NEWPORT BEACH – Central bank purists are confused. How can the European Central Bank, a Germanic institution, now be in the business of buying government bonds issued by five of its 17 members? Why is this monetary authority acting like a fiscal agency? Isn’t the ECB supposed to be a politically independent and operationally autonomous institution committed to fighting inflation and safeguarding the currency?
Well, yes and no. And that answer speaks to the disturbing realities of modern-day central banking (or, to be more exact, central banking in the post-bubble world of debt overhangs and sovereign-debt concerns). It also sheds light on the endgame now taking shape in a confused and unsettled eurozone.
A sea-faring analogy simplifies some of the complexity. Imagine that a highly agile coast-guard vessel is called out to rescue a floundering boat. As the rescue is taking place, the vessel finds that it must also rescue two other, larger boats. It does so, but not before the captain receives assurances that a larger ship is coming to assist.
As the crew of the now-burdened rescue vessel waits for relief, they are forced to deal with restless passengers. With the ocean getting rougher, the once-agile rescue vessel is now so overburdened that some officers are second-guessing the captain, who again calls for the larger ship to help. Unfortunately, this ship seems hostage to a confused sense of mission and a distinct lack of urgency.
The overwhelming hope is that the larger ship will come and save the day. The fear is that it may not. And the question then becomes whether the crew of the struggling rescue vessel will decide that they can stabilize the situation only through a once-unthinkable action – throwing someone overboard to lighten the vessel and save the rest.
In a nutshell, this is the ECB’s situation today. The outcome is both uncertain and highly consequential – for Europe, of course, but also for a global economy that is in the midst of a synchronized slowdown and operating with a weakened anchor, owing to America’s recent debt-ceiling debacle and the humiliating loss of its AAA sovereign credit rating.
The ECB has already purchased almost a €100 billion of peripheral government bonds, and it is committed to buying a lot more. Less visibly, it has acquired many times the current volume in so-called “repo operations,” through which the ECB provides euros to struggling banks in a “temporary and reversible” exchange for the government bonds on their balance sheets.
Clearly, back in 2009, the ECB did not make the controversial call that Greece was insolvent, not illiquid. My own sense is that it was able but unwilling, owing to its fear of collateral damage for the rest of the eurozone. It opted for delay in the hope that the eurozone’s most vulnerable members would reinforce their defenses against Greek contagion.
In that sense, the ECB may have been too trusting. It believed that the peripheral economies would deliver serious fiscal austerity, notwithstanding their dreadful growth outlook and general lack of competitiveness. It also believed that the core countries would relieve the ECB burden of mounting bailout costs.
But, even if the ECB has limitless patience, the rest of the world does not. Markets understand that the ECB cannot forever substitute for other government agencies, so they repeatedly call into question its bridging strategy. Without these other agencies’ help, the ECB’s unprecedented actions will end up being a bridge to nowhere.
Whichever way you look at it, the ECB – and with it Europe – is being forced into an endgame with three once-improbable outcomes. That endgame will play out in weeks and months, not quarters and years.
The first alternative is a disorderly breakup of the eurozone. Only chaos-lovers wish for such an outcome, but it is possible if core governments continue to hesitate in engaging their balance sheets; if peripheral governments abandon their fiscal-reform efforts; and/or if societies can no longer tolerate economic stagnation, high and rising unemployment, and budget austerity.
The second is the one preferred by political scientists and European visionaries: greater fiscal union among the 17 eurozone members, or, in blunt terms, German willingness to do for the eurozone what it did for eastern Germany – namely, write large checks for years to come. In return, Germany would insist on economic-governance reforms that force other eurozone members to surrender some of their national fiscal prerogatives.
The third alternative is the one embraced by several economists. It involves creating a smaller and more economically coherent eurozone, which would consist of core and near-core countries within a tighter fiscal union and more credible defenses against contagion. In the process, 2-3 peripheral economies would take a sabbatical from the euro, underwriting immediate economic uncertainty with access to a much wider range of instruments to deal with their debt overhangs and lack of competitiveness.
Although the endgame is close, it is impossible to predict which alternative will prevail. That will depend on decisions taken by politicians with low approval ratings, noisy oppositions, and inadequate coordination. Moreover, implementation will likely prove far from automatic, thereby testing the resolve of governments and institutions.
My sense is that politicians will opt for a weak variant of greater fiscal union, but that, ultimately they will fail to execute it for the eurozone as we know it today. After some considerable volatility, a smaller and more robust currency union will emerge; and, importantly, Europe will avoid the euro’s demise and a total breakdown of the eurozone.
No matter how you view it, the coming endgame will be neither simple, nor orderly. Had the ECB known this at the start of Europe’s debt crisis, it might have resisted taking so many risks with its balance sheet and reputation. Then again, it probably could not have done otherwise – just as our once-agile rescue vessel never really had the choice of remaining safely in port.
Mohamed A. El-Erian is CEO and co-CIO of PIMCO, and author of When Markets Collide.
Copyright: Project Syndicate, 2011.