MacroScope

The major euro zone event of the week starts on Tuesday when Germany’s top court – the Constitutional Court in Karlrsuhe – holds a two-day hearing to study complaints about the ESM euro zone bailout fund and the European Central Bank’s still-unused mechanism to buy euro zone government bonds.

The case against the latter was lodged by more than 35,000 plaintiffs. Feelings clearly run high about this despite the extraordinary calming effect the mere threat of the programme has had on the euro debt crisis. Some in Germany, including the Bundesbank, are worried that the so-called OMT could compromise the ECB’s independence and would be hard to stop once launched.

A verdict won’t be delivered until later in the year but already there is already jockeying for position. Germany’s Spiegel reported that a limit had been set on the amount of bonds the ECB could buy – directly contradicting what Mario Draghi has said. That was swiftly and categorically denied by the ECB, then Executive Board Member Joerg Asmussen warned there would be “significant consequences” if Germany’s constitutional court rules the bond-buying programme was illegal.

Draghi got his retaliation in first last week, saying the OMT had proved probably to be the world’s most successful monetary policy gambit. Given the dramatic fall in euro zone borrowing costs, he has a claim. French President Francois Hollande’s weekend assertion that the euro crisis is over looks a little more shaky.

Asmussen will represent the ECB in Karslruhe while his friend Jens Weidmann will put the Bundesbank case. Weidmann is speaking today as are a clutch of other ECB policymakers.

ECB President Mario Draghi had an interesting couple of things to say about historical perspective at his press conference on Thursday, responding to the IMF’s admission that it lowered its normal standards to bail out Greece, among other things.

While the EU Commission came out and said some of the IMF’s conclusions were flatly wrong, Draghi took another approach. Basically, hindsight is a wonderful thing:

“If this paper by the IMF, which I have read, besides being a mea cupla, identifies the reasons for mistakes that have been made an other things, we certainly have to take them into account in the future.

The British government faces another potentially thorny day with the International Monetary Fund delivering its annual review of the UK economy. If David Cameron has a consistent policy, it’s that the only way to get Britain back on its feet is to cut spending and debt. Trouble is, we know the IMF doesn’t agree and advocates a more growth-fostering approach. Finance minister George Osborne has changed rhetorical tack in response but is walking a tightrope as a result.

This comes at a time when there are distinct signs that Cameron’s Conservative party is unraveling and not just over Europe. Unless he gets a grip soon, who knows what further concessions may be made on an EU referendum which could push Britain further towards the exit door. It remains unlikely that the coalition government will fall apart before 2015 elections, not least because the junior, pro-EU Liberal Democrat partners face electoral evisceration according to the polls. It’s even less likely that Cameron will be toppled by fractious members of his party. But it’s no longer impossible.

Britain’s LibDem deputy prime minister will take the unusual step of holding a news conference to say the coalition will hold together until 2015. Another big flashpoint looms this summer with the government’s spending review where hardline Conservatives will push for big welfare cuts and the LibDems will resist. Former foreign secretary Geoffrey Howe, the man who did more than anyone else to end Margaret Thatcher’s reign, says Cameron is losing control of his party. From the other side of the political divide, Peter Mandelson says he has to lead not follow. Hard to argue with either of them.

All the talk of currency wars is mostly just that – talk. This week’s meeting of the Group of 20 nations at the International Monetary Fund was living proof. Despite speculation that emerging nations would redouble their criticism of extraordinarily low rates in advanced economies, the G20 ended up largely supporting the Bank of Japan’s new and bold stimulus efforts aimed at combating years of deflation.

Mr. currency wars himself, Brazilian Finance Minister Guido Mantega, told reporters Japan’s monetary drive was understandable given its struggle with falling prices and stagnant wages, even if he called for close monitoring of its potential spillover effects.

Outgoing Bank of Canada Governor Mark Carney said Japan’s action is consistent with the G20 communiqué that called for countries to refrain from competitive devaluation. Carney, the head of the G20′s Financial Stability Board, takes over the Bank of England in July. His comments echo recent remarks from Fed Vice Chair Janet Yellen.

The big euro zone development over the weekend was the re-election of ageing Italian President Giorgio Napolitano for a second term. The presumption is that to put himself through this again he must have got pretty serious expressions of intent from the warring political parties that they will strive for some form of grand coalition. That may have been made easier by the resignation of centre-left leader Bersani who was in danger of splitting his own caucus.

If that comes to pass it should push back the timing of fresh elections until next year at least, a welcome turn for markets which feared a new poll could result in an even more fractured outcome and put more power in the hands of the anti-establishment Five Star movement. All that means we should see a significant rally in Italian assets today. That should also benefit other peripheral euro zone bonds. Safe haven German Bund futures have already dipped at the open, Italian bond futures have leapt almost a full point and European stock futures are pointing upwards.

87-year-old Napolitano will address parliament later and could either rush through consultations with the parties or skip that step altogether since he’s already heard from them ad nauseam.

For Bank of Israel governor Stanley Fischer, this week’s high-powered macroeconomics conference at the International Monetary Fund was a homecoming of sorts. After all, he was the IMF’s first deputy managing director from 1994 to 2001. The familiar nature of his surroundings may have helped inspire Fischer to use a household analogy to describe the vaunted but often ethereal principle of central bank independence.

