Even the World's Central Bankers Might Fail to Save Our Global Economy

By Mohamed A. El-Erian

Friday, 09 May 2014 09:55 AM

Three of the world's most respected central bankersU.S. Federal Reserve Chair Janet Yellen, European Central Bank President Mario Draghi, and departing Fed Governor Jeremy Stein offered this week a remarkably consistent view of the future: a better economic outlook and a clearer policy picture, but with some important elements still in doubt.

In both Europe and the U.S., economic growth is picking up, confidence is improving (albeit not universally) and financial markets are holding up very wellall despite geopolitical headwinds such as those coming from Ukraine.

The Fed is on a more confident course to end its extraordinary bond-buying program this year, and the ECB is feeling more comfortable about taking measures next month to counter excessively low inflation.

Nonetheless, the central bankers are far from relaxed. Draghi pointed out the risk that a longer-than-expected period of extremely low inflation, together with the excessive fragmentation of credit markets along national borders, will weigh on growth and job creation in the euro area.

Yellen noted that a slowing housing market could damp the recovery in the U.S. Both are aware of the risks associated with the threat of disruptions in energy supplies to central and western Europe.

In sum, it's still not certain that the U.S. and European economies will achieveliftoffany time soon, and it's not a good thing that central banks continue to carry the bulk of the policy burden on their own.

Nor is it possible to know where the current phase of range-bound economic activity will eventually take us, and what the central bankers' better-telegraphed intentions will ultimately achieve, despite talk of a “Great Moderation 2.0.

Over the medium term, there's roughly as much chance of success as there is of economic stagnation and renewed financial disruption.

Committed as they are to doing whatever it takes to achieve a desirable outcome, central bankers are not naïve about their policy limitations. They have fixed many malfunctioning segments of the financial markets. They have floored interest rates near zero and boldly engaged in aggressive bond-buying programs. They have also bravely ventured into the world of providingforward guidance” on their future policy moves.

But the impact of all this is far from certainparticularly when central bankers are shifting their stated goals from specific variables such as detailed calendar guidance or the unemployment rate to broader economic objectives, as is happening in the U.S., and doing so in quite an evolutionary and experimental manner.

Stein laid out the risks this week in a well-crafted speech in New York. He reminded us that the efforts of the policy-making Federal Open Market Committee “to overly manage the market volatility associated with our communications may ultimately be self-defeating.”

This should not be particularly surprising given “the fact that the market is not a single person, the fact that the committee is not a single person, and the delicate interplay between the committee and the market.”

In short, we should feel reassured that the most powerful central banks in the world remainall inwhen it comes to improving the global economic outlook. We should also be concerned that their best efforts might not be enough.

© Copyright 2014 Bloomberg News. All rights reserved.

‘If the euro falls, Europe falls’

How the euro was saved  

In the third part of a series, examines Angela Merkel’s deft political moves that led to the end of the crisis

In her hands: Barack Obama and Angela Merkel at Camp David in 2012

May 15, 2014 7:04 pm

As soon as Angela Merkel was handed the piece of paper Barack Obama had just passed around the table, her guard went up. What is this?” the German chancellor asked. “I haven’t seen this before.”

The US president characterised the paper as talking points he and his seven European counterparts in the room could rally around when the Group of 20 summit ended that afternoon in Los Cabos, Mexico.

Most of the items were concise recitations of what had been formally agreed. But the last point was something new, say officials who read the sheet: a full-scale endorsement of a plan that had only been informally shopped around the summit by the man sitting next to Ms MerkelMario Monti, the Italian prime minister.

The scheme, which Mr Monti and his closest advisers had been working on for months before the June 2012 summit, called for the European Central Bank to protect eurozone countries when they came under attack from financial markets by automatically buying their bonds.

Only virtuouscountries that obeyed the EU’s budget rules would be eligible. But the Monti plan would ensure borrowing costs, which for Italy and Spain were again rising to dangerous levels, would be capped.

“We wanted to develop something that would not be dangerous for the control of the money supply in Europe, would not be offensive to German purism, would help concretely moderate the [bond] spreads, but could be earned only as a reward for virtue,” Mr Monti told the Financial Times.

