Angela Merkel’s Moment of Truth
Joschka Fischer
FEB 25, 2015

Merkel Hollande crowd

BERLIN – In the last two weeks, the two crises confronting Europe – in Ukraine and Greece – both escalated. In each case, Germany and its chancellor, Angela Merkel, were at the heart of efforts to achieve a diplomatic resolution. This is a new role for Germany, and the country is not yet accustomed to it.
The latest attempt to halt the war in eastern Ukraine by diplomatic means had an even shorter shelf life than the first attempt last September. The new accord – concluded, like the previous one, in Minsk – de facto recognized that Ukraine has been split by military means. But just where the dividing line is remains unclear, because Russian President Vladimir Putin may yet attempt to capture the strategic Black Sea port of Mariupol, thereby enabling the Kremlin to create a land bridge between Russia and the Crimea peninsula. Moreover, capturing Mariupol would keep open the option of conquering southern Ukraine, including Odessa, and extending Russian control all the way to Transnistria, Russia's illegal enclave in Moldova.
Through the continued use of military force, Putin has achieved the main aim of Russia's policy: control over eastern Ukraine and ongoing destabilization of the country as a whole.

Indeed, Minsk II is merely a reflection of facts on the ground.
The question remains, however, whether it would have been smarter to let the one power that Putin takes seriously – the United States – conduct the negotiations. Given Putin's low regard for Europe, this will most likely become unavoidable, sooner or later.
Still, despite the risks involved, it is important that Germany and France, in coordination with the European Union and the US, undertook this diplomatic effort. Though the Minsk II initiative exposed Europe's meager political clout, it also confirmed the indispensability of Franco-German cooperation, as well as Germany's changed role within the EU.
Merkel herself reflects this changed role. Her ten years in power were largely characterized by a new German Biedermeier era. The sun was shining on Germany and its economy, and Merkel regarded it as her highest duty to maintain citizens' sense of wellbeing by not disturbing them with politics. But Germany's new significance in Europe has put a brutal end to Merkel's neo-Biedermeier era. She no longer defines her policies in terms of “small steps"; now she takes strategic threats seriously and confronts them head-on.
This is also true of the Greek crisis, in which Merkel – despite her public image in southern Europe – was not aligned with the hawks in her party and administration. Indeed, Merkel seems to be well aware of the unmanageable risks of a Greek exit from the euro – although it remains to be seen whether she can muster the determination to revise the failed austerity policy imposed on Greece.
Without such a revision aimed at boosting growth, Europe will remain alarmingly weak both internally and externally. Given Russia's attack on Ukraine, this is a dismal prospect, because internal weakness and external threats are directly linked.
Greece has also shown that the euro crisis is less a financial crisis than a sovereignty crisis. With the recent election of the anti-austerity Syriza party, Greek voters stood up against external control over their country by the “troika" (the European Commission, the European Central Bank, and the International Monetary Fund), Germany, or anyone else. Yet if Greece is to be saved from bankruptcy, it will have only foreign taxpayers' money to thank for it. And it will be nearly impossible to convince European taxpayers and governments to provide further billions of euros without verifiable guarantees and the necessary reforms.
The Greek conflict shows that Europe's monetary union is not working because one country's democratically legitimized sovereignty has run up against other countries' democratically legitimized sovereignty. Nation-states and a monetary union do not sit well together. But it is not hard to understand that, should “Grexit" occur, the only geopolitical winner would be Russia, whereas in Europe, everyone stands to lose.
Though the geopolitical risks have, so far, barely figured in the German debate, they greatly outweigh any domestic policy risks of finally coming clean with the German public. Greece, Germans should be told, will remain a eurozone member, and preserving the euro will require further steps toward integration, up to and including transfers and debt mutualization, provided that the appropriate institutions for this are established.
Such a step will require courage, but the alternatives – continuation of the eurozone crisis or a return to a system of nation-states – are far less attractive. (Germany has a new national-conservative party whose leaders' declared aim is to pursue a pre-1914 foreign policy.) In view of the dramatic global changes and the direct military threat to Europe posed by Putin's Russia, these alternatives are no alternative at all, and the Greek “problem" looks insignificant.
Merkel and French President François Hollande should seize the initiative once again and finally put the eurozone on a sound footing. Germany will have to loosen its beloved purse strings, and France will have to surrender some of its precious political sovereignty. The alternative is to stand by idly and watch Europe's nationalists become stronger, while the European integration project, despite six decades of success, staggers ever closer to the abyss.

