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Debates

The Future of the Euro

Time runs out for Super Mario

David Thomas / Nov 2018

Mario Draghi, president of the European Central Bank. Photo: European Union

 

Ten years on from the global financial crisis, the European Central Bank (ECB) is finally talking about ‘normalising’ monetary policy and ending the emergency help it has provided to the euro zone financial sector and economy over the past decade.

Lagging years behind most other leading central banks around the world, the ECB says it will stop its programme of quantitative easing at the end of this year and has indicated that it will start to raise interest rates next autumn.

But making the case for even this sclerotic pace of monetary tightening has not been easy.

The ECB is having to talk up ideas of a tightening euro zone labour market and even rising wages, a message that many economic analysts have found unconvincing. Outside Germany, rising wages in many cases have been nothing more than the automatic result of indexation and, in other cases there has been a strong element of pure bounceback from the very low levels of pay rises which followed the crisis.

The ECB says it is confident that stronger wages will soon feed through into higher core inflation and so provide the trigger for a rate hike. But economists warn that such knock-on effects work only with a long time lag. In addition, the economic outlook has turned grim. The trade war rumbles on, threatening China particularly with a significant slowdown in growth, emerging markets are suffering the effects of a strong dollar as investors seek out safe havens, and the economic impact of Brexit still looms large and uncertain.

Events may yet conspire to deprive ECB President Mario Draghi of due cause to raise rates before he steps down in October 2019, leaving that important policy milestone to his successor.

But the succession also has become politically charged, where only one thing seems to be clear: it will not be Bundesbank President Jens Weidmann taking over the reins. The overly eager Weidmann burned his bridges with German Chancellor Angela Merkel by launching his own campaign for the ECB presidency rather than meekly awaiting the call from Berlin.

Merkel subsequently decided that putting a German at the head of the European Commission was a more coveted prize than the ECB presidency. German MEP Manfred Weber now seems a shoe-in as the centre-right’s ‘Spitzenkandidat’ to replace Jean-Claude Juncker following the European elections in May.

That leaves the field open to others including Bank of France Governor François Villeroy de Gulhau. While the scion of the Villeroy & Boch ceramic dynasty is said to be not campaigning actively for the role, he is also said to be available if needed. He also has a strong bond with French President Emmanuel Macron. The lack of such an entrée is considered the real reason for International Monetary Fund Managing Director Christine Lagarde’s decision to drop out of the race.

Villeroy de Gulhau might be more of a continuity candidate than former Bank of Finland Governor and former European Commission Vice President Erkki Liikanen, who is the candidate favoured by the Hanseatic grouping of euro zone national central banks. Liikanen is telling his inner circle that he is happy to stay retired.

Whoever ends up in the driving seat will be in the long shadow of the Draghi legacy.

Unlike predecessor Jean-Claude Trichet who made the mistake of raising rates in July 2011 and squelching an embryonic economic recovery, Draghi is set to leave with his reputation as the euro’s saviour intact.

But that legacy could prove vulnerable to events.

Former US Federal Reserve Chairman Alan Greenspan’s legacy was destroyed by the global financial crisis and the so-called ‘Greenspan Put’ strategy – which staved off numerous market meltdowns and economic crises - is now as derided as appeasement.

Could the same happen to Draghi? That brings us back to one of the real motives for raising rates at this time.

The ECB’s balance sheet has grown by over €2.5 trillion since 2008 to over €4.5 trillion today and its key deposit rate still languishes at minus 0.40 percent – all part of the massive ‘whatever it takes’ effort to save the euro in recent years. If a fresh crisis were to occur, it would be nice to have some scope to cut rates again, but the cupboard looks bare.

Policy paralysis also faces that other key institutional pillar of the euro, the Stability and Growth Pact. Italy’s Five-Star - Lega coalition has woken up to how toothless the euro’s fiscal regime has become. Its central sanction – the Excessive Deficit Procedure - exercises little sway over the populist regime. Unsurprising maybe, given Brussels’ record for letting past miscreants like France and Germany itself off the hook as well as the fact Italy could not fall out of the euro without it becoming an existential threat to the euro as a whole.

The ECB seems to be relying on the financial markets to penalise Italy in the short term, and Draghi has come close to even encouraging the markets to have a go. That is of course a dangerous game to play with the biggest government bond market in the euro zone. A more dramatic repricing of Italian debt than seen thus far could terminally undermine Italy’s weak banking system and trigger a toxic doom loop if the country has to launch another expensive bank bail out operation.

Raising rates now might give the ECB the ammunition it needs to fight any new crisis which may be sparked by Italy, Brexit, rising global protectionism or any combination of these growing dangers, but time may have already run out for Super Mario.

 

David Thomas

David Thomas

November 2018

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