The Market’s Christmas Wish List

London Asharq Al-Awsat- As we enter the festive season after a year of disappointing attempts from Eurozone leaders to solve the Eurozone crisis, it is useful to summarize the market’s dashed expectations in a Christmas wish list.

1. Unlimited or enhanced bond buying from the ECB.  The market has seen this tool as one of the simplest and most effective method to address the immediate effects of the  Eurozone crisis. Germany, however, with its historically ingrained aversion to inflation, has strongly resisted the ECB’s use of this mechanism, arguing that it monetizes deficits and is illegal under the EU treaty. Undoubtedly, such mechanism is potentially inflationary, much as quantitative easing programmes in the US and the UK a zero real interest rate policy. Nevertheless, this mechanism is an appropriate tool of monetary policy to be utilized within the discretion of a central bank, which can take into account the inflationary potential of the mechanism alongside the deflationary forces at work in the economy. As regards its alleged illegality under the EU treaty, the prohibition is only against direct ECB lending to governments, not to ECB purchases of government bonds in the secondary market. Article 18.1 of the Statute of the ECB authorizes the ECB to purchase government and private bonds in the secondary market, and the ECB has approved and has been engaging in a programme of bond purchases since May 2010, having purchased over €660 billion of bonds under the programme in 2011 and holding at 9 December 2011 over €200 billion of bonds purchased under such programme. The formal decision of the ECB on 9 May 2010 to engage in such a programme states that the Governing Council of the ECB will determine the scope of such interventions. Clearly, it would be detrimental to the ECB’s independence to have its monetary activities dictated by governments, but this need for independence must apply equally to the use of or restraints on all of the ECB’s available monetary policy tools, including its legally valid and authorised use of bond purchases.

2. Suitable capitalisation and regulation of banks. Politicians have done better in this respect. Eurozone banks have been preparing to meet Basle 3 requirements and EBA stress tests. Quite appropriately, politicians and regulators have signalled to banks to strengthen their capital base from retained earnings and shareholders prior to seeking government support, and banks are following suit, raising capital from shareholders where possible and disposing of non-core assets.  With advance notice and preparation, banks should be better prepared for the current crisis than they were in 2008. In the UK, the government is preparing legislation to implement the recommendations of the Vickers report to create firewalls between investment banking and commercial and retail banking. And while the ECB has felt constrained from providing liquidity to the sovereign bond markets, it has provided ample liquidity to the banking system.

3. Strategies for growth and competitiveness. Politicians have fallen well short in this regard.  All efforts to rescue the Eurozone so far have focused on addressing the immediate liquidity or solvency needs of peripheral Eurozone countries or imposing fiscal austerity programmes. There has been no concerted effort even to highlight growth programmes or efforts to improve the competitiveness of the uncompetitive Eurozone countries.  Growth programmes may be limited due to austerity budgets but governments must make more effort to mobilize private investment to spur growth, as the UK government did with its programme to mobilize pension fund investment into infrastructure investment. Increasing competitiveness must receive at least as much if not more attention than fiscal austerity. These efforts will need to take in labour market flexibility, education and training and deregulation.

4. More substance and less theatrics. Our political leaders need to deliver more substantive results and engage in less spin and theatrics. From former Greek Prime Minister Papandreou’s call for a referendum after agreeing the Greek rescue package, German Chancellor Merkel’s intransigence on ECB bond purchases or jointly issued Eurobonds, UK Prime Minister Cameron’s veto of the Fiscal Compact and French President Sarkozy’s apparent attempts to isolate the UK all demonstrate politicians’ willingness to pander to the local press and party political interests before pursuing the common interest of resolving the crisis.  It is not surprising that the markets and the ratings agencies are losing confidence in the desire or ability of EU political leaders to resolve the crisis.

It is uncertain how many, if any, of the items on our Christmas wish list will be given to us in 2012. What is certain is that if we do not receive at least a few of these items the crisis will continue and likely spiral out of control.