How ‘patient’ is Yellen?

Gavyn Davies

Feb 24 06:00

When Federal Reserve chairwoman Janet Yellen gives evidence to the Senate Banking Committee on Tuesday, she has an opportunity to speak above the heads of the financial markets to Congress and the American people. There is pressure in the Senate to bring the Fed under Congressional “audit”, something that almost everyone in the central bank abhors. So Ms Yellen’s main message is likely to be about how well the Fed has done in recent years, focusing on the generally good out-turns for unemployment and inflation.

The markets, however, will probably ignore most of this important stuff. Instead, they will focus attention on something which is intrinsically unimportant for the economy as a whole — the likely date of lift-off for short-term interest rates.

The Fed’s Open Market Committee is often impatient about the markets’ obsession with this date, arguing that this is irrelevant compared to the Fed’s wider message on the intended path for interest rates over the next couple of years. But investors know that a lot of money can be lost by getting the lift-off date wrong. And, if the FOMC is so unconcerned about this minor detail, why do they focus so much attention on it in their regular meetings?

The Fed’s main message is that the lift-off date will be determined by data, with a raft of releases on inflation and the labour market likely to be weighed in the overall balance. But they have muddied this simple message by giving an unnecessary further piece of guidance that depends on the calendar, not on the data. Here it is, as it first appeared in December 2014:
As progress in achieving maximum employment and 2 per cent inflation continues, at some point it will become appropriate to begin reducing policy accommodation. But based on its current outlook, the Committee judges that it can be patient in doing so. In particular, the Committee considers it unlikely to begin the normalisation process for at least the next couple of meetings. This assessment, of course, is completely data dependent.
That was Ms Yellen’s opening statement in her press conference, fully scripted in advance. The key piece of code is the word “patient”. This gives the firm guidance that there will be at least two clear meetings without a rate rise, unless the data develop in some totally unforeseen manner. Note that this code is different from the 2004 use of the word “patience”, which referred to only one clear meeting, as proven when rates were actually raised in June 2004 (see Tim Duy).

The “patient” attitude was reaffirmed in the January FOMC meeting, which means that lift-off is very unlikely in the March or April meetings. That presents no problem, but if “patient” is left in the statement in March, that would rule out a rate rise in April or June, which is too long for the hawks to stomach. Therefore they want to remove “patient” next month (see James Bullard).

The doves, however, made it clear in the January FOMC minutes that they are worried about removing “patient” in March, because the “two meetings” rule would then be used to price in a rate rise in June, with almost complete certainty. The doves are not ready to go that far at present. Here are the January minutes:
Many participants regarded dropping the “patient” language in the statement, whenever that might occur, as risking a shift in market expectations for the beginning of policy firming toward an unduly narrow range of dates. As a result, some expressed the concern that financial markets might overreact, resulting in undesirably tight financial conditions. Participants discussed some possible communications by which they might further underscore the data dependency of their decision regarding when to tighten the stance of monetary policy.
This begins to sketch out a viable solution to the problem. The FOMC could drop the word “patient” in March, but spell out much more clearly that this does not set any fixed timetable for the first rate rise. So they would remove the “patient” language, but also remove the “two meetings” interpretation at the same time.

In doing this, they might point to the fact that Ms Yellen has always said “at least” two meetings. The markets have never paid any attention whatsoever to the phrase “at least”, but the Fed could forcibly remind them that the words have always had an important meaning. Ms Yellen would not be forced to eat her words, always an important advantage for a central banker.

Exactly what language the FOMC might use to ram this home is unclear, but the Fed’s wordsmiths are nothing if not inventive (as well as verbose on occasions). The upshot would be that the Fed would be opening an option to announce lift-off in June at the earliest, while also retaining the option to delay until a later meeting, if the data work out that way. That, I think, is the message they want to convey at present.

How would the markets react to this? By opening the possibility of a June lift-off, there would probably be a sell-off at the front end of the money market curve, but there would be some uncertainty, so the sell-off may not be huge. After the announcement, the front end would become very sensitive to future data releases. That is what the Fed wants, instead of an “unduly narrow range of dates” for lift-off.

It is not clear whether Ms Yellen will do any of this on Tuesday. She might well prefer to wait until her March press conference.

Does any of this make any sense? Tim Duy again: “If you think this is a dumb way to manage monetary policy, you are correct.”

