Why an ailing eurozone still requires extreme treatment

29/12/2017

By Wolfgang Munchau

Even after a decade-long recovery, the ECB may never be able to halt asset purchases

Cyclical economic recoveries happen even in the worst economies. Gross domestic product in the eurozone has been rising at robust levels over the past few quarters, but rumours of a return to economic health are vastly exaggerated. They are based on an intellectually lazy habit of ignoring past history and noticing only the most recent economic data.

The European Central Bank is, fortunately, not in that camp. Its cautious monetary policy decisions last week were based on a much more realistic assessment of the health of the eurozone economy compared with the fashionable view. When the ECB looks at the slack in the economy, one of the variables it focuses on is the broader unemployment rate, known as U6, which includes not only officially registered unemployment but other categories of hidden unemployment. The U6 rates stand at about 18 per cent in the eurozone and 9 per cent in the US.

Another important variable is the core rate of inflation, excluding energy and food prices. The core rate matters as a leading indicator of future headline inflation. It has not been above 2 per cent since 2008. This core rate is very sticky: although it has gone up a little recently, it will take several years until it is close to 2 per cent.

The euro’s nominal effective exchange rate — against a weighted basket of currencies — is also not looking good. It has risen by 5.5 per cent since the beginning of this year. Large economies normally do not depend on exports as much as smaller ones, but the eurozone is an exception. It is highly sensitive to the exchange rate.

Europe’s central bankers may also be spooked by political uncertainties, from Brexit to the possibility of a violent stand-off between Spain and Catalonia.

These are some, but not all, of the reasons why the ECB has been persistently more dovish than many outside analysts. While there is more realism around today, I would still classify market expectations as too hawkish.

More important than last week’s widely anticipated decision by the ECB’s governing council to reduce monthly net asset purchases, was the vote not to set an end date for the programme.

Mario Draghi has exactly two more years before his term as ECB president expires. I would estimate that the asset purchases might continue to the very end of his term, or possibly beyond. Once the programme concludes, there will be a long period — one or two years — during which the ECB will keep reinvesting the money from the bonds that expire. This will leave the total size of the ECB’s balance sheet unchanged. From an economic point of view, it is the size of the balance sheet that matters, not the monthly purchases. In other words, the stocks are more important the flows. If the net purchases continue until 2019, the ECB’s balance sheet will not start to contract much before 2021. This is also about the time when one should expect interest rates to rise from the currently extremely low levels.

These extreme policies are needed because the eurozone economy is in such bad shape. It is getting better for sure, but we are looking at a decade-long recovery. It is thus meaningless to compare the relatively high current growth rates in the eurozone to that of the UK or the US. Neither experienced an economic shock on the scale of the eurozone’s. A cliff-edge Brexit might do the trick, but this is still a low probability.

There is another, unspoken reason, why the ECB continues to buy assets — if it were to stop, the eurozone crisis might return. At that point investors would have to assess whether Italy has the capacity to service its public sector debt, which is more than 130 per cent of GDP. If current political trends persist, next year’s general election could produce a hung parliament and a coalition between the two largest parties, the centre-left and the centre-right. I can see many bad outcomes of that election, but not a single one in which the next Italian government undertakes structural reforms to raise long-term productivity.

Also consider that the new German coalition will push for a European Monetary Fund. Unlike the current eurozone rescue umbrella, an EMF would have the capacity to bail out Italy, should this become necessary. But the quid pro quo will be automatic or semi-automatic debt restructuring. The mere thought could produce a financial crisis.

Herein lies the true tragedy of the ECB asset purchases. Depending on the politics, the ECB may never be able to stop them. If it did, it would cause financial and economic instability. An Italian debt restructuring would have severely disinflationary effects on the eurozone, and the ECB is under a legal obligation not to allow that.

If the eurozone is lucky, the ECB purchases end in 2019, there will be no debt defaults, and all is well until the next crisis. But if not, the purchases might go and on and on.

Πηγή

Σχετική δημοσίευση εδώ.