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Fire, no water

22 Mar 2012 By Ian Campbell

Smoke is again visible in the euro zone. The economy contracted in the fourth quarter of 2011 and looks like doing so again in the first quarter of this year. Sovereign yields have risen again. The European Central Bank put out the fires before by spraying one trillion euros on the banks. But its now greatly expanded balance sheet, and stubborn inflation, are big obstacles to a credible policy response.

The euro zone’s problems begin with growth. Output in manufacturing and services dropped further into contraction territory in March. Employment declined at the fastest pace for a year. That makes it harder for governments to cut fiscal deficits.

The market is having second thoughts again about Spain, whose 10-year bond yield has shot up to 5.5 percent – close to 1 percentage point above its lows in February. Last year the government targeted a deficit of 6 percent of GDP. It came in at 8.5 percent. The target is 5.3 percent this year. There must be large question marks over Spain’s ability to hit that goal. The country’s debt rose to 68.5 percent of GDP in 2011. The chances of containing it to the currently projected 80 percent of GDP in 2014/15 look poor.

For euro zone policymakers the challenges are big. To help growth the ECB ought to cut its interest rate. The problem is that German feathers might be ruffled: inflation, at 2.7 percent, is already above target. But a rate cut wouldn’t do much to ease debt strains.

Spraying out more money around the banking system would work better temporarily but any such move is hard to justify. The ECB’s balance sheet is larger now as a share of GDP than the U.S. Federal Reserve’s. It may be swollen – as ECB President Mario Draghi is keen to stress – by substantial gold holdings not present on the leaner books of the Fed or Bank of England. But a liquidity response to further sovereign strains won’t be what Germany and possibly other countries want to see.

Nor would it be desirable. The ECB can’t provide lasting remedies to fundamental fiscal and sovereign debt problems. Europe’s fires will need fighting again.


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