MacroScope

It’s European Central Bank day and we have it on very good authority that a quarter-point interest rate cut is on the cards, which will take rates to a record low 0.5 percent. A plunge in euro zone inflation to 1.2 percent, way below the target of close to but below 2 percent, has cemented the case for action.

In terms of reviving the euro zone economy this is pea shooter and elephant territory. The ECB has consistently diagnosed the key problem that already ultra-low interest rates are not transmitted to high debt corners of the euro zone, where lending rates are much higher and credit restricted. A rate cut won’t change that. It also illuminates the gulf in approach with the Bank of Japan and Federal Reserve who continue to print money at a furious rate.

The Fed said on Wednesday it would continue buying $85 billion in bonds with new money each month and added it would step up purchases if needed to protect the economy, dousing recent suggestions that the programme could be wound up in the months ahead. Nonetheless, a euro rate cut will help at the margins.

The ECB is also considering ways to help small- and medium-sized companies get easier access to credit. This is a thorny debate. There is clearly some internal opposition and even disinterested outsiders say it is an unusual thing for a central bank to get involved in. Don’t bet on it happening.

The really interesting point is that if the ECB fears deflation could take hold, all the arguments about what its mandate allows it to do (one reason it has not mimicked the Fed, BoJ and Bank of England in printing stacks of money) fall away and all sorts of expansionary policies are possible. If that fear doesn’t gain traction, then the ECB is reaching the limits of its policy response unless it gets an excuse to launch its bond-buying programme, which seems a distant prospect at the moment.

Is everything falling into place to at least declare a moratorium in the euro zone debt crisis?

Well the ESM rescue fund getting a go-ahead from Germany’s consitutional court and the Dutch opting to vote for the two main pro-European parties, following Mario Draghi’s confirmation last week that the European Central Bank would buy Spanish and Italian bonds if required, means things are starting to look a little rosier.

The risks? Next spring’s Italian election, and what sort of government results, casts a long shadow and it is just about conceivable that Spain could baulk at asking for help, given the strings attached, although the sheer amount of debt it needs to shift by the end of the year will almost certainly force its hand. If the Bundesbank mounted a guerrilla war campaign against the ECB bond-buying programme it could well undermine its effectiveness. That is a big if given broad German political support for the scheme. Key countries remain deep in recession with little prospect of returning to growth because of the imperative to keep eating away at their debt mountains, which could eventually trigger a dramatic public reaction. France could well get dragged into that category.

Another blockbuster chapter in the euro zone epic.

Top billing today goes to Germany’s constitutional court, which is expected to give a green light to the euro zone’s permanent rescue fund, the ESM, albeit with some conditions imposed in terms of parliamentary oversight. The ruling begins at 0800 GMT. If the court defied expectations and upheld complaints about the fund, it would lead to the mother of all market sell-offs and plunge the euro zone into its deepest crisis yet.

Without the ESM, the European Central Bank’s carefully constructed plan to backstop the euro zone would be in tatters. It has said it will only intervene to buy the bonds of the bloc’s strugglers if they first seek help from the rescue fund and sign up to the strings that will be attached. The first rescue fund, the EFSF, could perhaps fill this role for a while but its resources are now threadbare, so without the ESM, markets would scent blood.

The Dutch go to the polls but with the hard-left Socialists seemingly losing support, the ruling Liberal party and moderate centre-left Labour are  neck-and-neck and look likely to form a coalition government committed to tight debt control and, more importantly, to the euro zone. So unless voters are lying to pollsters, some of the drama has leached out of this particular saga although it could take some considerable time to put a coalition together.

Despite Mario Draghi’s game changer, or potential game changer, the coming week’s events still have the power to shape the path of the euro zone debt crisis in a quite decisive way, regardless of the European Central Bank’s offer to buy as many government bonds as needed to buy politicians time to do their work.

The nuclear event would be the German constitutional court ruling on Wednesday that the bloc’s new ESM rescue fund should not come into being, which would leave the ECB’s plans in tatters since its intervention requires a country to seek help from the rescue funds first and the ESM’s predecessor, the EFSF, looks distinctly threadbare. That is unlikely to happen given the court’s previous history but it could well add conditions demanding greater German parliamentary scrutiny and even a future referendum on deeper European integration. For the time being though, the markets are likely to take a binary view. ‘Yes’ to the ESM good, ‘No’ very bad.

Dutch elections on the same day look to have been robbed of some of their potential drama with the firebrand hard-left socialists now slipping in the polls and the fiscally conservative Liberals neck-and-neck with the likeminded centre-left Labour party. But there are no guarantees and Germany could yet be robbed of one of its staunchest allies in the debt crisis debate.

There’s a high degree of battening down the hatches going on before the Greek election by policymakers and market in case a hurricane results.

G20 sources told us last night that the major central banks would be prepared to take coordinated action to stabilize markets if necessary –- which I guess is always the case –  the Bank of England said it would  flood Britain’s banks with more than 100 billion pounds to try and get them to lend into the real economy and we broke news that the euro zone finance ministers will hold a conference call on Sunday evening to discuss the election results – all this as the world’s leaders gather in Mexico for a G20 summit starting on Monday.
Bank of England Governor Mervyn King said the euro zone malaise was creating a broader crisis of confidence.

The central banks acted in concert after the collapse of Lehmans in 2008, pumping vast amounts of liquidity into the world economy and slashing interest rates. There is much less scope on the latter now. The biggest onus may fall on the European Central Bank which may have to act to prop up Greek banks and maybe banks in other “periphery” countries too although the structures to do so through the Greek central bank are in place and functioning daily. In extremis, we can expect Japan and Switzerland to act to keep a cap on their currencies too. As a euro zone official said last night, a bank run might not even be that visible and start on Sunday night over the internet rather than with queues of people outside their local bank on Monday morning.

