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Fiddling at the Fire

PARIS – Financial markets have rallied since July on the hope that the global economic and geopolitical outlook will not worsen, or, if it does, that central banks stand ready to backstop economies and markets with additional rounds of liquidity provision and quantitative easing. So, not only has good – or better-than-expected – economic news boosted the markets, but even bad news has been good news, because it increases the probability that central-banking firefighters like US Federal Reserve Chairman Ben Bernanke and European Central Bank President Mario Draghi will douse the markets with buckets of cash.

But markets that rise on both good and bad news are not stable markets. “Risk-off” episodes, in which investor sentiment sours, are likely to return if economic news worsens and confidence in policymakers’ effectiveness drops.

In the eurozone, euphoria followed the ECB’s decision to provide support with potentially unlimited purchases of distressed countries’ bonds. But the move is not a game changer; it only buys time for policymakers to implement the tough measures needed to resolve the crisis. And the policy challenges are daunting: the eurozone’s recession is deepening as front-loaded fiscal consolidation and severe credit rationing continues. And, as eurozone banks and public-debt markets become increasingly balkanized, establishing a banking union, a fiscal union, and an economic union while pursuing macroeconomic policies that restore growth, external balance, and competitiveness will be extremely difficult.

Even the ECB’s support is not obvious. Monetary hawks – the Bundesbank and several other core central banks – who were worried about a new open-ended ECB mandate pushed successfully for strict and effective conditionality for countries benefiting from the bond purchases. As a result, they can pull the plug on the program if its stringent criteria are not met.