The following is an investment viewpoint by Mohamed El-Erian, chief executive officer and co-chief investment officer of at Pimco.
The beneficial impact of last weekend's $1 trillion “shock and awe” intervention by Europe to save Greece and safeguard the euro is fading – even more quickly than officials had feared.
The euro has weakened dramatically in the last few days. Sovereign risk spreads have started to widen again despite considerable (and noisy) buying by the European Central Bank (ECB). And equity markets have given up part of the dramatic gains that followed the policy announcements.
All of this is the result of two main factors:
First, having analyzed the news out of Europe in depth, markets recognize that the liquidity-based approach cannot sustainably address what is at heart a solvency problem. Rather than being “crowded in,” it appears that investors are using the liquidity from the official sector as an escape hatch to get out of their positions. As such, and this was highlighted earlier as one of the shortcomings of the current approach to Greece, the official sector is having to compensate both for natural debt maturities and for the exit of trapped longer-term positions held by the private sector.
Second, markets are worried about the collateral damage and unintended consequences of the “shock and awe.” Most importantly, they dislike the extent to which the standing and integrity of the ECB are in the process of being sacrificed. They understand, and are concerned that short-term stability is being pursued at the cost of long-term viability.
We should also be aware of a secular issue that underpins all this – and one that tends to escape the notice of policymakers and others that are more comfortable dealing with flows and rates of change, rather than stocks and levels.
A key dynamic of the past few years – namely, the serial contamination of balance sheets – is hitting the reality of scarcity.
Industrial countries are running out of balance sheets that can be levered safely in order to minimize the disruptive impact of past excesses. This lies behind the recent (warranted) concerns about the explosion of debt, and the related surge in sovereign risk measures.
The balance sheets that are left – which reside essentially in central banks – are not made (and, I would argue, should not be forced) to assume permanent ownership of dubious assets. After all, the revolving nature of central bank balance sheets is essential to the healthy functioning of a market system, and to the credibility of its institutions. Remember, it is the quality of institutions that distinguishes successful economies over time.
None of this should come as a surprise. It is a storyline that developing countries know very well. Fortunately, some of them have also learned from it. As a result, they continue to surprise on the upside in terms of their ability to navigate a world made more hazardous by the major disruptions in industrial countries.
While industrial countries are only beginning to understand this narrative fully – and this partly explains the series of policy and market slippages – it is important that past mistakes not be repeated. The risk is that they will.
The temptation in Europe over the next few days will be to do more of the same; and for the U.S. to press Europe to do more of the same.
This would involve European governments committing to even greater official intervention, and the ECB to even larger purchases of dubious assets. At the same time, there would be a temptation to dial up the rhetoric against markets, and to co-opt the IMF even more into an unsustainable approach.
“Active inertia” could, albeit with declining probability, stabilize markets for a short period of time. But the longer-term reality will not change. Absent a significant change in the European policy mindset, officials will find themselves pulled even more into multi-round dynamics that support debt with more debt and, in the process, contaminate the good with the bad.
The alternative approach – that of addressing directly the solvency issues and also focusing the backstop where, due to better fundamentals, contagion would be rendered temporary and reversible – is not risk-free. Nor is it simple.
Yes, it is not easy to change track, especially after last weekend's protracted negotiations and compromises in Brussels and Frankfurt; and, yes, the risks of immediate disruptions are material. Yet it is the right thing to do for the longer-term health of Europe and the global economy.
Let us hope that courage and vision, rather than short-term expediency, prevail.
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