Fischer, a vice chairman at Citigroup between 2002 and 2005, sought to answer a question posed by conference organizers: If central banks are in charge of monetary policy, financial supervision and macroprudential policy, should we rethink central bank independence?  His take: “The answer is yes.”

In particular, the veteran policymaker, who advised Fed Chairman Ben Bernanke on his PhD thesis at MIT, argued various degrees of independence should be afforded to different functions within a central bank.

Cypriot lawmakers are supposed to vote today on a bailout that hits at least some of its bank depositors but the president’s spokesman has said any such legislation is unlikely to pass. This could be brinkmanship but it doesn’t sound like it.

Last night, euro zone finance ministers urged Nicosia to spare depositors with less than 100,000 euros in the bank and hit the richer harder, in order to raise 5.8 billion euros to free up a 10 billion euros bailout. Without it, Cyprus will surely go bankrupt but that is a deal that President Anastasiades baulked at in Brussels over the weekend. The government faces a stark choice: hit those who vote for it and rip up the deposit insurance they thought they had, or clobber the richer (many of them Russians), thus threatening the meltdown of its banking model.

Despite their belated support for the little guy, the euro zone will accept pretty much anything that raises the requisite cash. Germany and others insist the days of bailouts funded solely by taxpayers are over and the Bundestag probably wouldn’t sanction any other sort of deal.

What a weekend. The euro zone crossed a dangerous Rubicon by whacking Cypriot bank depositors as part of a bailout – a dramatic departure from previous aid programmes. The finance ministers insist it is a one-off (as they did for Greece) but if investors and bank customers fear a precedent has been set, there could yet be a serious backwash for the euro zone. And all this for six billion euros? It seems perplexing to say the least although our trawl of the streets of the euro zone periphery has detected little alarm so far.

Markets are voting with their feet. The euro has dropped well over one percent, European stock futures are pointing to losses of two to three percent and the safe haven Bund future has leapt a full point at the open. Italian bond futures have done the reverse, suggesting that in the bond market at least, there is more than a little concern about contagion from Cyprus. “The crisis is back,” one bond trader told us. “Precedent” is the word on everybody’s lips. I’ve used it before but Bank of England Governor Mervyn King produced the definitive line on bank runs – it’s never logical to start one but it sure could be logical to join one.

To muddy the waters further, the Cypriots are trying to renegotiate the deal to ease the 6.5 percent burden on smaller depositors and raise it on the richer (from 9.9 percent). This suggests that the president fears that today’s parliamentary vote may be lost without changes. If it is lost – no party has a majority and three of them said yesterday they wouldn’t support the programme – we’re in for a real rollercoaster as everyone scrambles to avoid a default, with all the reputational damage that will do to the euro zone. At that point, we could probably kiss goodbye to the five months of calm imposed by the European Central Bank and its “do whatever it takes” pledge.

Four years ago world leaders, meeting in the G20 crisis session, agreed they would all work to move from recession to growth and prosperity.  They agreed to a global growth compact to be delivered by combining national growth targets with coordinated global interventions. It didn’t happen. After the $1 trillion stimulus of 2009, fiscal consolidation became the established order of the day, and so year after year millions have continued to endure unemployment and lower living standards.

Only now are there signs that the long-overdue shift in national macro-economic policies may be taking place. The new Japanese government is backing up a "minimum inflation target" with a multi-billion-dollar stimulus designed to create 600,000 jobs. In what some call the “reverse Volcker moment,” Ben Bernanke has become the first head of a central bank for decades to announce he will target a 6 percent level of unemployment alongside his inflation objective. And the new governor of the Bank of England, Mark Carney, has told us that "when policy rates are stuck at the zero lower bound, there could not be a more favorable case for Nominal GDP targeting.” Side by side with this shift in policy, in every area but the Euro, there is also policy progress in China. It may look from the outside as if November’s Communist Party Congress simply re-announced their all-too-familiar but undelivered wish to re-balance the economy from exports to domestic consumption, but this time the promise has been accompanied by a time-specific commitment: to double average domestic income per head by 2020.

The intellectual case for change is obvious. A chronic shortage of demand has developed for two reasons. First, as the IMF announced at the end of 2012, the adverse impact of fiscal consolidation on employment and demand has been greater than many people expected. Secondly, the effectiveness of quantitative easing has almost certainly started to wane. As former BBC chief Gavyn Davies has put it, “the supply potential of the economy is in danger of becoming dependent on, or ‘endogenous to,’ the weakness of domestic demand. ...With demand constrained in this way for such a lengthy period of time, supply potential is beginning to downsize to fit the low level of demand.” It is a new equilibrium that can be reversed only by boosting demand.

IMF Managing Director Christine Lagarde sat down for an interview with Thomson Reuters Editor of Consumer News Chrystia Freeland to discuss the European debt crisis and U.S. fiscal problems.

Lagarde also outlined the Fund’s agenda for 2013 at a news conference following the release of a $4.3 billion tranche of aid to Greece, which she said is moving in the right direction with reforms.