These are not happy times for Europe. Ukraine, Russia, and rising anti-democratic influences in Hungary and Poland represent latent threats at the European Union’s eastern front. The prospect of Brexit is a more acute one at its western front.
After letting loose manifold conflicting forces that continue shaping internal politics in many EU countries and setting them on collision course with their partners, the refugee situation appears to be on the verge of bestowing another humanitarian crisis on the union’s most vulnerable and unfortunate member: Greece. Never mind the Catalan question: it almost appears minor by comparison, but actually represents yet another fundamental challenge to the European project. “Misfortune seldom comes alone”, a German saying goes; the nation that is increasingly pulling the strings in European affairs but appears at risk of alienating itself even more so than its partners while doing it.
Considering all this the European political authorities may almost be forgiven for having lost sight of the smoldering crisis of the euro, the union’s flagship endeavor that was meant to foster prosperity and political union – but turned out to deliver quite the opposite. One key player, the European Central Bank (ECB), does not wish to partake in the peculiar mix of denial and delusion about the state of the euro. As the specter of deflation and lasting “Japanization” (or worse) is taking hold, again, the euro’s guardian of stability readies itself for unleashing a fresh round of unconventional policies to prop up the Eurozone’s feeble recovery.
So it’s Draghi showtime again. But how much good, if any, can the ECB really do at this point? I fear the ECB showman’s display of apparent power may be turning into a sad saga of hope and desperation. The ECB can no longer camouflage the fact that ample central bank liquidity alone will not heal the manifold and deep euro fault lines that are plaguing the currency and symbol of European unity. Make no mistake: Europe will very likely be facing crunch time this year – with nowhere to hide for no one.
It took the ECB many years to wake up to euro realities. The ECB is legendary for its reluctance to ease interest rates in the face of downside risks. It was still in hiking mode when Lehman Brothers failed in the fall of 2008. While keeping banking systems afloat through emergency liquidity provision it abhorred the idea of “quantitative easing” (QE) pursued by the Federal Reserve and Bank of England early on in response to the crisis. Instead the ECB even prematurely hiked rates twice in 2011. Draghi’s famous promise to “do whatever it takes” then calmed the markets in the summer of 2012, but this was only after interest rate differentials between Eurozone members had soared and credit dried up, as the risk of default on national debt and currency redenomination became investors’ foremost concern.
The ECB stood by when a credit crunch and brutal fiscal austerity were suffocating the Eurozone. Domestic demand shrank for eight consecutive quarters. A meager and uneven recovery only emerged in mid-2013. But lasting damage had been done by then, also in terms of wage and price trends. The urge to restore their competitiveness relative to Germany has forced Germany’s euro partners to embark on deflation, given that inflation in Germany itself is close to zero while wages are rising at barely 2.5 percent or so. As a result, inflation in the Eurozone as a whole was set to diverge downward from the ECB’s declared price stability norm of 2 percent. It took the ECB until the summer of 2014 to realize that it would miss its mandate by a wide margin and more than just temporarily.
To its credit, the ECB has explored new paths since then. It has designed special liquidity programs to entice bank lending. It has cut its policy rates and moved short-term market rates below zero. And it has belatedly also engaged in QE featuring large-scale purchases of national public debt. These measures have done some good. Interest rate levels and spreads have shrunk considerably. Bank lending has stopped shrinking and is even growing a little. Falling interest rates reduce debtors’ burdens. So one benevolent side effect was to provide relief to public finances and restore some fiscal space. Following years of counterproductive austerity fiscal stance has turned broadly neutral. Another side effect was to depreciate the euro. This may seem convenient at first, but in view of the eurozone’s surging external imbalance it can only be judged as a globally destabilizing factor.
Hence doing more of the same might well backfire. In particular, cutting short-term rates deeper into negative territory would risk currency market instability and retaliation. Regionally, the ECB would turn on the heat on Denmark, Sweden, and Switzerland in particular, as their central banks have to keep their rates below euro rates to battle disruptive currency moves. Globally neither the Japanese nor the Chinese authorities will be amused for sure – assuming that at least the U.S. authorities will practice benign neglect regarding dollar strength. The point here is that domestic demand is weak and economic instabilities ripe everywhere. There just is no neighbor around to beggar who could really afford it.
But doing more of the same also threatens the Eurozone’s already fragile banks. Banks’ business is to transform risks and maturities. Apart from fee income and trading, bank profitability hinges on risk and term spreads. If they cannot pass on negative rates to their own liabilities, reducing returns on their assets squeezes spreads and profit margins. Especially when banks are still laboring with legacies of nonperforming loans anyway, bank lending might suffer as a result. Also, as capital is scarce and costly, banks may resist exploring riskier propositions: they are operating under somewhat more scrutiny these days.
So what else could the ECB try? For one thing, instead of relying on portfolio rebalancing into riskier assets by banks the ECB might have to pile into those riskier assets itself. Timidity may stand in the way here. For another the ECB should focus its purchases on Eurozone assets other than German ones. In the promised land of the common market and common currency borrowers would be facing equal financial conditions irrespective of their nationality. While sovereign spreads (and private credit spreads priced of them) have decreased, the playing field is still far from level. For political and legal reasons this route may be blocked completely.
One peculiar irony is that German banks are suffering the most as a result. German sovereign debt shows negative yields up to almost ten years now. The ongoing profit squeeze is particularly brutal for them, and “more of the same” would likely mean just that. If the ECB could bluff the yield curve steeper, it probably would have happened already. This only highlights the futility of deliberately pushing a large economy into deflation while hoping to rescue it by easy money alone. And it also underscores that the German authorities have done themselves a great disservice by once again blocking constructive and responsible policies at the latest G-20 meeting.
Consider adding “Gexit” to the list of potential challenges facing Europe in the near future. A country that is running an 8-percent of GDP external surplus but resists rebalancing is holding its euro partners – and through them the world at large – hostage. Germany has steered Europe seriously off track and shows few signs of learning from the experience. In the end, Gexit might actually come as a relief.
Update: the ECB cut the main repo rate to zero and added €20n to its QE program on March 10