No Claim to Victory
While most commentators who listened to Mario Draghi’s first press conference in 2013 focused on the upbeat tone of the remarks made by the ECB’s president, I prefer to focus on his stubborn refusal to say that the worst is over for Europe. “It’s too early to claim success,” Draghi said, “the jury is still out.” Super Mario repeatedly stressed that the overall situation is still characterized by a high degree of uncertainty, particularly given the less than stellar record of politicians in sticking to their commitments once pressure eases (for more on this, see recent Peterson Institute essay by Jacob Kirkegaard). He also cited non-specified global challenges as potential roadblocks on a still tentative path back to economic recovery (overcoming various fiscal cliffs should be high on his list). However is it also true that Draghi reiterated his belief that things should improve in the second half of 2013. For markets, this was reason enough to cheer.
While Draghi in fact reported that the primary goals of the ECB’s most recent unconventional measures (both the Longer Term Refinancing Operation (LTRO) for banks and the sovereign bond buying program known as Outright Monetary Transactions (OMT)) have been largely met—namely by reducing financial fragmentation and therefore eliminating the tail risk of a sudden and disorderly euro breakup—the central bank’s monetary policies have done very little to substantially improve credit conditions in the periphery of Europe. In data released just a few days before today’s meeting of the governing council, the ECB points out that in November 2012 the annual growth rate of loans to non-financial corporations stood at -1,8%, a clear sign that despite the return of international investors to the euro area (Draghi pointed out that the ECB has observed significant capital inflows into the euro zone in recent months) banks are still repairing their balance sheets and remain extremely risk averse. Demand for loans also remains subdued. These factors represent a toxic mix for an economy still mired in a deep recession.
Draghi also issued a stern warning to Europe’s politicians, saying that high unemployment is largely the result of structural weaknesses in some labor markets (see Spain or Italy or even France) where reforms in the past decade have created dual labor markets that punish the younger generations. “Monetary policy cannot do much about addressing structural unemployment” he said, adding that it is up to politicians to address the structural adjustments. These are needed in order to avoid having a euro area split between “permanent creditors and permanent debtors.”
While fiscal consolidation appears to be within grasp—as long as markets continue to be vigilant and don’t completely refrain from applying pressure on debtor countries for fear of the ECB’s wrath—labor market reforms remain a huge stumbling block for any politician in the euro area.
Italy is a good example and a significant first test. The upcoming elections will determine whether the next Italian government will have the necessary political majority needed to stick to its ambitious fiscal consolidation and show more courage in addressing the labor market distorsions that Draghi cited in his remarks on Thursday, January 10th. For months, German government and Bundesbank officials have complained that the government led by Professor Mario Monti should and could have done more. Italian officials have reacted by pointing out that the Italian labor market reform enacted by Monti is in fact quite similar to what Germany did earlier in the decade. Both sides are right. The problem is that Germany can hardly be cited as an example of a country with a modern and flexible labor market, quite the contrary in fact.
German employers and employees regularly resort to internal labor market flexibility (within companies) to offset external labor market rigidities. When the crisis hit, many small and medium sized businesses did not want to loose the expertise of their employees. Workers, on the other hand, agreed to wage restraints because they simply did not want to loose their jobs. It was largely this cooperative climate between business leaders and their employees that prevented a shock in the wake of the severe recession of 2009 rather than flexible labor laws. In fact, the World Economic Forum ranks Germany 112th out of 142 countries in term of labor market flexibility. Without structural changes, even the current role model Germany could slip back quickly. According to German ECB board member Joerg Asmussen, in the absence of significant reforms his country could easily once again become the “sick man of Europe.” (For More on the German outlook in 2013, see report from Deutsche Bank Research)
However, in the absence of outside pressure, nobody, not even Germany, will introduce any reforms, particularly not in an election year. Caution is warranted. The ECB has made its move. In the coming months it will merely monitor the situation. In 2013, it will be up to politicians to show that they have the will to continue on a path of reform.
In order to do so, they need to do more to convince their own citizens. This is why the Italian election in February is such a significant first test in determining not only who gets to rule the country, but also in clarifying who gets the voters’ blame for the country’s ills: is it going to be Europe, Germany, Italy’s controversial billionaire-politician Silvio Berlusconi, or Mario Monti? The Italian Mario Draghi knows the answer all too well, but his institutional role prevents him from speaking out. However, his message to Europeans and his fellow Italians is very clear. After many sacrifices, it would be a grave mistake to reverse the painful steps undertaken in recent months. Ultimately, as Draghi puts it, “fiscal consolidation is unavoidable.” In the eyes of Draghi, the need for sacrifices is simply not over yet.