The ECB’s Battle With the Markets: Home Truths from the Eurozone

Amid an equity rout, tensions have resurfaced in Eurozone markets. Economists generally think that markets reflect fundamentals. But sometimes, it is the other way around. Whatever triggered serious market turmoil in the first place, the turmoil itself can create new facts.

And if these sentiments are headline-grabbing enough, then they can – and will – further dent economic confidence in Europe. Business investment as well as some consumer spending will decline for a while. The transmission mechanism is simple: Uncertainty begets uncertainty.

But such self-reinforcing dynamics usually do not run for long. The less scary – or less spectacular – reality usually prevails again after a while.

Fundamentals and sentiments

What about Europe’s fundamentals then? Germany and much of core Europe are fundamentally healthy. Equally notable is the fact that Spain, Portugal and Ireland are in much better shape than they used to be.

The “problem countries” now are the ones that never had to ask European authorities for help, France and Italy. But even there, the “mountain” is beginning to move. Structural reform measures are on the verge of being launched.

Given that, there should be a return to growth in the Eurozone in early 2015, after the stagnation now, with a significant risk of a mild recession in late 2014.

Strong safety net

What if the panicky mood takes hold on a more prolonged basis? Then Berlin and the ECB will do all it takes to defend all euro members who play by the rules against any irrational market panic.

True, the two do not act as readily and as fast as markets would like. But if need be, they could – and would – jointly deploy a safety net strong enough for almost any contingency. Just ask those market participants who bet on a euro break-up in late 2011 and in spring 2012.

Fiscal policy cannot and will not play a major role in staving off the tail risk of a third Eurozone recession in six years. Those dreaming of massive German infrastructure spending to lift France out of its largely self-inflicted misery should think again.

The role of monetary policy is limited

With Germany’s cumbersome procedures and its dismal record on big infrastructure investments (ever heard of the new train station for Stuttgart, the new airport for Berlin or the new concert hall for Hamburg?), it would take years before serious money could actually be spent. And hardly any of that would benefit France.

Instead of counting on a big boost which never worked for long in Japan, the one country that tried this strategy in earnest, automatic stabilizers will be allowed to work everywhere in the Eurozone.

In addition, fiscal targets can be relaxed if France and Italy reform their labor markets – and EU funds could be disbursed with less conditionality and hence faster. But a headline-grabbing fiscal boost is not on its way.

We would also all do well to realize that a serious stimulus is in the pipeline already. It consists of five arrows:

1. A more fairly valued euro

2. Low financing costs

3. The end of the ECB’s health check of banks on October 26th

4. The ECB’s new liquidity offers and

5. Its coming purchases of ABS, RMBS and covered bonds of, say, €300 billion plus.

Low oil prices are adding to that stimulus package nicely. But it will take time to work.

What about America’s favorite tool, QE? Major purchases of sovereign bonds are the ultimate last resort. Under extreme circumstances – such as a serious recession, a huge flare-up of tensions in the Eurozone or a need to shield the Eurozone from the fallout from an unlikely, but not impossible Greek accident – Berlin would give the ECB the nod to do it.

For now, full-scale QE is not yet the most likely outcome (I see a 40% probability for it to start in early 2015). The situation isn’t seen as dire enough for the last resort. And anyway, it would take time for a sufficiently overwhelming ECB majority and for Berlin to conclude that there is no other way out.

OMT-style magic again?

Before then, the ECB still has one shot left short of actually buying a vast amount of sovereign bonds. In other words, it could try the OMT magic all over again.

Mr. Draghi could thus announce that the ECB will finalize the logistical contingency planning for QE (which bonds to buy by maturity and country, as well as other technical and legal details) within a month or two without committing to actually activate the program.

In a way, it’s a game between markets and the ECB. If markets lapse into full panic mode, the ECB would have to deploy its ultimate panic-control instrument. If markets mistake the ECB’s (and Berlin’s) hesitation to do so as evidence that the ECB would always remain passive, that would eventually force the ECB’s hand.

But if global investors understand that the safety net is there even if it is not deployed as eagerly as markets would like, calm may prevail after a while without the ECB actually having to buy tons of sovereign bonds.