There’s a school of thought that the Eurozone is on the mend. After all, the economic contraction is over, most forecasts show that member countries will all register a rise in economic growth in 2014, and bond yields have been falling across the periphery of Europe. The Euro, therefore, has been enjoying the fruits of a revival of confidence, and the reflow of capital into the region’s bond markets and even into its banks. Europe’s leaders have also agreed on a banking union – or a form of banking union, we should say. So is it Mission Accomplished?
Far from it, unfortunately. The recovery in the Eurozone is anemic, and probably not much more than a bounce. The economic condition is becoming more and more deflationary, which would be bad news for sovereign debt sustainability. The reflow of capital is opportunistic. And the banking union is irrelevant to the current circumstances, and in any case, not based on the joint liability structure that maters, i.e. where Germany and other creditors are on the hook to finance common deposit insurance, and a common system of bank resolution. A major reason for the perky Euro against the US dollar – though not against the pound – is the sustained contraction in the ECB’s balance sheet as previously extended liquidity under long-term refinancing operations (LTROs) has rolled off. Ity has also been a factor pushing up Eurozone money market rates since December, and negating the effects of the Fed’s tapering announcement.
|ECB balance sheet back to where Draghi took over|
No one could deny that ‘Draghinomics’ has played an essential role in restoring financial stability to the Eurozone and allowing the economic contraction to end. But these are relatively low benchmarks against which to measure economic success and in the meantime, the ECB’s balance sheet has shrunk back to levels that obtained when Mr. Draghi took over in November 2011. Eurozone countries have agreed nothing to alter the prospects for weak economic growth and deflationary risks across the Eurozone, and so the ECB’s easing job is by no means over. Weak growth and deflationary risks are, of course, opposite sides of the same coin. The latest Eurozone inflation data show that consumer prices were just 0.8% higher in December 2013 than a year earlier. The core rate, excluding food and energy, was 0.7% higher, the lowest since records began in 2001. For 18 months or so, the ECB has been undershooting its 2% inflation target, and as things stand, the main tendency in Eurozone prices is still lower.
In the third quarter 2013, Eurozone GDP was 3% lower than it had been at the peak in the first quarter 2008. If the Euro Area does indeed expand by about 1% in 2014, as the OECD expects, GDP will still be almost 2% lower at the end of the year, and it might not surpass the 2008 peak level until the end of 2015, or even later.
It stands to reason, therefore, that if the Euro Area inflation rate continues to sink, flirting with outright deflation, there will be strong pressures on the ECB to live up to the ECB President’s recent statement that the central bank still has tools left to combat an ‘unexpected departure’ from the baseline inflation scenario and ‘unwarranted’ increases in money market rates. This would go far beyond the as yet unused and conditional Outright Monetary Transactions programme designed for individual countries. In fact, nothing short of renewed and unconditional balance sheet expansion will make a meaningful difference.
In the first instance, the ECB would probably anounce additional LTROs, or long-term repurchase agreements, providing the banking system with additional liqudity. Some form of lending encouragement is also possible, perhaps utilising a variant of the Bank of England’s Funding for Lending scheme for small businesses, introduced in the UK in July 2012. But ultimately, and in spite of expected resistance by the Bundesbank and perhaps some other European central banks, the adoption of proper QE is quite possible, under which the ECB would buy sovereign bonds across the Eurozone.
This would take the ECB into contentious political and policy territory, but it is within its remit to buy sovereign bonds in the secondary market. It cannot flout the Treaties by making new inflation or any unemployment commitments and it is expressly forbidden from lending directly to governments, or via the European Stability Mechanism. But it can, if controversially, talk down the Euro, reintroduce covered bond purchases, buy foreign bonds, and introduce a QE scheme where sovereign bonds would be purchased according to some formula, for example capital shares in the ECB, or market capitalisation.
As the ECB treads further down the easing road, the Euro is most likely to depreciate again, perhaps back down below the 1.28 level it reached last summer amid the tapering talk that proved premature. If in the face of political resistance, the ECB doesn’t go far enough, the deflationary risk to debt sustainability in an economically and politically fragile Eurozone, promises the same endgame but in more fractious circumstances. The next six months will prove a testing time for Draghinomics.