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Wednesday, January 25, 2012

Central Banking Works!

Some readers of this blog have been wondering why I haven't posted anything since returning to Europe from Goa on New Year's Eve.

The reason is Mario Draghi, who proved in late December that central banking works, at least for the time being. While he didn't deploy the 'big bazooka' of a credible backstop for Italian and Spanish bonds (or massively buy them up on the secondary market), as many people had expected, he did do the next best thing. And a very unconventional thing it was, squaring the circle of not explicitly monetarizing sovereign debt (the great German taboo) while bringing down intra-EZ spreads. He provided massive three-year liquidity to EZ banks, accepting national bonds as collateral. This has induced creditors to return to these bond markets, reducing spreads of Italian and Spanish bonds over German Bunds, substantially on maturities below three years, but even on longer term ones. Yes, Victoria, central banking works!

But does this put an end to the Eurozone crisis, as even Reuters BreakingViews has argued? Was the Euro crisis a figment of our imaginations (as a self-fulfilling prophecy, of course there is always something to that)?

Unfortunately, I think the ECB has only bought us an admittedly much needed respite by bringing us back from the brink. The fundamental issues I and many others have discussed still remain: the real exchange rate imbalances in the EZ, austerity as a self-defeating deflationary policy prescription, and the lack of a governance structure that would turn the Eurozone into a viable currency zone instead of a fixed exchange rate regime with a central bank with one hand tied behind its back. I'm currently working on a fundamental treatment of the latter - what does it really mean to be a currency, and why the Euro never was one - which will appear either has an extended post or a working paper, hopefully sometime soon.

In the meantime the threat of a disorderly Greek default looms, as does Italy and Spain's (not to mention Ireland and Portugal) increasingly desperate search for a growth alternative to the Greek austerity death spiral.

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