Europe’s Chimerical Capital-Markets Union
Howard Davies
FEB 26, 2015

Europe castle hot air balloons

LONDON – The eurozone's survival is in doubt again, as Greece demands debt forgiveness and an end to austerity – or else. But, though Europe's currency union is at risk, and its banking union remains at an early stage of development, the endlessly creative European Commission is embarking on another adventure: a so-called “capital-markets union."
That “so-called" is appropriate, because the project, despite being only vaguely defined at this point, is most certainly not intended to create a single European capital market. Indeed, European Union leaders know better than to announce such an ambition, which would require a new treaty – no one is prepared to open up that can of worms. After all, European voters are in no mood to transfer more powers to Brussels.
The capital-markets union actually began as a slogan, coined by one of EU Commission President Jean-Claude Juncker's acolytes. Now, the new financial markets commissioner, the United Kingdom's Lord Jonathan Hill, has been assigned the unenviable task of putting flesh on bare bones. The Commission's “Green Paper" consultation round on the subject produced more questions than answers.
Think tanks, lobby groups, and national regulators have wasted no time in trying to influence Hill's efforts, and to head off any initiatives that might damage their interests. The Bank of England has argued that there should be no replication of the banking union grant of new powers to the European Central Bank at the expense of national central banks. The capital-markets union, the BOE argues, “does not require institutional change," so no super-regulator should be created.
The Commission has accepted that conclusion for now, though one of Hill's aides has suggested that, “at some point…supervisory issues will pop up." In fact, establishing a European version of the US Securities and Exchange Commission is a longstanding aim of the Brussels Eurocracy – one that may be achieved one day, but not just yet.
But before delving into institutional issues – a favorite topic of EU veterans – one should consider what problem the capital-markets union is supposed to solve. And here, there is considerable agreement.
Most regulators and market participants agree that Europe's financial markets are dysfunctional. With banking assets amounting to roughly 300% of EU-wide GDP, compared to some 70% in the United States, large pools of savings are being left unused.
Moreover, European companies receive an excessive 80% of their finance from banks and less than 20% from capital markets (the proportions are roughly reversed in the US). The need to redress that imbalance has become increasingly evident since the recent financial crisis, as banks' efforts to rebuild their capital bases (and meet stricter regulatory requirements) has led to credit rationing.
Loosening that constraint on output growth would improve the European economy's resilience, encourage risk-taking, and promote dynamism.
The overall aim of the capital-markets union is thus relatively straightforward. But achieving it is not – in no small part because Europe's heavy reliance on bank finance stems from structural and cultural factors. And the remedies that the Commission has suggested so far – for example, encouraging crowdfunding and standardizing the terms of securitization – appear unlikely to promote rapid growth in non-bank finance.
Promoting a pan-European private placement market might help, as would aligning standards for covered bonds. But both strategies would face serious legal obstacles.
Indeed, though Hill's modest initial agenda certainly would do no harm (and should be pursued as quickly as possible), any substantial measures beyond it would confront major roadblocks. For example, harmonizing insolvency regimes across the continent and reducing tax incentives that favor debt over equity, while entirely logical, strike at the heart of member states' remaining sovereignty, and thus will be extremely difficult to push forward. Some of the other ideas that Hill has floated, such as relaxing the capital standards for long-term investments, run counter to the EU solvency standards for insurers and pension funds that will be implemented next year.
Some old nags have also been dragged out of the stables for another run around the course.
“Streamlined" prospectuses and exemptions from some accounting standards for small companies have been tried before in individual countries – and have failed. Looser standards for issuers weaken protection for investors, and there is evidence that lax regulation of new issues may reduce investor demand for them, raising the cost of finance.
Unless the political mood changes radically in Europe – an unlikely development – it would be unrealistic to expect the capital-markets union to be anywhere near as transformational as the banking union has been. It will be, at best, a small disturbance, in which few national sacred cows are slaughtered.
What began as a slogan may turn out to be helpful. But a capital-markets union is highly unlikely to end Europe's love affair with its banks. The biggest impact on market structure will continue to come from ever-rising capital requirements, which will make bank credit more expensive and encourage borrowers to look elsewhere.


ECB Faces Struggle in Sourcing Enough Bonds for QE

Scant supply of top-rated government bonds poses challenge for asset-purchase program, say analysts

By Christopher Whittall

Updated Feb. 25, 2015 10:06 a.m. ET

 The European Central Bank’s headquarters in Frankfurt. The ECB plans to buy €60 billion of debt securities each month until September 2016, but some analysts and investors say it may struggle to find them. Photo: European Pressphoto Agency

The European Central Bank has pledged to buy hundreds of billions of euros of government bonds to help revive the eurozone economy. Now it will have to find them.