Spain’s plans to revive Bankia with state money and sort out its regions’ finances have well and truly unnerved the markets. It seems that Plan A — to inject state bonds straight into the stricken bank so that it could offer them to the ECB as collateral in return for cash — was roundly rejectd by the European Central Bank, so Madrid rapidly produced a second plan which will involve the government raising yet more money on the bond market, not helpful to its drive to cut debt.

That leaves the impression that Spain is making up policy on the hoof, not something likely to endear it to the markets. That’s particularly unfortunate since it has actually done an awful lot on the austerity and structural reform front over the past two years. But not enough.

It’s not all one-way traffic. Madrid is pressing its insistence that the ECB should be the institution to deliver a decisive message to the markets that the euro is here to stay – presumably by reviving its bond-buying programme (highly unlikely at this stage).

With Spain’s banking system looking ever more parlous and the Damoclean Sword of Greek elections hanging over the financial markets, next week is not going to be for the faint-hearted.

Stock markets have endured another volatile week, rising early on before falling sharply just before the EU summit, then rising the day after – all this when very little changed on the euro zone landscape. Increasingly, the downward moves are sharper than the upward ones and there is little prospect of things settling before the June 17 Greek elections. It seems everyone is so nervous that if they are sitting on a day of gains, they cash them in double-quick.

Page one of the crisis management manual says get all the bad news out quickly. The handling of troubled Spanish lender Bankia has been an abject failure in that respect. First, the government said it would require about 9 billion euros to shore up, a few days on they are looking at 20 billion. One proposal doing the rounds is to create one nationalized bank out of a number of failed lenders. The big question, to borrow heavily from Louis XV, is: Apres Bankia la deluge?

So we’ve got the fresh Greek elections we expected and markets, despite the inevitability that we would get here, have reacted with some alarm. European stocks have shed  around 1 percent, and the harbour of German Bunds is pushing their futures price up in early trade. The Greeks will try to form a caretaker government today to see them through to elections expected on June 17.

The key question is whether the mainstream parties can mount a convincing campaign second time around, playing on the glaring contradiction in SYRIZA’s position (no to bailout, yes to the euro) and essentially turning the vote into a referendum on euro membership, which the overwhelming majority of Greeks still support. Don’t count on that. SYRIZA remains ahead in the polls.
To be able to pull it off, PASOK and New Democracy will need some help from Europe. There have already been hints from Brussels that if a pro-bailout government is formed, Athens could be given some leeway on its debt-cutting terms. But equally other voices are saying there is no more room for manoeuvre.

France’s Francois Hollande used his presidential debut to frame help for Greece within his push for a European growth strategy last night, saying he hoped that could also foster a return to prosperity there. He and Germany’s Angela Merkel are due in the United States for a G8 summit at the end of the week where doubtless they will come under heavy pressure to make sure Greece doesn’t bomb out of the euro zone or, if it does, that the effect is contained. Easier said than done. Given a Greek euro exit would probably require rapid concerted reaction from the EU, IMF (to shore up Spain?) and the world’s big central banks (remember the global monetary policy response after the collapse of Lehmans?), planning for that could well be bubbling below the surface at the G8.

Greece is stumbling inexorably towards fresh elections which polls suggest will give the anti-bailout far left a stronger grip on power. Last ditch talks aimed at creating a unity government will continue under the aegis of the president today but the leader of the radical leftist SYRIZA has said he will not turn up. Alexis Tsipras says he wants Greece to stay in the euro but will rip up the bailout agreement. Go figure.
This morning the more moderate left party has said it won’t take part in a government lacking SYRIZA.

A big question is whether the mainstream parties can mount a convincing campaign second time around, playing on the glaring contradiction in SYRIZA’s position and essentially turning the vote into a referendum on euro membership, which the overwhelming majority of Greeks still support. Don’t count on that.

Two ECB policymakers –  Honohan and Coene – were out over the weekend talking about the possibility of a Greek euro exit: there goes another taboo. Policymakers must be running through the hard default and exit scenarios now. We need to be asking.

Attempts to form a Greek coalition government appear to be running into the sand with no one prepared to dance with the two mainstream parties, New Democracy and PASOK, raising the probability of a fresh round of elections with all the uncertainty that will entail. The far-left Socialist Coalition will have a stab at forming an administration today but doesn’t really have the numbers to do it.

The only plan that looks like it offers a glimmer of hope is that put forward by PASOK leader Evangelos Venizelos. He is after a “pro-European” coalition and has pledged to spread the cuts Greece has been ordered to make under its bailout programme over three years not two. If a burst of realpolitik every takes hold in Athens (and it’s worth noting that nearly all the parties say they want to stay in the euro), that could just be enough to get others on board. BUT, Venizelos would then have to go to Brussels to persuade the EU to go along with this relaxation of its targets and, on and off the record, officials lined up yesterday to say there was no prospect of that happening.
And his PASOK was the party that was most badly humiliated at Sunday’s election so it’s hard to see how it has a mandate to rule the Greeks, a majority of whom voted firmly against austerity, even it is in a broad coalition.

So new elections next month are likely which leaves a very compressed timeframe and who knows what political landscape will result second time around. The EU/IMF/ECB troika is supposed to return in June and can’t negotiate on the next bailout tranche if there is no government. In any case, Athens is supposed to find 11 billion euros of extra cuts as part of the aid programme and none of the parties are in a position to do that as things stand.