

In the run-up to the Jackson Hole meetings over the weekend, it was no surprise that all eyes were on central banks.

They have demonstrated in recent years that they can act swiftly and decisively when they choose to. While eurozone governments have failed to maintain a united front to deal with a sovereign debt crisis, and American politicians have concocted their own budget crisis, central bankers have retained the moral and operational high ground.

Yet, given the problems of growth in the United States, and of growth, solvency and the coherence of the eurozone, there is a limit to what central banks can do.

Ben Bernanke, who said little new in his speech on Friday, suggested that the Federal Reserve was close to the limit of what it could do to try to promote stronger growth in the US. It is not obvious that further quantitative easing would help. The situation is different in the eurozone, where the European Central Bank has huge potential, if it is willing, to stabilise the bond markets of Italy and Spain. The ECB can be powerful in promoting market normalisation, but it has far less ability to promote broader economic outcomes.

That Mr Bernanke deferred further discussion until after the Fed’s September meeting may reflect a lack of consensus on how to proceed when it met this month. It may also be that the Fed is waiting to see what President Obama says in his economic address scheduled for September 5. The President has the opportunity to lay out a clear agenda of structural policies to promote growth, including policies aimed at the housing and labour markets.

The ECB is in a different position.

It has engaged in only partial quantitative easing and, although it has provided a great deal of liquidity support in Europe, it has been cautious in using its balance sheet to buy government bonds and other assets outright — especially when compared with the Fed or the Bank of England. After the earlier rather incoherent interventions in the government bonds of Greece, Ireland and Portugal, the ECB has embarked on what looks like a more credible policy of buying Italian and Spanish government bonds, apparently trying to maintain a ceiling measured at 5 per cent or so on ten-year bonds.

Yet a huge amount of uncertainty remains about the strength of its commitment, not least after past U-turns. The ECB was clearly reluctant to start buying Italian and Spanish government bonds and the Bundesbank was and remains a vocal critic of the approach. A large part of the reason relates to the need for a more credible division of labour within the eurozone’s fiscal authorities.

At their July summit, eurozone governments signalled a more decisive approach, including a clear sign that they would separate efforts to deal with the solvency problems facing Greece and, quite likely, Ireland and Portugal from the bigger and more important effort to build a firebreak between those three small troubled countries and Italy, Spain and the European banking system.

Italy and Spain have suffered more from technical contagion, given the eurozone’s inability to ring-fence the three small countries than an abrupt reassessment of their fundamentals.

The contagion has had an impact on the banking system and France, at the core of the eurozone. This is something that the aggressive use of the ECB balance sheet can address.

As has become wearyingly familiar over the past two years, the eurozone’s fiscal policymakers, having taken a step or two forward, subsequently have taken a step or two back.

There are important challenges of policy design and effectiveness. Most of all, there are huge question marks over political commitment and the ability of eurozone governments to overcome co-ordination problems.

The ECB has kept Italian and Spanish government spreads stable but elsewhere, across financial markets, eurozone governments have contributed to market turmoil.

Eurozone governments must do their part as a matter of urgency. The menu is fairly clear and it includes controlled fiscal adjustment, common bond issuance or cross-border guarantees, deeper fiscal integration and structural reforms to promote growth.

Austerity alone is not enough. The best use for the European Financial Stability Facility is probably to provide loans for the purpose of recapitalising banks in peripheral countries and, perhaps, in core countries alike. It does not look like a credible vehicle for intervening in secondary government bond markets.

The ECB can be a bridge, but a fiscal solution is required for stability. Given the extent of the challenges, it makes sense for investors to remain cautious on the threats facing the eurozone and the global systemic implications.

The planned Greek default need not be the cause of European and global systemic crisis, nor the challenges of Ireland and Portugal. If the eurozone’s policymakers, fiscal and monetary alike, allow the problems in Italy, Spain, France and the banking system to spiral out of control, however, that is a very different matter.

In his Jackson Hole speech, Mr Bernanke said: “The quality of policymaking in the United States will heavily influence the nation’s longer-term prospects.”

That judgment is true in spades in the eurozone.