ECB Under Pressure to Abandon Superior Policy Stance

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euro ballThe European Central Bank is under pressure. Inflation in the eurozone is at 0.7 percent but as Ben Bernanke supposedly stated, we are never sure if we measure these things correctly. So by all we know, the eurozone may already be in mild deflation.

This should come as no surprise. The eurozone has practically had zero money growth and zero growth in lending for some time. As reported yesterday, growth in the M3 money aggregate fell to a snail’s pace of 0.8 percent year-over-year in April. Loans to the private sector are 1.8 percent lower in April 2014 when compared to the same month last year. This has been going on for some time as these graphs about credit extension illustrate:

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Naturally, the easy-money brigade is in uproar. Billionaire hedge fund manager David Tepper said the ECB was “really, really behind the curve.” Martin Wolf is demanding “another bazooka”, and Ambrose Evans-Pritchard has long suspected that a secret “hard-money” fraternity is controlling the central bank, running the whole economy into the ground.

Is the ECB Controlled By Some Old Bundesbank-Hardliners?

Well, I for one certainly hope so but still doubt it.

In my view the ECB’s policy has been the most sensible (or shall I say, least irresponsible) of all the main central banks. Of course, I maintain that ultimately only completely apolitical and probably inelastic money is suitable for a free market economy (or even a broadly free market economy), and that elastic fiat money, any form of monetary policy (persistent intervention in money and banking), and thus the very institution of central banks have no place in capitalism correctly understood. I am no friend of central banks but I also know that central banks are not going to disappear anytime soon. So if you have to have central bankers you can do much worse than having such types as crusty old Helmut Schlesinger in charge. In my book, inactivity is a virtue in a central banker. If Evans-Pritchard is right and a silent network of Bocconi-trained hard-money Italians, Austrian-School-inspired Spaniards and old-fashioned Bundesbankers does exist somewhere in the bowels of the European money bureaucracy and constitutes an ideological road-bloc to Krugmanesque stimulus, I say all power to them!

An extended period of no money growth or even moderate contraction should not only be not a surprise after an extended credit boom that had led to a major bust, it should be eminently sensible and thoroughly recommendable.

The charts above not only illustrate the flat-lining of credit extension and thus broad money growth since 2009 but also the substantial growth in bank credit in the run-up to the crisis. I thought that after 2009 most people agreed that a period of deleveraging and bank-balance sheet repair was unavoidable. Is that not simply what we are seeing now?

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I see no reason to advocate an active policy of disinflation or deflation but if the healthy downsizing of the European banking system should lead to a period of moderately falling prices, so be it. The ECB’s 2-percent inflation target is silly under most conditions as it can frequently be realized only with policy-stimulated bank credit creation, the dangers of which should have become apparent to everybody after the recent boom-bust cycle. But this policy objective seems particularly counterproductive at a time when repairing bank balance sheets should be the overriding goal.

The financial crisis was not an act of God or a force of nature, and whichever way you cut it, reckless lending played a big role in it; reckless lending that was generously funded by the central banks. Spanish, Italian, French, German, Greek banks – they all looked like the walking dead in 2009, and many certainly still do. Would I really sleep better if I knew that the ECB would pump newly printed billions into the banking system encouraging the bankers to go back to their merry old ways? Would it reassure me if I new that vast sums of liquidity were washing through the system in search of another Fred Goodwin to put them to “good use”?

As an aside it should be stressed that zero or even slightly negative credit growth does not mean that nobody gets a loan, only that in aggregate banks make fewer new loans than get simultaneously repaid by existing borrowers.

Naturally, zero money growth lays bare structural rigidities of which there are plenty in the eurozone, not least overregulated labor markets, unsustainable government spending and excessive debt. None of these are anywhere near their solution, and the largely paralyzed political elite has long considered tackling them unpopular and potential political suicide. The potential for crisis remains but the blame for this does not lie with the central bank.

The Politics: Germany vs. France

The Euro-project depends on the Germany-France axis and can be seen as an ongoing cold war between the political elites of the two nations with their very different views on economic policy. For the French elite, the euro was always a vehicle for breaking German monetary hegemony in form of the Deutschmark and the all-powerful but rigid Bundesbank. Once the DM was gone and the Bundesbank neutered, German monetary Puritanism was supposed to be passé, as an École-here and Polytechnique-there educated bureaucracy would run the European show and infuse the whole thing with some Gallic vigor.

As recently as a few years ago the idea was widespread that France could lead the anti-austerity Mediterranean bloc against Germany. That seems a distant memory now.

The French political elite is entirely discredited and seems in a state of complete disarray. In Germany Merkel’s right-wing anti-euro challengers in the European election last week, the Alternative für Deutschland, got 7 percent of the vote, France’s more right wing and thoroughly anti-euro Front National, 25 percent.

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It is maybe telling that the media speak of a populist backlash at the elections. Many may have thought that Hollande with his eat-the-rich socialism could be the face of the new European populism but in fact he was not (Ed Miliband, take note.) In any case, Hollande is politically a dead-man walking, while Merkel reigns supreme in Europe. She may not want to overdo the austerity drive but the push for structural reform and ‘moderate’ austerity in the eurozone will continue. A politically and economically (fairly) strong Germany takes pressure off the ECB at the margin.

Whichever way you cut it, Germany is presently the haven of stability in Europe: low unemployment, no meaningful deficit, fairly solid growth, and political stability to the point of numbing boredom. (I remain negative on German fundamentals in the long run. The observation here is a snapshot and solely on a relative basis.)

The Germans and the ECB

The Draghi-ECB is not popular with the German political elite. The Germans are skeptical of quantitative easing and many share the reservations of the German Constitutional Court, which suggested that such policies could be considered government funding via money printing (of course they are!). Neither is Draghi’s famous line to do “whatever it takes” to save the euro, which diffused the sovereign debt crisis, popular with the German government (and the Bundesbank, I guess), although everybody is probably happy that it seemed to work for now. It is simply fortunate for everyone involved that the markets have not tested Draghi’s resolve. Although the ECB will now give in to pressure and ease further, any large-scale QE appears unlikely for the time being, in my view.

Takeaways

What does it all mean? – I don’t know (and I could, of course, be wrong) but I guess the following:

The ECB will cut next week but no QE will be announced for the time being. I think the ECB will go for a negative repo-rate before it goes for large-scale QE. This move is largely anticipated. I think the impact on fx markets and markets in general should be muted. This is not a game changer.

Contra the mainstream, I do not think that this is a better policy than what is in place now. I prefer ECB policy to what the Fed has been doing, so any move toward Fed-style accommodation does not get my blessing (not that anybody cares).

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Monetary aggregates in the US (including credit metrics) are expanding healthily, or not so healthily, if you share my philosophy, as the Fed appears to be buying itself a recovery with easy money, which will lead to problems in the long run (same old, same old). But not now. I do not see any major derailment of the economy any time soon (famous last words). Over coming months the discussion of when the Fed and the Bank of England will tighten will continue and probably intensify. The ECB is out of synch with other central banks. The rate cut next week could be its last – at least until other problems materialize.

(None of the above constitutes investment advice. Please see “terms of use”.)

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About Detlev S Schlichter

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