As she read the page, Ms Merkel’s anger rose. “She was absolutely livid,” said another person in the room. Although her objections were procedural, it was clear the Italian and US delegations had conspired to get her to endorse an ECB bond-buying scheme that would have fundamentally changed the way the eurozone fought the crisis.

Washington had been advocating an ECB-backedfirewall almost since the start of the crisis, arguing that the Federal Reserve had proved indispensable to quelling the US banking panic. Mr Monti was viewed by the White House as its strongest ally, particularly after Nicolas Sarkozy, the French president, lost a re-election bid a month earlier.

Mr Obama pushed Ms Merkel to embrace the understated Italian. In an intimate meeting over a picnic table on the patio of his Aspen Cabin at Camp David only weeks before Los Cabos, Mr Obama told her: “You need to work with him.”

In the face of Ms Merkel’s angry objections in Los Cabos, however, Mr Obama turned to his summit sherpa, White House international economics chief Michael Froman, to ask whether he had failed to share it with other delegations – a gesture many took as a graceful way to end the stand-off. When Mr Froman acknowledged the oversight, the discussion ended.

At the time, the bust-up appeared to be the latest in a series of failed efforts by Mr Obama and EU co-conspirators to push Ms Merkel into backing a larger firewall to shield besieged eurozone countries. The year before, he had teamed up with Mr Sarkozy at the G20 in Cannes; this time it was Mr Monti.

In retrospect, it marked the beginning of the final turning point in the crisis. Three months after the testy exchange, Ms Merkel would give her tacit endorsement to an equally ambitious bond-buying scheme designed by another Italian technocrat, ECB president Mario Draghi. This would end the existential crisis that had faced the euro for more than three years.

That planunveiled after ECB staff spent a furious summer constructing the system following Mr Draghi’s declaration he would dowhatever it takes” to ensure the euro’s survival – has long been hailed as the coup de grâce of the eurozone crisis.

Yet Mr Draghi’s programme was unlikely to have quelled markets without Ms Merkel’s acquiescence, which was given despite the public objections of the powerful German Bundesbank. This was the quiet political victory that proved to be the linchpin of the ECB’s success.

A year of evolving ideas

Those who spoke to Ms Merkel at the time said her reservations about Mr Monti’s scheme were rooted in her view of how the eurozone should work. It was not the role of politicians to set bond rates. The ECB deciding such a plan on its own, on the other hand, was an appropriate decision for an independent central bank to make.

But many officials, particularly those who worked with her team in other eurozone capitals, argued Ms Merkel’s ultimate embrace of Mr Draghi’s programme capped a year-long shift of thinking in Berlin. If Germany’s original vision of the eurozone no bailouts, no shared debts and, in some quarters, no Greece – was becoming unachievable, Berlin was going to ensure that shared burdens came with centralised control.

In December Ms Merkel won agreement for a “fiscal compactrequiring all eurozone countries to write the EU’s tough budget rules into national constitutions. And two weeks after the fight in Los Cabos she struck a deal that would mark the biggest shift in sovereignty since the euro’s creation: in exchange for allowing common eurozone funds to rescue failing European banks, oversight and liquidation of those institutions would move from national to EU control. In both initiatives, she found an energetic partner in Mr Draghi.

German officials insist Ms Merkel did not back these policies to clear the path for ECB action. Similarly, Mr Draghi never explicitly promised EU politicians he would act if they moved to shore themselves up first. “Have you ever heard two Jesuits talking to each other?” said a person who participated in meetings where Mr Draghi lobbied for government action. “You have to listen not to what they say, but to what they do not say.”

Some ECB officials who worked with Mr Draghi argue that securing Ms Merkel’s support for his bond-buying plan, formally known as “outright monetary transactions”, or OMT, was the result of a carefully orchestrated political cultivation of the chancellor.

“The real difference was his relationship with Merkel,” said a former ECB official who worked closely with Mr Draghi. “He knew that if one day something difficult had to be decided, he had to have her confidence.”

Senior officials close to both leaders acknowledge Mr Draghi was far more willing to engage with Ms Merkel and other political leaders than his predecessor, Jean-Claude Trichet, who was more likely to keep his deliberations to colleagues within the bank.

