Monday, 3 September 2012

Why yield targets would hit the mark…

Dr. Philipp Rösler. Source: Wiki

The war of words between the ECB and Bundesbank rages on with the previously isolated Bundesbank seemingly having regained an ally in the German government.  As well as being the German Economy and Technology Minister, Philipp Roesler is also Germany’s Vice Chancellor, a rather grand title for a thirty-nine-year-old.  Note however that he is not Mrs Merkel’s most trusted deputy but rather the leader of the coalition’s junior partner (the Free Democratic Party) - so perhaps more of a Clegg.

Mr Roesler continues the line of the Bundesbank President; rather than backstopping bond markets only structural reforms will return Europe to prosperity. The New York Times quotes s Mr Roesler:
"ECB President Mario Draghi has pointed out himself that only structural reforms in individual countries can secure the competitiveness and stability of our currency, not bond purchases. That must be the course."
There is, however, no indication that the ECB wish the two paths to be mutually exclusive.  Indeed our support for the policy of yield-targeted bond purchases has always been that the targets could be set depending upon the current state of reform for an economy.  For example, if your economy is a dynamic hive of innovation, efficiency and fluidity then it ought to borrow at similar rates to those of Germany.  Alternatively if your economy is a web of vested interests, bureaucracy and rigidity then it should bear the associated costs.  

The ability for yield targets to be the carrot (or indeed the stick) that drives the structural reform process exists:  if the ECB’s economic ground troops determine that reforms have been passed then a lower target can be set;  alternatively if backsliding has occurred then the target can be lifted.

Such an incentive is needed.  Implementing structural reforms at the best of times is difficult as the policy can be easily attacked by your opponents and is unlikely to engender immediate results.

It is easy for the German government to lament the failure of peripheral governments to implement reforms, but they should remember the happy coincidence of events back in 2003 which secured Germany’s position as the poster boy of economic competitiveness. 

These days the reforms introduced by German Chancellor Gerhard Schröder in 2003 are regularly exalted.  Schröder called his reform program Agenda 2010 in recognition of how long it takes for structural reforms to bear fruit.  They were passed because they originated from the Chancellor’s  left wing coalition which, given that they allowed the creation of low-paid mini-jobs and scythed unemployment benefits in return for tax cuts, would normally have been the source of greatest resistance. 

The reforms were implemented between 2003 and the beginning of 2005, during a reasonably vibrant global recovery from the 2002 recession.  Nevertheless opposition to the side-effects (an initial rise in unemployment) came from within Schröder’s  Social Democratic Party, as well as without, before ultimately causing the Chancellorship to pass to the Christian Democrats’ Angela Merkel.
It is hard to afford any would-be reformer a greater chance of survival in the today’s more challenging economic conditions.  Indeed the likelihood is that it will now be harder still just to get any reforms agreed, let alone implemented.  To this end it is absolutely right that the ECB should step up to the plate with sticky buns for those who reform (lower borrowing costs and effective financial security) and slapped wrists for those who don’t (higher interest rates and the risk of abandonment). 

Make no mistake, the policy is risky. The ECB would have to be prepared to suffer losses in the worst case scenario that a debtor goes backwards instead of forwards.  But the carrot and stick formula of yield-targeted purchases gives peripheral governments something to hide behind whilst trying to make the tough choices the German government and Bundesbank require.

Guy Foster
Head of Portfolio Strategy

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