Article / 07 December 2015 at 13:00 GMT

Eurozone craves monetary and fiscal symbiosis

Managing Partner / Spotlight Group
United Kingdom
  • ECB announced half-hearted stimulus package last Thursday
  • The bank relies on internal medium-term forecasts that are too optimistic
  • Is ECB policy experiencing a diminishing return to scale?
  • Monetary and fiscal policy must work in tandem, focus on supply-side reform

By Stephen Pope

The European Central Bank led the markets down a blind alley, and the stimulus package it announced last Thursday fell far short of expectations. 

At its October 22 news conference following the governing council meeting, president Mario Draghi pledged that he would do everything necessary to stimulate the Eurozone economy.

Before October, the ECB governing council's Austrian member Edwald Nowotny had openly called for more aggressive monetary accommodation. Since that meeting no heavyweight governing council member warned the markets that a bumper bout of pre-Christmas financial festivity would not be forthcoming.

ECB Governing council
 ECB governing council meeting in Frankfurt. Image: ECB news conference webcast

There was at best a hint of such a possibility from Sabine Lautenschläger. She has, however, been outside the main group of decision-makers, so it is not surprising that markets paid scant attention to her comments.

So last week's decision was regarded by the markets as a genuine disappointment. Here's what it looks like from my vantage point:

• No change in the refinancing rate, left at 0.05% Should be zero
• 10 basis point cut in the deposit rate cut to -0.30% Should be -0.50%
• 6 month extension to APP / QE to March 2017 Should be open-ended
• APP widened to include state and municipal debt That is good
• Reinvesting QE principal payments A throw-away gesture

Money supply

During the past year, market interest rates and short-dated sovereign bond yields have declined in line with the sovereign bond purchases undertaken through the asset purchase programme. It is frustrating then that the size of loans to the Eurozone private sector have not risen as one might have expected, and clearly consumer prices have not moved in the intended direction.

Over the past 12 months, the measure known as “M1”, which is essentially “the money in circulation” in the Eurozone, has increased to €6.5 trillion from €5.8 trillion.

Loans to private sector in the Eurozone increased to €1.07 trillion in October, from €1.02 trillion. And in the 12-month period, just six months have seen CPI above zero, one month was zero, and the other five all showed deflation. The inflation rate has been below the ECB’s 2.0% target since December 2012.

This last point often seems to be ignored by the ECB, who have dallied with the core rate, which is currently just 0.9% and has not seen 2.0% since 2008. There is simply too much reliance on the internal staff economic projections that have consistently been over-optimistic with regard GDP growth and inflation.

The process has seen the ECB inject money into the system at a time when the structural reform to create a pro-business, pro-start up culture is so badly lacking that there has been little in the way of private-sector demand for new liquidity.

We know that monetary policy can do a great deal, but it cannot do everything alone. Even so, I must ask why there was not a more substantive reduction in the deposit rate or a ramp-up in the monthly total of assets purchased?

The Japanese, UK and US economies have a substantially higher scale of monetary accommodation via QE than the Eurozone.

Source: ECB, BoE, BoJ and Federal Reserve

It seems like the ECB governing council meeting last week was not controlled by the president of the ECB but by the president of the Bundesbank. Jens Weidmann. He may have argued to the hawks on the council that the accommodative monetary policy has so far delivered a diminishing return to scale.

I will not blame anyone for bemoaning the lack of political will to embrace reform. There is no reason for the ECB to have been so lightweight last week.

ECB president Mario Draghi
 ECB president Mario Draghi. Was he forced to water down the QE package by the Bundesbank president? Image: ECB news conference webcast

Do not dismiss QE

Without the benefit of the QE programme, the interest rate structure in the Eurozone would have been higher, and it is highly likely that the level of lending would have been lower than it currently is.

In fact, it is not too far-fetched to suggest that had QE not been delivered last March, the Eurozone would not have enjoyed the least trace of a recovery. It would have stalled, hurling the economy into a recession and thereby establishing an entrenched deflationary trend.
Fiscal policy, that means public spending, right?

I am not one to advocate a massive round of public borrowing to undertake pan-European public investment projects. No one wastes other people’s money like national or local government. Often the money is spent on so-called “vanity projects” that deliver a short-term boost to a politician’s appeal and the multiplier effect is soon dissipated.

Just look at the great network of super-highways in Spain. Spain has more kilometres of toll roads per capita than any European nation and yet it has the lowest per kilometre toll take. That is because the locals rarely use the toll roads. They take the side roads that follow the same path, and although the journey may take an hour longer, the only costs are that of fuel, vehicle wear and tear plus the driver’s time.

In fact, “Data Envelopment Analysis” from the World Bank, International Monetary Fund and Cairn Institute demonstrates that the most efficient nations in terms of public spending and improvement in the national production potential frontier are Japan, Switzerland and the US.

For the Europeans, their efficiency scores decline as more state spending is undertaken. The decline is most pronounced in Italy, Spain and France.

In addition to such empirical results I have to remind the reader that the levels of national debt across the Eurozone are already too high and the debt burden will be passed down to the next generation.

The key to economic activity and inflation is to be found in the private sector, and yet the lack of reform has passed the burden to the ECB. It would be helpful if the central bank would do more as finance is about perception, and doing something now is superior to doing it later.

That said, the process must be jointly managed, and it is for politicians of every stripe to step up and meet the challenge. Their resolve and the fickle nature of the electorate suggest that the politically motivated still expect someone or something else to pay for the lifestyle the Eurozone craves. If the politicians do not act, if they leave everything to the ECB, then there is a risk that the need for even more accommodation in the future will create a bubble.

Punchy private sector implies jobs and demand

Capacity utilisation in the Eurozone rose to 81.50% in the fourth quarter of 2015 from 81.10% in Q3. And yet this is below the all-time high of 85.30% in Q4 1989. The region is suffering from high unemployment, and there is large gap between actual and potential output.

The need for QE in balance with supply-side reform is acute because there is a worrying shortfall of demand. Consumer spending in the Eurozone increased to €1.4 trillion in Q2 2015 from €1.3 trillion in Q1. But this is still below the level seen in 2008. In the US, the 2008 figure was exceeded in 2011, and in the UK it was surpassed by 2014.

It does not take much intellectual dot-joining to suggest that the Eurozone could do with a little more, maybe a good deal more, of the Anglo-Saxon approach.

The basic fact that has yet to be fully appreciated in the Eurozone is that the euro system is in its entirety a half-baked project. Too much focus was placed on admitting new members when they were unsuitable candidates.

This was because the powers that be wanted to have an economic bloc with a population and a GDP level to square up to the US. Monetary union was pursued before political or federal union, with the result that the region is not in harmony, but in discord.

In a federal system like the US, fiscal and monetary policy work in a symbiotic, osmotic relationship. But for the Eurozone the great puzzle is how to make a currency union function when the central bank is more of a talking shop for national central banks, or when the president of the central bank can have his strings pulled by a banker from the biggest individual economy.

The real problem is that there is no Europe-wide streamline business programme, no process for cutting back on non-jobs in town halls or Brussels, and certainly no desire to roll back the ball and chain of the state that fetters the entrepreneurial spirit that creates jobs, demand and lasting prosperity.

ECB Building in Frankfurt
 "The great puzzle for the Eurozone is how to make a currency union function." Photo: iStock

— Edited by John Acher
Stephen Pope is managing partner at Spotlight Ideas


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