Analysts and investors are skeptical on its chances, though, given that many investors will be unwilling or unable to sell top-rated government bonds, particularly those belonging to Germany.

“It will be challenging for the ECB to source enough government bonds to meet its QE targets,” said Anthony O’Brien, co-head of European rates strategy at Morgan Stanley.

From next month, the ECB’s program of quantitative easing, or QE, involves buying €60 billion $68 billion) of debt securities each month until September 2016. Since late last year, the central bank has been buying around €13 billion of other assets a month, and analysts expect the difference—around €47 billion—to consist of government bonds.

Which government bonds the ECB buys depends on each country’s share of the European Union’s population and gross domestic product.

The problem is top-rated bonds are already in short supply—especially Germany’s, which make up the largest individual chunk of the program. German government debt, or bunds, will account for just over a quarter of the purchases, or around €12 billion each month.

But the German treasury says it expects to issue this year €147 billion of eligible bonds—those with maturities of two to 30 years—while €132 billion of bonds will mature, meaning net new bund issuance of just €15 billion for the whole year. Overall, the ECB’s plans mean it has to buy €215 billion of German government bonds between this March and September 2016—26 times more than the amount the German government bond market is predicted to grow over the same period, Morgan Stanley says.

This contrasts with the Federal Reserve’s multitrillion-dollar QE program, which was done against a backdrop of plentiful bond supply from the U.S. Treasury.

Peter Praet, the ECB’s chief economist, said the bank should be able to find enough investors willing to sell government bonds.

“We hear that pension funds and insurers don’t want to sell…But banks will probably rise to the bait,” Mr. Praet told Belgian weekly Trends in an interview released Wednesday.

“Institutions outside the eurozone also have large holdings of government bonds. They can sell too.”

The ECB could find that buying in-demand bunds from investors on the secondary market won’t be easy either. Investors have already sent yields on bunds tumbling. The yield on 10-year German government bonds is now 0.34%, compared with 1.69% a year ago. Yields fall as prices rise.

ECB President Mario Draghi has said the ECB would consider buying negative-yielding debt.

“There is already a huge shortage of German bonds in the market,” said Philipp de Cassan, head of euro core rates trading at Nomura. “We’re already seeing the symptoms of an ECB buying program.”

Central banks and financial institutions own by far the majority—around 90%—of the €1.1 trillion German government debt market. Banks and insurance companies favor these bonds because they help them meet regulatory capital requirements, while central banks also tend to hold bunds and other top-rated government bonds when building their foreign-exchange reserves.

“[European] passive investors and banks are unlikely to sell bunds in large size due to investment mandates and regulatory reasons,” said Cagdas Aksu, rates strategist at Barclays .
Anke Richter, head of European credit research at Conning, a U.S.-based asset manager with around $90 billion in assets, notes that some client portfolios will have guidelines dictating that government bonds must account for a certain proportion of their investments.

“The logical assumption is that everybody is going to sell and move into something else, but not everybody can do that,” she said.

Other investors may be reluctant to sell top-rated government bonds because there is a lack of appealing alternatives. Around a quarter of euro-area government debt now has negative yields, according to J.P. Morgan , meaning investors effectively pay to hold these assets.

Swapping bonds with positive coupons for investments with negative yields “doesn’t look like a very sensible move” for many investors, said Frances Hudson, global thematic strategist at Standard Life Investments, which handles £195 billion ($301 billion) in assets.

The ECB’s governing council has said it may have to be flexible when choosing what bonds to buy. It has also pledged to lend out the bonds it purchases to help the market function more smoothly.

Mr. O’Brien said the ECB could loosen a self-imposed restriction not to own more than 25% of any single bond, aimed at ensuring the central bank doesn’t hold a stake large enough to block a debt restructuring. It could also consider increasing purchases of bonds belonging to government agencies, such as German development bank KfW, instead of government debt.

Analysts note that the ECB will find it easier to buy other government bonds such as those belonging to Spain and Italy, which should make up 17% and 13% of the program, respectively.

Meanwhile, some investors say the ECB will find willing sellers at the right price.

“There is definitely a scarcity of safe assets, but a price will be found,” said Luke Bartholomew, an investment manager at Aberdeen Asset Management , which oversees £323 billion in funds.

