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Mario Draghi’s “big bazooka” remains to be tested

THE CONTRAST between poor economic prospects and continued financial market buoyancy has become more pronounced. Growth forecasts for both 2012 and 2013 have been downgraded further, while most stock markets remain near their highs for the year and risk appetite appears to be increasing.

This inconsistency reflects the financial markets’ increased addiction to cheap cash, and the willingness of the major central banks, most notably the European Central Bank (ECB), to satisfy this appetite. The US Federal Reserve, the Bank of England and the Bank of Japan may also inject more money soon. But aggressive monetary expansion, though sometimes useful, is risky and cannot enhance the economy’s productive potential. In the longer term, weaker growth must mean lower profits and falling share prices.

The big bazooka

The ECB’s decision to launch a bold programme to purchase bonds issued by eurozone governments facing difficulties was a major move. ECB president Mario Draghi said the bank could buy an unlimited amount of sovereign debt, with maturities of between one and three years.

There will be strict conditions. The ECB will only purchase bonds issued by governments that accept the rules imposed by the EU bailout funds or the International Monetary Fund (IMF). But the authority given to the ECB to deploy unlimited resources to buy the bonds of countries that may face speculative attacks, notably Spain and Italy, is a big step forward. Bond yields have fallen in reaction to the scheme. But to be eligible, Spain and Italy would have to apply to the bailout funds and accept tough terms – and so far, they have been reluctant. It is premature to assume the ECB’s new weapon would prove to be the long-awaited “big bazooka” needed to save the euro.

Securing the agreement of all the eurozone’s governments, including Germany’s, for the new scheme was a major diplomatic success for Draghi. His prestige and influence have risen considerably and his role is now indispensable. The threat of a disorderly euro collapse has lessened. However, the Draghi plan does not solve the euro’s basic structural imbalances which result from continued lack of competitiveness in the periphery (Greece, Spain, Portugal and Italy). Longer-term risks to the euro’s survival will persist. The Draghi scheme cannot be used to avert a Greek default, and the political controversy it has unleashed could reduce its effectiveness.

Within Germany, where earlier bailout schemes are subject to legal challenges, the plan has encountered strong resistance. German chancellor Angela Merkel and finance minister Wolfgang Schäuble have backed the ECB’s move, but the German representative on the ECB council (Bundesbank president Jens Weidmann) voted against it. The opposition of the highly respected Bundesbank, on the grounds that Draghi’s plan is tantamount to printing money, will heighten public hostility. Demands for Germany to leave the euro, though unrealistic, will intensify and be a major issue in the 2013 German elections.

Welcome initiative

While the markets have welcomed the ECB’s initiative, the eurozone’s economic situation is dire. Unemployment rose by 88,000 in July, to a new peak of 18 billion. The jobless rate stayed at 11.3%, a record high. The disparities between members persist. Spain and Greece face dangerous political pressures, with unemployment rates at about 23-25% and jobless rates of more than 50% in the under-25s age group. The rise in eurozone consumer inflation to 2.6% in August from 2.4% in July, due to higher oil and food prices, was an unwelcome development – complicating the ECB’s job.

However, with recessionary pressures worsening and business confidence falling, monetary policy will have to stay expansionary in the near term. The Bundesbank’s opposition to the Draghi plan will increase resistance to further easing. But we still expect on balance a cut in the key ECB policy rate in the next three months, from 0.75% to 0.50%.

While the eurozone economy is expected to decline in 2012, the US remains firmly in positive territory. But performance is lacklustre and this will be a key issue in the November elections. US GDP growth for the second quarter of 2012 was revised up marginally to 1.7%, lower than in the first quarter and inadequate for this stage of the economic cycle. US job creation slowed in August to a disappointing 96,000, well below expectations. Revisions to June and July data show that fewer jobs were created than previously reported. Longer-term comparisons point to a slowdown. The jobless rate fell to 8.1% in August, but this is only because discouraged workers gave up looking for work. Prospects are mediocre, with growth likely to edge down in 2013. The improvement in the housing market offers longer-term hopes of consumer recovery.

But the big near-term potential threat to the US is a huge package of spending cuts and tax rises totalling $600bn (£373bn) that comes into effect automatically early in 2013, unless Congress can agree new measures. If the political paralysis between the parties precludes a sensible accord, the clear danger is that massive fiscal tightening could push the US, and even the world economy, into a new recession.

UK GDP is also likely to fall in 2012, even though the second quarter decline has been revised to 0.5%, slightly better than the initial estimate of a 0.7% fall. The figures exaggerate the recession. But UK stagnation has lasted for too long, and measures are needed to stimulate growth while still adhering to the deficit-cutting plan. The focus must be on deregulation, infrastructure spending and policies aimed at boosting lending to businesses. An increase in quantitative easing is also likely, but such a move would be unnecessary and potentially risky, while offering little help to the real economy. ?

 

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