What is the greatest motivating force in economics? Greed is a good answer; a better one is laziness. The U.S. Federal Reserve and the European Central Bank have made governments lethargic and sloppy by unleashing waves of liquidity that have propped up the financial markets, and dropped sovereign yields to absurdly low levels, allowing some countries to fund themselves at money-for-nothing costs, or close to it.
It was not supposed to be that way. The crisis was supposed to be an equal opportunity fix-it job, one split between central banks and governments. In exchange for austerity and economic reform on the governments' parts, central banks would make the dirty work easier through quantitative easing, dropping interest rates and, in the ECB's case, backstopping the sovereign debt of distressed countries.
It was a fine idea, but it was the central banks that did most of the heavy lifting. They did so again this week, when the ECB cut the refinancing rate by a quarter-point, to a record low 0.5 per cent, and hinted that it was willing to accept negative interest rates, that is, it would charge banks a fee to deposit funds at the ECB, all the better to encourage the gun-shy banks to lend it out instead. The Fed, meanwhile, said it might speed up quantitative easing, not slow it down.
All the monetary moves worked wonders. On Friday, the yield on 10-year U.S. bonds was 1.64 per cent; Germany's was 1.18 per cent. The plunge of the yields in countries allegedly hurtling towards bankruptcy is even more impressive.
Italy's borrowing costs hit 3.73 per cent on Friday, down for a one-year fall of 177 basis points (100 basis points equals one percentage point). At the height of the crisis, in 2011, Italian yields were dangerously close to 7 per cent, the level that triggered bailouts in Greece, Ireland and Portugal. The yields in Spain have fallen to 4 per cent, for a one-year fall of 179 basis points. Both countries are in deep recession and their jobless rates and debt loads are soaring. Spain is even blowing its budget deficit targets. But never mind. The ECB has come to the rescue and "crisis" no longer applies to the sovereign debt market (though corporate borrowing costs in the weak European countries remain distressingly high, giving German companies a huge competitive advantage).
The central banks have been heroic. ECB president Mario Draghi made good on last year's promise to do "whatever it takes" to keep the euro intact. But it has all come at a cost. Marco Annunziata, chief economist for General Electric, summed it up nicely in a May 2 note. "The Fed and the ECB are now caught in a trap, victim of their own success," he said. "They have muzzled financial markets, but this has made governments lazy, and without progress on fiscal and structural policies, central banks have no choice but to do more, with diminishing returns and increasing risks."
The central banks are running out of ammunition. The situation in the United States is not dire (note the sweet jobs figure on Friday); it is in Europe. The European Commission's new forecasts, adjusted downward, call for a 0.1-per-cent economic contraction in the 27-country European Union this year and a 0.4-per-cent contraction in the 17 countries that share the euro.
The wall of liquidity took the pressure off politicians to clean up their governments' fiscal acts and make their economies more competitive. It wasn't the ECB's intention to create zombie governments, but that appears to be the outcome.
Take Italy. With plummeting sovereign funding costs, and the assurance that the ECB would not let the euro zone's third-largest economy bring down the whole show, what incentive does the new government have read the riot act to its uncompetitive industries and bloated bureaucracy? None, is the answer. Even at the height of the crisis, economic reform was minimal, at best. No wonder Italy's unit labour costs, to name but one disaster area, haven't fallen since 2008. They have in Spain and Greece. Their export markets are on fire, as a result.
No wonder Mr. Draghi this week again called for fiscal discipline and vigorous reform in the euro zone. If the countries in deep recession don't realize that the ECB's monetary policy has reached its limits, Mr. Draghi certainly has.
Europe is in a lull, one that may not last long. The recession and budget deficits are problems, and national debt loads are rising. So is unemployment. At some point, investors will figure out that Mr. Draghi's pleas are going largely unheeded and will respond in the usual manner when risk goes up – they will drive up yields. The ECB did too much to take the edge off the crisis, the governments too little. That's why the crisis will return.