Crossing the New Rubicon?
Mario Draghi, the president of the European Central Bank, knows a thing or two about the importance of timing. As markets anxiously wait for new clues from the central banker about the possibility of the launch of a full blown, European version of QE, it is important to put a few things into perspective.
The most important element is to recognize the need for political cover. Draghi’s success and credibility depends on German acquiescence, not necessarily from the Bundesbank, but most certainly from Berlin. This was the case when he launched the program that saved the euro, Outright Monetary Transactions (OMT) in 2012. At the time, the German Chancellor Angela Merkel decided to abandon the once all-powerful German central bank and instead backed Draghi. Once again, as the ECB inches closer to crossing a new Rubicon, it needs political cover from Merkel. Monetary policies, especially in the euro area, are just as much about politics as they are about setting interest rates. Hence, some media outlets are more interested in the political implications of a possible new ECB move than the impact of QE on the real economy, in other words, on inflation and employment. As a consequence, the public debate in some member countries is often hijacked by speculation about the political power game. The obsessive focus of this exercise is to establish whether there is enough evidence for the theory that the German government is finally being cornered by a softening central bank that has decided to support the spend-thrift periphery of the euro zone against the fiscally conservative German core. In other words, we are witnessing a new bout of the old growth versus austerity debate. For purely domestic reasons, politicians have to react. But one should not be mislead by the noise.
Conscious of the limits of monetary policies, Draghi is proceeding very cautiously. This time, instead of launching a program that so far has been neither implemented nor tested by markets (OMT), he is trying to bind several elements into a comprehensive strategy, one that includes fiscal policies — made of a temporary but still legal loosening of the euro area fiscal straightjacket — an agenda of credible structural reforms and last but not least, an even looser monetary policy stance. The ECB is obviously following Abenomics closely. If there is an early lesson from the latest Japanese experiment, it is that in order to minimize the counterproductive flash in the pan effect, expansionary monetary policies should not precede but accompany fiscal measures as well as structural reforms. The ECB is trying to convince Germany and others that continuing to play a game of chicken — along the lines of: “I’ll give you what you need if you move first” — carries the risk of sending the euro zone’s economy, including Germany’s, into a tailspin. Germany has finally hit a soft patch, and emerging countries are unlikely to come to the rescue of its export-oriented economy for some time. The crisis in the Ukraine, the biggest tailrisk to the fragile recovery, is worsening, and hitting German companies hard. Business as well as consumer confidence is suffering as a consequence. For Europe, the specter of a lost decade of weak growth, high unemployment and flat or even falling prices is materializing fast.
Against this backdrop, Draghi has finally admitted that inflation expectations in the Euro area may not be well anchored in the medium term. Weak growth now appears to be the consequence of weak demand as well as weak supply. Many observers have interpreted this as a sign that Draghi is abandoning the German economic recipe primarily based on supply side economics. This development caught many wrong footed. Only a few weeks earlier, in public remarks made right after the latest meeting of the ECB’s governing council, Draghi appeared to side with Germany showing increasing frustration with France and Italy. At the time Draghi implied that the recent bad euro area GDP readings had been caused by Italy and France’s lackluster implementation of structural reforms, not by weak (German) demand. The truth is to be found somewhere in the middle. Draghi is warning politicians that the central bank is prepared to act, but if it does so alone, the real economy of the euro area won’t get the lift that it needs. For now. markets are giving the central banker the benefit of the doubt. While the Federal Reserve is about to end its own asset purchases and could start to tighten monetary policies, investors believe that the ECB will continue to loosen its monetary policy stance. The euro is finally weakening. If the trend continues, the need for some form of QE may well melt away, drowned in slightly better inflation readings and stronger exports. In that case Draghi could have worked his magic again with the sheer power of well timed words. But that alone will probably not be enough to put the recovery in Europe back on track. This time politicians, both in the periphery as well as the core of Europe, should listen carefully to what Draghi says and finally heed his advice.