CREDIT SUISSE: The Game Of Chicken Is Almost Over

Joe Weisenthal 

Dec. 4, 2011

 6:31 AM

Image: Nienetwiler, Wikimedia Commons

Right now, the hope among Eurozone optimists is that this week, European leaders will be able to quickly move to an agreement on a fiscal pact, and be ready to announce something on December 9 (Friday).

 
Then, if it's clear that the governments have committed to joint, enforceable reforms, the ECB will be able to come in with the serious asset purchases that might actually depress yields, buying Europe a lot of time.
But there's a simple problem with this: Politicians? Can they really get their act together on this kind of timeline?
In a note out, Credit Suisse's European economics team is skeptical.

But not moving before a government does becomes a dangerous game as the dearth of liquidity in the market shows. And with the risk that the liquidity crisis turns into a full blown solvency crisis and thus potentially the end of the euro, the game of chicken is nearly up unless politicians deliver a Christmas miracle on 9 December. Since miracles are rather uncommon, our view is that the ECB will need to step in more decisively early in the New Year. In the first quarter alone, the euro area sees EUR143 bn of bonds maturing with Italy accounting for EUR 64 bn of those.  

(The game of chicken -- a metaphor for two cars zooming at each other on the road, with each betting the other will swerve first -- is a useful way of understanding the European situation. One car is the ECB; one car is the European governments. Which swerves first?)

So then what's next if there's no fiscal solution? Large-scale QE.

Assuming politicians fail to restore market confidence by the start of next year, what are the options for the ECB? For many, the ECB announcing that it would buy unlimited amounts of sovereigns embarked on an austerity course would do the trick. In our view, such an announcement could easily be challenged from a Treaty point of view. It would also blur the boundaries between monetary and fiscal policy further and on top bring up questions of democratic legitimacy. 

It would be far easier to announce large scale asset purchases along the lines of QE as long as it is announced as a monetary policy tool. This would not be against the treaty since under the latter, the ECB has a clear price stability objective of below but close to 2%. The backdrop is given to use QE as a monetary policy tool. The euro area is sliding back into recession, which will be accompanied by a mounting risk of deflation exacerbated by the fact that the periphery has embarked on large scale fiscal adjustment and has started to restore competitiveness through relative price declines. The risk that in the medium term, inflation undershoots the price stability objective, is thus not negligible.
Even the German orthodoxy, which likes to take its cues from money supply can rest assured that the risk for price stability objective is on the downside rather than on the upside.