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As the Fed gets ready to start tapering its quantitative easing policy, I am reminded of one of the first lessons that I learnt during my six years as a Wall Street economist about the way that global financial markets actually work. A seasoned, albeit cynical, Salomon Brothers bond trader taught me that “when the winds are strong even turkeys fly.” By this he meant that when global liquidity conditions are strong even countries with the weakest of economic fundamentals are able to place government bonds at very favorable interest rates. By the same token, when global liquidity dries up, those very same countries with weak fundamentals get truly punished by the market.
One has to wonder whether European policymakers would not do well to heed that lesson. For if they did, they would recognize that a large part of the marked improvement in European sovereign bond markets over the past year is to be ascribed to the massive amount of liquidity that has been pumped into the global financial system by the Federal Reserve and by the Bank of Japan. It is this liquidity rather than any improvement in Europe’s economic and political fundamentals that has underpinned the European bond markets. Recognition of that fact might shake European policymakers out of their present state of complacency to take bold policy measures to address some of the European Monetary Union’s glaring weaknesses before the global liquidity cycle turns.
To be sure, European sovereign bond markets have also substantially benefitted both from Mario Draghi’s famous statement in July 2012 that the ECB would “do whatever it takes” to save the Euro as well as from the ECB’s subsequent introduction of its Outright Monetary Transaction program. However, with the passage of time, market participants have become increasingly cynical about the likelihood that the Outright Monetary Transaction program will in fact be activated. For they know that the OMT’s activation requires that recipient countries first sign up to an IMF-style adjustment program with the European Stability Mechanism. They also know that political conditions in Italy and Spain are such that those countries are precluded from signing up to any such adjustment program.
Rather than the ECB, the true driver of international risk markets over the past year has been the Federal Reserve and the Bank of Japan with their unprecedented provision of global liquidity. In September 2012, the Fed launched its third round of quantitative easing in an open-ended fashion that involved purchases in US Treasuries and mortgage-backed securities at a rate of US$85 billion a month. Further adding to global liquidity, in April 2013, as part of Abenomics, the Bank of Japan committed itself to buying US$70 billion a month in Japanese government bonds through end 2014.
This unprecedented wall of global liquidity has allowed even countries like Honduras and Rwanda to sell government bonds at modest interest rates to global financial markets despite their shakiest of economic fundamentals. It also has sent interest rates on US corporate junk bonds to record low levels and it has permitted countries in the European periphery to raise money at reduced interest rate spreads.
Over the past six months, Europe has provided a particularly strong measure of the power of ample global liquidity to mask underlying economic and political problems. For European sovereign bonds have held up remarkably well in the international capital market despite a deepening in Europe’s economic recession, a rise in European unemployment to record post-war levels, and an increase in public debt to GDP ratios to more than 125 percent in Ireland, Italy, and Portugal. European bond markets have also held up well despite an egregiously bad election result in Italy, deepening cracks in the Greek and Portuguese government coalitions, a widening slush fund scandal in Spain, and generalized manifestations of austerity fatigue across the European economic periphery.
It has to be regretted that European policymakers have allowed calm European bond markets to lull them into a false sense of security that the worst of the European crisis is now well behind us. For this has reduced their sense of urgency to get more growth oriented policies in place across the European periphery. It also has all but removed the impetus for bold policy action to get bank credit flowing again in the European periphery or to move more decisively towards the sort of banking union that Europe so desperately needs.
Sadly, the European policymakers’ present tardiness in becoming more proactive in their policy formulation despite Europe’s all too challenged economic and political outlook is likely to validate yet another lesson that I learnt on Wall Street. Europe does not distinguish itself in anticipating economic and political difficulties and it only moves forward on the policy front when it has its back to the wall.
Desmond Lachman is a resident fellow at the American Enterprise Institute.
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