Governments, not central banks, must act
–Michala Marcussen is global head of economics at Société Générale Corporate and Investment Bank. The opinions expressed are her own.–
The reflex induced by three decades of success is to look to central banks to steer the economy back to a path of sustainable growth, but five years on from the outbreak of the crisis, it is becoming increasingly evident that, despite the introduction of multiple unorthodox policy tools and huge balance sheet expansion, central banks can only help buy time, they cannot fix the underlying issues of huge debt mountains and weak trend potential growth. For this, government action is required, and as each new round of monetary policy easing seemingly comes with diminishing returns – both in terms of the absolute impact and its duration – there is a growing sense of urgency for governments to act.
Steering the economy in the right direction, however, is no easy feat. Stronger financial market regulation is welcome, but the wrong mix implemented too quickly could force disorderly deleveraging of the economy. Well functioning credit channels are an essential part of any recovery. Fiscal austerity is clearly required, and all the more given ageing populations. Fast track austerity, however, comes with increased fiscal contraction multipliers weighing on real economic growth, pushing the economy into an austerity trap. This entails not only missed public finance targets as growth falters, but triggers a loss of confidence with financial markets and electorates alike – each with its own dangers. Boosting trend potential growth is a pre-requisite for both sustainable public finances and for recovery. Often slow to deliver and unpopular with electorates, such reforms become harder to implement the weaker the economy is.In the euro area, there is also the special challenge of risk sharing.
The consensus is that the euro zone will either move to a fiscal and banking union or break-up. Full break-up remains an extreme tail risk; but reaching a fiscal and banking union will take time. As such, a by now all too familiar pattern is set to repeat: market turmoil, a peek into the abyss, an additional policy patch, market relief rally, policymakers declaring the worst over … only subsequently to see turmoil return. The likeliest next policy patch is to give the European Stability Mechanism a banking licence, potentially double its fresh lending capacity to €1 trillion and allow the institution to recapitalise banks directly. This solution does not require a Treaty change (although it needs to be ratified by national parliaments); nor does it place huge potential liabilities on Germany (and the other fiscally strong member states). Ultimately, such a move would only be an additional stepping stone towards a banking and fiscal union and would not secure the longer term credibility required to see sovereign risk premia durably reduced.
While much of the market focus is on the euro area, credible policy roadmaps are also lacking elsewhere. In the United States, a fiscal cliff is looming and while further quantitative easing from the Federal Reserve is likely, it comes with diminishing returns. In China steering the economy to a new domestic demand driven model is far from easy. The temptation to ease monetary policy and initiate a new round of credit financed stimulus is evident, but comes with clear dangers. Debt for the three major sectors of the Chinese economy (households, corporates and public sector) doubled from 100% of GDP to 200% over the past 15 years. This is not something China can afford to repeat.
A version of this post also appears on Thomson Reuters IFRe.com