Moody’s downward adjustment of the sovereign debt of nine European countries was just the latest in a long series of negative assessments of Europe’s fragile economy. But while the headlines focused on Europe’s poor fiscal management and anemic economic prospects which threaten needed structural reforms, the credit rating agency signaled–somewhat vaguely–its strong support for the European Central Bank’s newly accommodative monetary policy.
“An important factor limiting the magnitude of Moody’s rating adjustments is the European authorities’ commitment to preserving the monetary union and implementing whatever reforms are needed to restore market confidence,” its rating action stated, adding its approval of unspecified “measures adopted to stem the risk of contagion.”
And indeed the European Central Bank, under the new leadership of Mario Draghi, has made a sharp departure in its monetary policy, most notably through its Long-Term Refinancing Operations, which very quickly made hundreds of billions of euros in cheap financing available to Europe’s sickly commercial banks, enabling them to make overnight profits by buying European sovereign bonds. The action simultaneously strengthened Europe’s banks and shored up Europe’s sovereign debt, while vastly expanding the ECB’s role in the eurozone economy much as the Federal Reserve has propped up the U.S. economy.
While the U.S. market–buoyed according to some observers by the Fed’s plans to extend its zero rate policy through the end of 2014–has enjoyed an extraordinary rally so far in 2012, rising over 7 percent year to date, European stocks have done even better, rising more than 8 percent so far this year.
The ECB has essentially reassured markets that it will not allow Europe’s banking system to fail and it will guarantee member states’ sovereign debt (while supervising an orderly restructuring of already bankrupt Greece). The ECB has already signaled a new, possibly larger LTRO program will be forthcoming, which is no doubt pleasing news to stock markets and credit rating agencies.
But the monetary easing is not without risks. A new policy analysis by Charles Wyplosz, a professor of international economics at the Graduate Institute of Geneva, calls the ECB’s policy move a “trillion euro bet.” Wyplosz warns that while the ECB has succeeded in rapidly reducing spreads on eurozone public debts, it has also vastly increased systemic risk if sovereign defaults are not successfully prevented. That is because banks are now sitting on even more sovereign debt than before. As Wyplosz points out, “by guaranteeing bank access to liquidity, the LTROs effectively eliminate the risk of illiquidity, but they do not address the risk of insolvency.”
At issue is how credible is the central bank’s assurance of public debt. Adding to the uncertainty is that the ECB is hardly alone in propping up government bonds. A recent analysis by James Bianco of Bianco Research shows that the eight largest central banks in the world are all engaged in massive quantitative easing programs, which Bianco defines as increasing the size of banking reserves (through bond purchases, for example). Bianco says that the balance sheets of these central banks now total $15 trillion, amounting to just under a third of global stock market capitalization.
Bianco argues that markets are rising or falling in tandem based on the market’s assessment of central bank behavior and that investors by and large are not making distinctions between better managed and worse managed companies. This will remain the case, Bianco argues, as long as central banks remain a pillar supporting the market. Bianco concludes, ominously, that “as long as this is perceived to be a good thing, like perpetually rising home prices were perceived to be a good thing, risk markets will rise.”
So the question is whether the central banks’ combined $15 trillion bet will restore confidence in time for the economy to grow again, or whether the global economic system collapses, sending waves of pain on a scale greatly exceeding the fallout of the still unrecovered U.S. real estate market.