AMERICA’ DEBT CRISIS MAY DRAG THE ERUOZONE DOWN

(conctac:massimo coltrinari: geografia2013@libero.it)

The temporary agreement to avoid a debt default in the US will produce severe

consequences, not only in America but also in the rest of the world, notably in

the eurozone.

As long as Barack Obama’s administration and US Congress remain in the

hands of different parties, they will muddle through, trying to gain time by

postponing the fundamental decisions. The deadline for raising the debt

ceiling will be pushed forward, but there is no certainty that the worst scenario

can be definitely avoided. In fact, the two main actors have an incentive each

time to move ever closer to the precipice and try to obtain some advantage by

threatening a default.

This is similar to the game of chicken European policy makers played during

the eurozone debt crisis, bringing the single currency very close to collapse.

Only at the last minute, when the risk of implosion became apparent, did

European politicians ultimately decide to create a European Stability

Mechanism and to move towards a banking union. The intervention by the

European Central Bank, pledging to do whatever it takes to avoid a collapse of

the monetary union, calmed the markets but catastrophic risk has not

disappeared. It is reflected in the risk premium of some eurozone sovereign

bonds.

If the US political authorities continue to follow the same pattern, market

participants will have to start pricing in a non-zero probability of a disaster

scenario. The memory of Lehman Brothers has not faded away, after all. Tail

risk is likely to increase in the near future.

A repricing of risk for Treasuries can be expected to affect a whole range of

asset prices, including in other countries. At the global level, international

October 23, 2013

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1 di 3 23/10/2013 18.00investors will be induced to further diversify their portfolios, reducing the

overweight of dollar-denominated assets in favour of real assets or financial

assets denominated in liquid currencies such as the euro.

The incentive to rebalance investors’ portfolios may also be influenced by the

US Federal Reserve’s reaction to the recent deal. Interest rates may remain low

for longer and capital may be induced to flow outside the US, chasing higher

returns.

Overall, the increased tail risk on US government bonds and the likely reaction

of US monetary policy should increase demand for non-US assets. The best

rated European sovereigns should benefit from such a portfolio shift. It is less

clear, however, that the eurozone as a whole will benefit.

Indeed, the supply of euro-denominated assets is not increasing at the same

pace as the global demand. As a result, the euro exchange rate can be expected

to further appreciate, continuing the trend of the past few weeks. In fact, the

European currency is rapidly heading towards the levels prevailing before the

start of the euro crisis. The rising current account surplus of the eurozone,

resulting from asymmetric internal adjustment, is further contributing to this

trend. This restricts monetary conditions in the eurozone.

On balance, the recent US budgetary events will produce direct and indirect

restrictive spillover effects in the eurozone, symmetrical with those the

eurozone crisis produced in the US at the peak of the crisis between mid-2011

and 2012. However, eurozone authorities seem less well equipped to deal with

these spillovers than the US authorities.

While at the peak of the euro crisis the US authorities flew frequently over the

Atlantic to convince European policy makers to get their act together and take

the steps needed to complete the institutional framework underpinning the

single currency, it is more difficult to imagine Herman Van Rompuy, European

Council president, meeting back and forth with John Boehner, speaker of the

US House of Representatives, and Mr Obama to convince them they need to

reach an agreement on the next debt limit in the interests of the world

economy.

Furthermore, while the Fed embarked on various waves of quantitative easing

to inundate financial markets with liquidity, avoiding an over-appreciation of

the dollar, the ECB’s options are more limited. Cutting further the policy

interest rate may help divert some of the demand for euro-denominated assets.

The acknowledged weakness of the eurozone recovery and the low inflation

rate – increasingly distant from the 2 per cent ceiling – provide the necessary

justification for such a cut. It would hardly be sufficient, however, to

discourage international investors’ demand for euro-denominated assets.

If the strengthening of the euro is a result of increased demand for euro assets

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2 di 3 23/10/2013 18.00by international investors, the only way to counter it – in the absence of capital

controls – is to increase the supply of euro assets or to discourage demand.

The only institution in a position to do so is the ECB. It could increase overall

euro liquidity by operating directly in the markets, which would not be

inflationary as long as the liquidity is held by foreign investors for

diversification reasons. Alternatively, it could discourage demand for euro

liquidity by imposing a negative interest rate on euro deposits held by the

central bank.

Either measure would be a significant innovation for the eurozone. However,

they may in the end be unavoidable to counteract the unintended

consequences of the way the US is managing its debt problems.

The writer is a former member of the executive board of the European

Central Bank and currently visiting scholar at Harvard’s Weatherhead

Center for International Affairs and at the Istituto Affari Internazionali in

Rome