The Eurozone Crisis and the Implications for the Global Economy and Financial Markets

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1 The Eurozone Crisis and the Implications for the Global Economy and Financial Markets Jacob Funk Kirkegaard, Peterson Institute IIB Annual Conference Washington, March 5 th 2012

2 1. The ECB To the Rescue 2. Understanding the Political Economy of the ECB 3. What Are the Downside Risks in the Euro Area Now? 4. Broader Implications From the Euro Area Crisis

3 The ECB To the Rescue Central Bank Balance Sheet Expansions Since August 15, 2011 (=100) ECB Federal Reserve BoE 144.6(est) Note: ECB balance sheet for Feb 29 assumed to have grown by 310bn over available Feb 22nd level of 2.7tr Aug-11 5-Oct Nov Jan Feb-12(est) Source: ECB, Federal Reserve, Bank of England

4 Understanding the Political Economy of the ECB The ECB is a fully political actor in Europe The ECB has consistently had three demands during this crisis: 1) Fiscal consolidation/tougher fiscal rules for the Euro Area 2) Structural economic reforms in the Euro Area periphery 3) A forward move (JCT s Quantum Leap ) in Euro Area institutional integration The ECB did not commit its balance sheet until Euro Area leaders had acted on these political demands 1) Only effective euro area crisis actor + unique institutional independence 2) Paramount concern is political moral hazard won t let the politicians off the hook 3) Main concern was never ending the crisis, but always ECB s political demands The ECB is easily the most powerful central bank in the world 1) Utterly unaccountable to any single democratic entity 2) Claims its mandate from the European people (e.g. headline inflation target) 3) Can in crises make explicit political demands of elected leaders

5 Downside Risks in the Euro Area The muddling through/weak growth scenario is prevailing and doomsday trades losing money Greece: 1) PSI bond swap is a non-event probably be coercive with CACs and CDS trigger 2) Private sector is now out of Greece, now a political/financial intra-euro Area issue 3) Risk is purely political; I. Greece unlikely to adhere to new IMF program Eventually IMF will leave II. Euro area will probably offer a 3 rd bailout to Greece Want full control in return III. Greece must choose between another bailout/loss of sovereignty or exit IV. Greece will not be kicked out, but allowed to leave if they want to V. 3 rd bailout inside euro area baseline/exit maybe 20% chance Ireland/Portugal 1) Will get more euro area money, if no market access 2) Referendum will probably bring forward financial support (NAMA notes) France: 1) France is the junior partner and Hollande cannot/will stop the Fiscal Treaty 2) Potential upside, as Hollande might be a French Gerhard Schröder

6 Broader Implications From the Euro Area Crisis General Government Gross Debt/GDP Ratio, Percent of Nominal GDP Source: IMF Fiscal Monitor Update Jan 2012

7 Broader Implications From the Euro Area Crisis To Achieve 60 percent Gross Debt Target by 2030, Change in CAPB Source: Author based on IMF GFSR September 2011 Data

8 G-7 Government Indebtedness Increases Volatility G-7 Governments Will Not Have the Fiscal Policy Levers They Used to 1. Ability of G-7 governments to engage in counter-cyclical fiscal policy is much lower than at any point since WW2 2. Gradual erosion of risk free status of G-7/OECD country sovereign debt will require lower equilibrium debt levels than before 3. Even modest credit risk associated with sovereign debt will greatly affect governments ability to act decisively (bailouts) in future economic crises 4. G-7/OECD fiscal policies will consequently generally become increasingly pro-cyclical

9 Broader Implications From the Euro Area Crisis Brinkmanship is Already Unfolding in Europe and in the U.S. Congress An operational definition of brinkmanship ; The political strategy of deliberately pushing a dangerous situation to the brink of disaster in order to compel the opponent into offering concessions Nobel Prize Winner Thomas Schelling in his 1966 classic Arms and Influence describes it as manipulating the shared risk of war. exploiting the danger that somebody may inadvertedly go over the brink, dragging the other with him

10 When things get really difficult... suddenly solutions which seemed impossible become possible Because of this, the crisis represents an opportunity.. Sometimes you need a little pressure for certain decisions to be taken Wolfgang Schäuble, German Finance Minister to Reuters, December 2011