Istanbul – To believe the headlines, Mario Draghi and the European Central Bank had saved the day earlier this month when they announced their unlimited short-term sovereign debt-buying program, which they boringly named outright monetary transactions (OTM). General commentary following the plan was positive, often noting the road ahead would be tough, but claiming stability was in sight.
And then violent protests broke out in Spain and Greece yesterday, thus shattering the false narrative.
There never was a future of stability, so perhaps it is just the smokescreen that has been pieced. And the failure for stability to take root isn’t because the ECB hasn’t done enough. The problem is that the ECB has been ignoring the source of the problem altogether.
Use of monetary machinations to create an allegedly easy path out of the crisis simply delays the need for markets to reallocate capital. Fiscal policy that favors populism over austerity simply delays the inevitable budget busting moment. As long as this mentality remains in Europe, yesterday’s protests won’t be the only source of instability in Europe’s financial future: the ECB itself could light the fuse.
The first sign that the financial market could wind up promoting its own undoing is the irony behind positive views on recent negative data. It turns out that bad news is good news for bankers… when bad news means cheap money dumped on the economy.
At least in the mind of the short-term thinking financier, bad economic data like collapsing business confidence in Germany is just greater cause for the ECB to dump Euros onto the financial sector. (Never mind that in the long-term the financial community will actually be hurt by the capital misallocation created by the central bank.) Even data suggesting the whole continent is descending into recession is “good news” because it just means more action from the ECB, which has clearly given away the game and decided to do whatever is necessary to preserve its own perceived order.
If this sounds ridiculous, just consider the reaction to August’s terrible employment report in the United States. A commonly heard refrain immediately afterward was “the good news about unemployment being so bad is now we are guaranteed to get QE3.” If you don’t remember, just go check the twitter feed of pretty much every one that regularly pontificates on economic policy. And the Federal Open Market Committee did not disappoint; instead announcing a QEnfinity-quantitative easing with no announced end date. The financial community was positively gleeful at that bad economic news, knowing they would capture nearly all of the short-term gains from more money being dumped by Easy Ben.
At a banker’s forum in Istanbul this week, many panelists representing financial institutions across Europe and the Middle East spoke with the relief of a parent recovering a lost child when praising the ECB’s early September OTM decision. The whole point of the OTM announcement was to create a tool to fight fires when bank runs or rising yields threaten a sovereign’s stability. The bond purchases will only come provided those nations meet certain fiscal reform standards. But there has yet to be much evidence that Spain, Italy, Greece, and Portugal can undertake substantial fiscal reforms over the long-term. The Greeks are in danger of missing their next round of bailout money because they are running a 20 billion euro deficit, and Spain’s prime minister has ruled out cutting any pension money.
This lack of responsibility could severely hurt the ECB’s credibility if, when it is time to buy bonds, the country in need is short on their fiscal reforms and the ECB has to consider expanding its definition of qualifying for a bailout. And since one of the top reasons a country might have to start paying more to borrow is its failure to meet fiscal goals, the program could prove worthless, or just be another smoke screen.
Further, if yields are rising on short-term sovereign debt, and the ECB moves to bring down those yields with large purchases even under its own terms, it will inherently be injecting instability into the market by distorting the market signals that risk is imminent.
The ECB’s bond buying announcement is also only a delay tactic, and not a solution to unsustainable government spending in Europe, nor banks pinned down under the weight of their bad debt. Perhaps just ending the short-term crisis is all some people care about, but making it cheaper for countries to borrow distracts from the need for more austerity and realignment of the European economy. If markets ultimately decide they don’t trust Italy, Spain, or Portugal to repay their debts, the ECB should not be artificially propping those countries up because the long-term damage and moral hazard created will be worse than any short-term economic losses from a sovereign default.
Rather than bringing real stability to the markets, the ECB’s decision actually underscores the massive instability in the European financial system – a system that could be shaken again at any moment.
It is clearer than ever that Greece is no lock to stay in the Euro. The present Greek government trying to enforce austerity is losing support, and new elections could hand the keys over to a party that wants to pull out of the Eurozone. It nearly happened this year, and that was before any serious austerity began to take hold.
Spain’s banks are far from being out of the woods, even with bailout promises (though don’t call it a bailout around the Spaniards). A continent-wide recession is likely to have many unknown consequences for the public and private sectors.
And don’t forget that just as the U.S. economy is impacted by changes in Europe, so too does our dismal economic state create a feedback loop towards the other side of the pond. And with weak third quarter corporate earnings reports expected in the U.S., along with a continuously weak labor market and potential fiscal drop off in 2013, any number of things could reflect back to Europe and trigger some substantial problem.
Right now all that Europe has in the way of hope for future economic and financial stability is a vague promise of some kind of new era of united fiscal responsibility, and tighter financial oversight. It is a good sign that German Chancellor Merkel is out there fighting for the painful reforms and tough budget polices. But if the failed states and institutions that created this instability remain the bedrock of the new system, ignoring any kind of fundamental reform, then instability appears to be the long-term outlook for Europe.
Anthony Randazzo is the Director of Economic Research at the Reason Foundation. He can be reached at anthony.randazzo@reason.org. This piece first appeared at RealClearMarkets.com.