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Satyajit Das: Poker bluffs & the European crisis

The ECB programme is a tactical bluff in the long poker game to buy time in the hope that growth, inflation and some structural reforms restore the euro zone's fortunes

Satyajit Das 

Satyajit Das

The strength in European bond and stock markets since June 2014 reflect faith in the policies of the European Central Bank (ECB). Unfortunately, such faith may be misplaced. European economic and political risks are increasing. Rather than creating growth, increasing inflation and weakening the euro, the programme is likely to have unintended consequences.

The ECB actions have reduced borrowing rates for euro zone members. While making existing high debt levels more manageable, the falling funding costs removes incentives for reducing debt and undertaking structural reforms. The Italian government proposes to use the benefit of lower rates, estimated at around euro 10 billion over three years, to increase spending and relax fiscal policy.

In a candid speech at the annual Jackson Hole meeting of central bankers, ECB President Mario Draghi questioned whether governments had used the period of low rates and interest cost savings on sovereign borrowings to undertake necessary but politically difficult reform.

Expectations of further falls in the credit spread of Italy, Spain and previously vulnerable peripheral nations are driving purchases of their government bonds supporting the value of the euro, at least in the short term.

A weaker euro policy may also prove problematic in the medium to long term. Falls in the euro may not trigger the hoped-for rise in economic activity driven by exports. A high proportion of trade is conducted in euro within the euro zone itself, limiting the currency effect. Weak growth in export markets, such as the US and emerging countries, may limit the benefits.

The US, UK and Japanese experience suggest that monetary policy may not be able to increase inflation significantly, reflecting the effects of deleveraging by companies, households, banks and governments. Falls in the euro may increase the cost of imported products driving higher inflation. But the erosion of real household incomes may reduce consumption, limiting any pick-up in growth.

There are systemic risks. A weaker euro entails pursuance of a "beggar-thy-neighbour" policy, exporting euro zone. Retaliation through competing monetary easing or capital controls may defeat the ECB's efforts to weaken the currency.

The ECB initiatives also do not address the fundamental problems of over-indebtedness and need for structural reforms. Maintenance or increasing debt levels is a curious solution to a problem of too much, not too little debt, which lies at the heart of the European crisis.

With few exceptions, the May 2014 elections for the European Parliament saw rejection of existing policies emphasising austerity and debt reduction. In France, the "Seisme", as Le Figaro termed it, saw Marine Le Pen's Front National win in 73 electoral departments against President Francois Hollande's Socialists two.

Europhiles argue that pro-European mainstream parties (centre-right, centre-left, liberals, Greens) won around 70 per cent of the parliamentary seats. The business as usual stance was evidenced by the unseemly imbroglio over the presidency of the European Commission. The election of former Luxembourg Prime Minister Jean-Claude Juncker highlighted deep differences within members. The spat may have longer-term effects, increasing the risk of a British exit from the European Union (Brexit).

Euro-sceptics point to the significant gains by anti-euro and anti-European integration forces. But the real risk lies in its effect on domestic politics and complex coalitions between nations at the European level.

Italian Prime Minister Matteo Renzi's strong showing in the European elections has strengthened his position. In alliance with France, Greece and Spain, Renzi is seeking a relaxation in the previously agreed programme for improving public finances and debt reduction and a new political agenda focussed on growth.

This has revealed internal problems within Germany's governing grand coalition. The Social Democratic Party (SPD), Chancellor Angela Merkel's Christian Democratic Union (CDU) partners, have aligned themselves with Italy and their supporters. While the differences are being "spun" as presentational not substantial, the CDU risks being outflanked by the SPD and also the rising anti-euro Alternative for Germany (AfD) in domestic politics.

The likely resolution, a typical euro zone fix, is likely to be continued support for the stability pact, requiring (for most members an unattainable) three per cent structural budget surplus and a debt/GDP of 60 per cent. Instead, there will be a change in interpretation and application. Likely changes include further extension in the time allowed to reach targets and the exclusion of investments designed to support growth from the calculation of the budget position. Classified as technical in nature, these changes highlight repeated cute accounting games, which have contributed to European problems and a refusal to face harsh truths.

The significant shift in European politics increasingly attenuates growing economic risks.

In reality, the ECB programme is a further tactical bluff in the long European poker game to buy time, in the hope that growth, inflation and some structural reforms restore the euro zone's fortunes.

Draghi's July 2012 statement that the ECB would "do whatever it takes" helped stabilise money markets and reduced sovereign borrowing costs without requiring any actual intervention. Draghi has continued to follow the strategy.

In October 2013, he was ready to consider all available instruments. In November 2013, there were a whole range of instruments that he could activate, if needed. For absence of doubt, in December 2013, he reiterated that he was ready to consider all available instruments. In January 2014, he would take further decisive action if required. In February and March 2014, he vowed to take further decisive action if required. In April 2014, the ECB president undertook to act swiftly, if required. In May 2014, he repeated that he will act swiftly, if required.

Announcing the June 5, 2014 initiatives, Draghi told reporters: "Are we finished? The answer is no." It will be reasonable, based on established practice, to expect the ECB president to repeat this formulation in the coming months, until circumstances dictate a new message. But the utterances are increasingly reminiscent of the Wizard of Oz: "Make no mistake, I have powers, powers beyond your understanding! Powers to make you quake!"

It is unlikely that the policies in place will result in an immediate return to the required levels of growth. Inflation is likely to remain low. The pace of structural reforms in individual nations will remain slow, particularly in the face of electoral disquiet and with low borrowing costs reducing pressures for change. Already elevated debt levels will continue to increase, becoming unsustainable.

The ECB package of low-cost funding is unlikely to have the intended effect on the real economy, though it may assist in keeping bond yields low and stock markets buoyant.

In the June 5, 2014 press conference, the ECB president acknowledged that almost all of policymakers' conventional tools were now exhausted. With politicians having all but totally abnegated economic responsibility to monetary authorities, the ECB has only one more card left to play - a large-scale programme of asset purchases.

But the ECB's own simulations, reported by the Frankfurter Allgemeine, show that the impact of full-scale quantitative easing (QE) on growth and inflation will be limited. The simulations indicated that a QE programme of euro 1 trillion per year, roughly euro 80 billion per month, will increase inflation by only 0.2 to 0.8 per cent.

Since July 2012, European policymakers and investors have ignored real economy weaknesses, choosing to concentrate on the effect of massive central bank liquidity injections. The strategy has generated spectacular returns. But the balance of risk and return is shifting.

Should growth and inflation not increase significantly and the current policies prove ineffective, Draghi's bluff is likely to be called. The ECB president is relying on Mark Twain's observation that: "It is sound judgment to put on a bold face and play your hand for a hundred times what it is worth; forty-nine times out of fifty nobody dares to call it, and you roll in the chips." But as Ambrose Bierce knew: "The hardest tumble a man can take is to fall over his own bluff."

The writer is a former banker and author of Extreme Money and Traders, Guns & Money

First Published: Mon, October 06 2014. 21:46 IST