Mario Draghi was more willing to engage with Angela Merkel than his predecessor at the ECB

Without compromising the ECB’s independence, Mr Draghi worked informally with Ms Merkel, carefully testing what might be acceptable, while Mr Trichet had preferred formal settings such as EU summits, officials said.

But others insist a Draghi charm offensive is too simplistic to explain Ms Merkel’s embrace. Even Draghi critics within the German government dismiss talk of a deal between the two leaders. “It wasn’t a deal,” groused one. “We didn’t get anything in exchange.”

Instead, several officials said they believed Ms Merkel’s willingness to back OMT was a reflection of how deep the crisis had grown that summer. But more importantly, it was the final move of a two-step dance between political leaders and central bankers that was crucial at every important turning point in the crisis.

A crisis-fighting team

Since the start of the crisis, ECB firefighting power had been politically constrained by Germany. Mr Monti’s idea of the ECB buying bonds of struggling countries had long been seen as the solution to the crisis among policy makers from Washington to Paris. If the ECB made such a commitment, especially if it were unlimited, no bond trader would dare challenge its bottomless pockets. Panicked sell-offs could end overnight, advocates argued.

But many in Berlin saw such ECB action as improper. Buying eurozone bonds was, in essence, lending those governments money printed by the central bank, a practice known as “monetary financing”. That not only put off the day of reckoning for ministers tasked with balancing budgets, it could also spur inflation.

Mr Trichet had twice pulled the euro back from the brink when he agreed to purchase Greek bonds at the outset of the crisis in May 2010 and when he expanded the bond-buying programme to Italy and Spain in the turbulent summer of 2011.

Mario Monti called for the ECB to protect eurozone countries by automatically buying their bonds

But his plans were always described as limited. “It was a way for governments to buy time,” said Lorenzo Bini Smaghi, an ECB executive board member under Mr Trichet. “It was not something to save the euro.”

When Mr Draghi took the ECB helm in November 2011, the bank resembled a foreign outpost in enemy territory. The German public, never enthusiastic about bailouts, were outright hostile towards Mr Trichet’s bond-buying.

His efforts, formally known as the security markets programme or SMP, had been challenged in the German constitutional court and survived. But they also led to the resignation of Axel Weber, the Bundesbank chief. Mr Trichet’s decision in August 2011 to expand SMP to Spain and Italy also led to the loss of a second German who, until then, had kept his objections private: Jürgen Stark.

The lone German on the ECB executive board, Mr Stark had been uncomfortable with Mr Trichet’s approach but had refrained from public objections. “I was loyal maybe for too long to the ECB,” Mr Stark said. The day after the ECB board approved Italian and Spanish bond-buying, Mr Stark resigned. There was little doubt in Berlin who would be next in line: Jörg Asmussen, the shaven-headed economist who had been the finance ministry’s point man since the crisis began.

Almost uniquely among German officials, Mr Asmussen had maintained cordial ties across the eurozone despite complaints of German arrogance in the struggling south, which would need to approve the appointment. Those close to him say Mr Asmussen fretted over the job, since he knew he would ultimately face the same choice as Mr Stark and Mr Weber: agree with an ECB programme that was radioactive in his home country or resign.

Either you do what is right for Europe and they crucify you in Germany or you are the hero of the FAZ [the conservative Frankfurter Allgemeine Zeitung newspaper] and you ruin Europe,” he told a confidant.

When Mr Asmussen was announced as the German choice, French officials realised they needed a nominee who could work closely with a man they believed could give Mr Draghi the German cover needed to be more aggressive. They settled on Benoît Cœuré, an economist of Mr Asmussen’s generation and political affiliation who knew the German well.

Like Mr Draghi, who spent most of his government career as head of the Italian Treasury before heading the Bank of Italy, Mr Asmussen and Mr Cœuré were not traditional central bankers. Both rose to prominence in their respective finance ministries, where they became accustomed to the rough and tumble of politics. The tone in Frankfurt began to change.

