Beware when leaders speak the truth: James Saft

July 19, 2012

July 19 (Reuters) – If there is one thing more worrying than
leaders avoiding the truth it is when they start to speak it.

Unusually frank comments from German Chancellor Angela
Merkel on Wednesday came, within this context, as quite a
surprise:

“We have not yet shaped the European project in a way that
we can be sure that everything will turn out well, we still have
work to do,” Merkel said in an interview posted on her Christian
Democratic Union party’s website.

Gee, Angela, now that you mention it, we’re not so sure
either.

Merkel quickly added she was “optimistic that we will
succeed,” though she has been saying roughly that for seemingly
ever and progress has been, well, mixed. The question then is
why she chose this particular moment to state the blindingly
obvious.

As ever, a look at how markets reacted can be illuminating.
In this case, the euro fell, sharply, and government bonds
rallied, sending yields lower. Clearly such statements don’t
inspire much confidence – if you were a corporate manager would
this make you more or less likely to invest and hire? The rally
in German bonds, for example, may also denote a conviction that
Merkel’s honesty denotes a smaller chance that the German
treasury will be picking up ever larger bills.

As for the euro, a currency whose principal backer thinks it
might not make it is one with risks skewed to the downside. I’d
also like to point out that for the foreseeable future whenever
we see a high official say or do something surprising, that
surprise can be expected to usually have the effect of driving
their home currency lower. We are, after all, in a currency war.

Probably internal politics, both within Germany and between
it and its European partners, has as much a role in Merkel’s
new-found realism as did any concerns about the price at which
Germany can sell to China and the U.S.

A shock can tend to galvanize one’s negotiating partners.
And she faces a revolt within her own party – one unlikely to
succeed – ahead of a vote Thursday in the lower house of
parliament over Germany’s contribution to the Spanish bailout.

That being said, the risks officially ignored have a nasty
habit of moving straight to reality once officialdom actually
acknowledges their existence. The risks of euro break-up are
probably higher than many who heard Merkel realize and
definitely higher once she uttered the words.

WELCOME WORDS FROM THE IMF

Another unusual, and welcome, source of plain talk on
Wednesday was the International Monetary Fund, which positively
lit into the European Central Bank, calling on it to be far more
active in supporting the euro zone economy. The IMF said there
was about a 25 percent chance of falling prices, and outright
deflation by early 2014, with risks concentrated in the hard-hit
southern parts of the euro zone.

Besides calling for the ECB to be given full lender of last
resort responsibility, the IMF was emphatic in calling for much
easier monetary policy and more active work to support the
transition to a more highly integrated zone.

The IMF is essentially calling for a kitchen-sink policy
from the ECB in which it would cut interest rates, do “sizable”
quantitative easing, make more targeted purchases of weak
sovereign bonds and do further rounds of offering banks cheap
liquidity. They also called on the ECB to accept equal status
with other creditors.

This was a blunt message and disconcerting in its vehemence,
made all the more so when you realize that the ECB is highly
unlikely to follow anything close to this course of action
unless it finds itself in truly dire circumstances.

Apparently, a one-in-four chance of deflation may not be
enough to rouse the bank from its narrow view of its remit and
obligations.

While it is difficult to forecast events in Europe, it is
becoming easier and easier to understand Europe’s likely
economic and market impact over the next couple of years. While
the negative impact started out about a year ago as mostly due
to uncertainty, the impact will be becoming more and more real
as the months go on, the southern economies slump and the euro
zone sends out wave upon wave of deflationary power to the rest
of the global economy.

While a disruptive change in the euro is the biggest risk,
the longer the crisis goes on without resolution, the higher the
baseline cost in dropping demand will be.

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