The world economy: Mountains to climb

Published on The Economist, September 3, 2011.

CENTRAL bankers are not known for seeking solace in the heavens. But at their annual symposium in Jackson Hole, organised by the Federal Reserve Bank of Kansas City, the world’s leading monetary mavens could be found, after dinner, peering enthusiastically into telescopes set up by the local astronomy club. As he spied the M82 galaxy, 12m light-years away, one central banker remarked: That puts our problems into perspective. 

On the ground, though, those problems are as big as ever. Christine Lagarde, the new managing director of the IMF,
voiced a collective sentiment when she said the world economy found itself in a “dangerous new phase”. Things could get riskier still in the coming weeks … //

… The third and biggest reason to worry is that the EFSF is too small. The fund is being increased to €440 billion. But subtract the money already committed to bail-outs as well as the extra Greece might need if “voluntary” private debt-restructuring falls short (see article), and only around €200 billion may be left. At the ECB’s current pace of bond-buying (€6 billion-22 billion a week), that will not last long, especially if some is also set aside for banks.

European politicians are unlikely to cough up more, so much discussion behind the scenes is about how to lever up the rescue facility. Daniel Gros of the Centre for European Policy Studies and Thomas Mayer of Deutsche Bank think the EFSF should be registered as a bank and allowed to borrow from the ECB, using the government bonds it buys as collateral. That kind of arms-length arrangement, they argue, would be much better than having the ECB buy bonds itself, and would give the EFSF huge firepower. Conservative central bankers worry that it would still break the rule that bans direct purchases by the ECB, in spirit at least.

An alternative, quietly touted by some North American officials, is to tempt investors into buying bonds by giving them access to non-recourse loans from the ECB. The model is another American innovation from the financial crisis—the Term Asset-Backed Securities Loan Facility, or TALF. Soft loans from the FED were designed to tempt investors into buying securities; the Treasury promised to take the first tranche of any losses, thus protecting the Fed. In a European version, cheap, non-recourse loans would encourage investors to buy Italian or Spanish bonds and bring down yields. The ECB would provide leverage, but any initial losses would be borne by the EFSF. The facility’s resources would be magnified, private investors would be drawn in and the price of bonds would still be set by the market.

Dusting off America’s crisis-management ideas makes sense: they were effective. But Europe’s task is far harder, not just because there are many more parties involved but because the end goal is so unclear. American officials were battling the temporary collapse of a financial system. European politicians need to create a new one, either with a more integrated fiscal union or a break-up of the current euro area. Without political leadership, the technocrats cannot solve the problem. (full text).

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