Trichet Faces ‘Trap’ as ECB Prods Leaders on Deficit Vigilance

By Simon Kennedy and Gabi Thesing

Oct. 8 (Bloomberg) -- Jean-Claude Trichet needs governments to walk through the emergency exit first if he’s going to be able to keep nurturing Europe’s recovery with record low interest rates and cash injections.

As an economic rebound allows policy makers to mull how they will withdraw stimulus measures, the European Central Bank President is demanding that when growth takes hold, lawmakers execute “ambitious” plans to reverse the region’s largest budget deficit since the euro began trading in 1999.

Failure by politicians to devise a plan and then carry it out may fuel debt and inflation, forcing the Frankfurt-based ECB to raise interest rates faster in the recovery, according to economists at Goldman Sachs Group Inc. and Barclays Capital. That could then threaten the economic pick-up by driving up the euro and bond yields.

“Deficit spending and tight money mean much higher interest rates,” said Barry Eichengreen, a professor at the University of California at Berkeley and author of a 2006 book on Europe’s economic history. “That’s a very unfriendly investment mix.”

Central bankers may already be fretting that their unlimited loans to banks are being cycled into government bonds. That would put the Trichet into a “trap,” said Julian Callow, chief European economist at Barclays Capital.

“It’s anathema to the ECB to be financing deficits,” he said. “It’s a factor which encourages the ECB to be getting out of its non-standard operations.”

Concern

Trichet may today signal his concern today by detailing how the ECB plans to unwind its policy of offering banks as much money they want for up to 12 months at the central bank’s benchmark rate, Callow said.

While lending to households and companies has almost ground to a halt, banks expanded their holdings of government bonds by 241 billion euros and their loans to the public sector by 34 billion euros in the first eight months of the year. That will fund almost half the euro area’s estimated 2009 budget deficit of 560 billion euros, Barclays estimates.

The yield on 10-year German bunds, the benchmark European government security, was between 3.1 percent and 3.2 percent this week, compares with a high this year of 3.75 percent on June 8, and a low of 2.85 percent.

‘Sustainable Finances’

The ECB will probably leave its key rate at 1 percent when its Governing Council meets in Venice today, according to all 53 economists in a Bloomberg News survey. It may keep the rate there until September 2010, a separate survey shows. It will announce its decision at 1:45 p.m.

When policy makers last convened to debate policy on Sept. 3, Trichet said afterward that governments “must now substantiate their commitment to ensuring a swift return to sound and sustainable public finances.”

Since then, they have said it’s too early to scale back their own emergency measures and signaled they intend to leave them in place at least into next year to support the economy.

“When the economy is walking solely with the aid of fiscal and monetary crutches, it’s not advisable to whip them away,” ECB council member Axel Weber said Sept. 10. Luxembourg’s Yves Mersch said the same day the bank will monitor the impact of its stimulus measures “until the end of the year.”

‘Picked Up’

The global economy may be recovering faster than some economists had envisaged. The International Monetary Fund last week raised its forecast for global growth next year to 3.1 percent from 2.5 percent. The Federal Reserve last month said the U.S. economy has “picked up,” while Australia’s central bank on Oct. 6 became the first Group of 20 nation to raise interest rates since the start of the global financial crisis.

Marco Annunziata, chief economist at UniCredit Group in London, said that if governments heed Trichet’s request, Europe’s economy will benefit by allowing the ECB to keep rates lower for longer and giving investors a reason not to push up long-term borrowing costs.

“If fiscal policy starts to tighten first, the central bank has room for maneuver,” he said. “The dangerous mix is too- loose fiscal policy, so you have rates rising over many yields.”

Currency Moves

The euro may also be pushed higher if governments force the ECB to act. The single currency is already irritating Trichet as its 17 percent rise against the dollar since February threatens profit at companies such as Metro AG, Germany’s largest retailer, and sporting-goods maker Adidas AG.

“An undesirable mix of easy fiscal and tight money would be a recipe for a strong euro, just about the last thing anyone in the euro zone wants,” said Erik Nielsen, chief European economist at Goldman Sachs. “The fiscal exit should start ahead of the monetary exit.”

The ECB isn’t alone in looking for governments to commit to fiscal consolidation when expansion is secured. Bank of England Monetary Policy Committee member Adam Posen last month warned in the Financial Times of “policy mismatches” that generate higher interest rates, as happened in the U.S. in the early 1980s.

European governments are sending mixed messages. While German Chancellor Angela Merkel is resisting a campaign for deeper tax cuts from her probable coalition partners, French President Nicolas Sarkozy says his government needs to spend more borrowed money to kick start growth.

Stephane Deo, chief European economist at UBS AG in London, predicts the deficit of the five biggest euro-area nations will rise to 6.7 percent of gross domestic product in 2010 from 6.2 percent this year, more than double the European Union limit.

“We find little evidence of a fiscal tightening next year,” said Deo.

Governments may play a “game of chicken” by refusing to retrench and daring the ECB to carry out interest-rate increases that may derail the recovery, said UniCredit’s Annunziata.

“You may have the central bank telling governments that if they don’t start tightening, they’ll have to,” he said. “Governments may say ‘try it, do you have the guts?’”

To contact the reporters on this story: Simon Kennedy in Paris at skennedy4@bloomberg.netGabi Thesing in Frankfurt at gthesing@bloomberg.net