Beware when leaders speak the truth

If there is one thing more worrying than leaders avoiding the truth it is when they start to speak it.
Unusually frank comments from German Chancellor Angela Merkel on Wednesday came, within this context, as quite a surprise:
"We have not yet shaped the European project in a way that we can be sure that everything will turn out well, we still have work to do," Merkel said in an interview posted on her Christian Democratic Union party's website.
Gee, Angela, now that you mention it, we're not so sure either.
Merkel quickly added she was "optimistic that we will succeed," though she has been saying roughly that for seemingly ever and progress has been, well, mixed. The question then is why she chose this particular moment to state the blindingly obvious.
As ever, a look at how markets reacted can be illuminating. In this case, the euro fell, sharply, and government bonds rallied, sending yields lower. Clearly such statements don't inspire much confidence - if you were a corporate manager would this make you more or less likely to invest and hire? The rally in German bonds, for example, may also denote a conviction that Merkel's honesty denotes a smaller chance that the German treasury will be picking up ever larger bills.
As for the euro, a currency whose principal backer thinks it might not make it is one with risks skewed to the downside. I'd also like to point out that for the foreseeable future whenever we see a high official say or do something surprising, that surprise can be expected to usually have the effect of driving their home currency lower. We are, after all, in a currency war.
Probably internal politics, both within Germany and between it and its European partners, has as much a role in Merkel's new-found realism as did any concerns about the price at which Germany can sell to China and the US.
A shock can tend to galvanize one's negotiating partners. And she faces a revolt within her own party - one unlikely to succeed - ahead of a vote Thursday in the lower house of parliament over Germany's contribution to the Spanish bailout.
That being said, the risks officially ignored have a nasty habit of moving straight to reality once officialdom actually acknowledges their existence. The risks of euro break-up are probably higher than many who heard Merkel realize and definitely higher once she uttered the words.

WELCOME WORDS FROM THE IMF
Another unusual, and welcome, source of plain talk on Wednesday was the International Monetary Fund, which positively lit into the European Central Bank, calling on it to be far more active in supporting the euro zone economy. The IMF said there was about a 25 percent chance of falling prices, and outright deflation by early 2014, with risks concentrated in the hard-hit southern parts of the euro zone.
Besides calling for the ECB to be given full lender of last resort responsibility, the IMF was emphatic in calling for much easier monetary policy and more active work to support the transition to a more highly integrated zone.
The IMF is essentially calling for a kitchen-sink policy from the ECB in which it would cut interest rates, do "sizable" quantitative easing, make more targeted purchases of weak sovereign bonds and do further rounds of offering banks cheap liquidity. They also called on the ECB to accept equal status with other creditors.
This was a blunt message and disconcerting in its vehemence, made all the more so when you realize that the ECB is highly unlikely to follow anything close to this course of action unless it finds itself in truly dire circumstances.
Apparently, a one-in-four chance of deflation may not be enough to rouse the bank from its narrow view of its remit and obligations.
While it is difficult to forecast events in Europe, it is becoming easier and easier to understand Europe's likely economic and market impact over the next couple of years. While the negative impact started out about a year ago as mostly due to uncertainty, the impact will be becoming more and more real as the months go on, the southern economies slump and the euro zone sends out wave upon wave of deflationary power to the rest of the global economy.
While a disruptive change in the euro is the biggest risk, the longer the crisis goes on without resolution, the higher the baseline cost in dropping demand will be.
The Federal Reserve, the Bank of England, the Bank of Japan and the People's Bank of China will all outpace the ECB in mounting an activist response, with lots of extraordinary measures yet to come.

— James Saft is a Reuters columnist.
The opinions expressed are his own.