What looks like a fairly settled policy is fast becoming a very dangerous situation. The outlook for the world’s second largest economic block is pretty awful.
-Christian W. Thwaites, president and CEO, Sentinel
Imagine you are in a boat about the size of a car. The waves coming at you are equivalent to a twelve story building. Your boat is leaking badly and you're about to head into the Roaring Forties, some of the most ill-tempered seas in the world. What do you do? Well, Donald Crowhurst faced this in 1968 in an attempt to be the first to sail solo round the world. The stark choices were to continue, and meet almost certain disaster, or turn around and face bankruptcy. Then a third option came to him. Stay still, wait for other racers to pass him by, slip into their wake and return home the short way. Survive with a simple deception. No harm done. It turned out very badly and if you want to know the ending, watch a tremendous documentary called Deep Water. But for today, the “staying where you are and waiting it out option” is what is happening in Europe. What looks like a fairly settled policy is fast becoming a very dangerous situation. The outlook for the world’s second largest economic block is pretty awful.
On we stumble
The ECB is a curious animal. Its only mandate is price stability and to do it with very few tools. QE? Nope. Asset purchase? Not really. Buyers of sovereign debt in the primary market? Definitely not. Foreign exchange intervention? No. Reserve management? No.
This week the bank kept interest rates unchanged even as unemployment hit the 19m mark. Mario Draghi warned that in a bank-based economy, i.e. where capital markets play little part in the financing of enterprises and nearly all expansion and growth must be financed with loans, the transmission mechanism was still very weak. In simple terms, this means that credit does not flow and that banks’ poor asset quality and risk aversion prevents liquidity flowing to where it’s needed most. So we have a situation where i) inflation is at or below the forecast rate ii) the flow of money is seized and iii) the OMTs are a solution that, as yet, no one wants to engage . So what we face is very limited ECB support to the wider economy in Europe.
Some commentators suggest the ECB has failed. In fact, it has done a lot given the very limited arsenal at its disposal. Draghi managed to talk away the risk of a break up last summer and the all important spread differential of Italian and Spanish debt to Bunds has held up. But we’re now entering a phase where the low rates simply forecast low growth, low demand and inertia. Not any broad confidence in growth. The ECB is not to blame. It has all the tools of a Swiss penknife in a world which needs backhoes. Meanwhile the real economy stats look pretty sad: 4Q GDP in the eurozone fell 0.6%, and nearly every component fell in unison. Exports were down 0.9% and consumption fell again. It has not registered positive growth since mid 2011. The French economy is feeling the pinch. Government is pulling back, the relatively strong euro hurts French exports, and its decade long history of increasing labor costs at twice the rate of Germany means that large parts of the economy are very uncompetitive. The overall risk, of course, is that if France begins to hurt, the core cohesion of the EU will come under increasing duress.
There are few hints that the road of “growth through austerity” will change in Europe. But there are more voices calling out. Last week the boss of Fiat said “I understand austerity, but we can lose weight until we die.” Or, another way, just staying put and trying to sit it out is highly dangerous. By any normal standard, Europe should be pursuing easier monetary conditions immediately and governments should be on a course of gradual fiscal growth. The fact that it is not happening means more woe.