Central bankers are very sensitive. If half a sentence in a newspaper is critical, they are completely offended,” said an official who knows all three men well. “When you come from the Treasury, you have this every single day . . . [All three were] used to much more public pressure and to a more dirty environment.”
The two pragmatists would become the core of Mr Draghi’s new crisis-fighting team, building bridges to Paris and Berlin in ways their predecessors could not.

The new team at the ECB

Draghi, Asmussen and Coeuré lobbied hard for approval for a new crisis-fighting scheme
Peacetime and wartime
Amid the chaos of two Greek elections that nearly led to “Grexit” and new fears about Spain’s banks, panic returned to bond markets in May. Bankiacreated by merging Spanish savings banks brought low by the bursting of the housing bubblewent bust itself, requiring partial nationalisation. Concern spread to the health of all European banks.

Mr Draghi knew the ECB had to do more. By early June, he began discussing with a small circle of confidants, including Mr Asmussen and Mr Cœuré, the need for a new crisis-fighting programme, officials say.

Word of Mr Monti’s plan reached ECB officials before he presented it in Los Cabos but they deemed it unworkable. As they began to discuss their own blueprint, the central bankers in Frankfurt knew any new bond-buying plan would cause political problems for Mr Asmussen. He shared the economic worldview of Mr Stark and Mr Weber but believed an extreme crisis required extraordinary measures.

People try to violate principles every day. You have to resist it 99 per cent [of the time] and say, ‘this is not the extraordinary situation’,” Mr Asmussen said. “You have peacetime and then you have wartime. In peacetime, I’m on the Bundesbank line but the situation was very different.”

Evidence was mounting that wartime had arrived. Companies were making contingency plans for a euro break-up. Eurozone banks were holding day-to-day cash in far-flung subsidiaries – an expensive policy but one that would protect them if the euro split apart. Italian and Spanish borrowing costs soared.

At the ECB, discussions about how to stop the panic intensified. But even those close to Mr Draghi were taken by surprise when, at the end of July, he said the ECB would do whatever it takes” to prevent euro break-up.

Jens Weidmann, Bundesbank president, was left isolated in opposition to the plan

His words had an immediate calming effect on the markets. Now ECB officials had to develop a policy to back it upone that would pass muster where it faced its biggest challenge: Germany.

In Frankfurt, Mr Draghi’s allies worked furiously to peel off opponents to the plan, tweaking provisions in a bid to win over conservatives on the ECB governing council, including Mr Asmussen and the Dutch and Finnish central bank chiefs. Once they had succeeded, Jens Weidmann, the Bundesbank’s president, was isolated in opposition.

By now, Ms Merkel was secure in her belief that allowing the euro to fall apart would be far too dangerous. Gaining her approval for the ECB plan would come down to something she had argued for all along: in exchange for aid, struggling countries had to agree to economic reforms. That “conditionalityhad to be thorough and legally binding.

When Mr Draghi unveiled the final version of his plan in September, the political winds had shifted in Berlin. Having secured her banking union, Ms Merkel gave the Draghi plan her public blessing. Speaking the day after Mr Draghi’s announcement, she highlighted the prerequisite of economic reform. “Conditionality is a very important point,” she said. “Control and help . . . go hand in hand.”

10-year government bond yields

The day she spoke, Italian 10-year bonds yields closed below 5.1 per cent for the first time in five months. Spain’s fell below 6 per cent for the first time in four months. Those levels would not be reached again.

Europe’s debt crisis was over.

Two years on, it is clear the frantic, improvised actions of the final year of the crisis saved the euro. Yet the eurozone is far from full health. Debt levels in Europe’s south are extreme.

Unemployment remains near historic highs, a side effect of the bitter medicine imposed by the crisis-fighters. Anti-EU parties may be the beneficiary of the fallout in next week’s European elections
But the 15-year-old currency union passed its most important test: in its darkest hour, its leaders did whatever it took to hold it together. And no one mattered more than Angela Merkel, raised in east Germany, chancellor of a united Germany and, thanks in part to the crisis, Europe’s most powerful leader.
“I have chosen for Europe and the euro, and thus for Greece,” Ms Merkel said near the end of the crisis. If the euro falls, then Europe falls.”

Read parts one and two of the series