Further demand for 10-year German government bonds will push yields even lower, Mr. Bartholomew said, which is exactly what the ECB wants to achieve to get more cash flowing around the system.

“I see no reason why Germany’s 10-year bond yield can’t be negative by the end of the year,” he said.

Managing the ISIS Crisis

Richard N. Haass

FEB 23, 2015

Kurdish fighter Sunni ISIS

NEW YORK – One day, historians will have their hands full debating the causes of the chaos now overtaking much of the Middle East. To what extent, they will ask, was it the inevitable result of deep flaws common to many of the region's societies and political systems, and to what extent did it stem from what outside countries chose to do (or not to do)?
But it is we who must deal with the reality and consequences of the region's current disorder. However we got to where we are in the Middle East, we are where we are, and where we are is a very bad place to be.
The stakes – human, economic, and strategic – are enormous. Hundreds of thousands have lost their lives; millions have been rendered homeless. Oil prices are low, but they will not remain so if Saudi Arabia experiences terrorist strikes or instability. The threat to the region is large and growing, and it menaces people everywhere, as extremist fighters return home and still others who never left are inspired to do terrible things. Indeed, though the Middle East is facing an abundance of challenges to its stability, none is as large, dangerous, and immediate as the Islamic State.
Those who object to calling the Islamic State a state have a point. In many ways, IS is a hybrid: part movement, part network, and part organization. Nor is it defined by geography. But it does control territory, boasts some 20,000 fighters, and, fueled by religious ideology, has an agenda.
Ultimately, of course, deciding whether to call what has emerged “ISIS" or “ISIL" or the “Islamic State" matters much less than deciding how to take it on. Any strategy must be realistic. Eliminating IS is not achievable in the foreseeable future; but weakening it is.
A strategy must also be comprehensive. First, the flow of money to the Islamic State must be reduced. Lower oil prices help, and there are only so many banks to rob. But extortion continues, as does financial support from individuals. Such flows should be shut down both by governments and financial institutions.
Curtailing the flow of recruits is even more essential. Countries can do more to make it difficult for individuals to leave for Iraq or Syria; a Europe-wide watch list, for example, would help. But nothing would have a greater impact than Turkey deciding that it will no longer allow itself to be a conduit, and that it will enforce United Nations Security Council Resolution 2178, which calls for stronger international cooperation against terrorism.
Another component of any strategy must be to counter IS's appeal and propaganda. This means publicizing the misery it has caused to those living under its rule. It also means persuading Muslim religious leaders and scholars to make the case that IS's behavior is illegitimate from the standpoint of Islam.
Of course, any strategy must challenge IS directly in Iraq and Syria. In Iraq, there is some evidence that its momentum has been halted; but the growing role of Iran and the Shia militias it backs all but guarantees that many Iraqi Sunnis will come to sympathize with or even support the Islamic State, whatever their misgivings. This is why outsiders should place greater emphasis on providing military and political support to Kurdish forces and Sunni tribes.
Syria is a far more difficult case, given its civil war and the competition among outsiders for influence. Attacks from the air on IS forces are necessary but insufficient. Because IS is a territorially based entity, there must be a ground dimension if the effort is to progress; after all, only ground forces can take and hold territory.
The best approach would be to create a multinational force consisting of soldiers from neighboring countries, particularly Jordan. The United States and other NATO countries could offer assistance, but the fight must be waged largely by other Sunnis. What is occurring in the region is a clash within a civilization; to enable IS to portray it as a conflict between civilizations – and itself as the true defender of Islam – would be a grave strategic mistake.
Moderate Syrian opposition forces and local Kurds could be part of such a multinational Sunni force, but they are not in a position to substitute for it. If such an expeditionary force cannot be formed, air attacks can be stepped up, thereby at least slowing IS and buying time to develop alternative strategies. Under such a scenario, IS would remain less a problem to be solved and more a situation to be managed.
Diplomacy cannot play a large role at this point. No solution can be imposed, given disagreements among the outside countries with a stake in Syria and the strength of both IS and the Syrian government. What diplomacy may be able to do is reduce, if not end, the fighting between the Syrian government and its own people, as the UN is attempting to do in Aleppo.
The biggest danger in 2015 may well be a widening of the regional crisis to Saudi Arabia and Jordan. Intelligence and military support for both countries will be essential, as will enhanced efforts to help Jordan shoulder its massive refugee burden. In this time of unprecedented turmoil in the Middle East, one of the region's basic rules still applies: No matter how bad the situation, it can always become worse.