The European Central Bank is on a knife edge. Investors are questioning whether the Frankfurt-based institution will finally, as promised, end its gargantuan quantitative easing programme by the end of 2018. And will the ECB really deliver on its pledge to raise interest rates, for the first time since 2011, next summer?
The US Federal Reserve and Bank of England, having long since moved away from QE, are now clearly in rate-rising mode. The Fed has increased rates eight times over the last three years, with the benchmark US rate now 2.25pc.
The UK base rate is still ultra low, at 0.75pc. Since last autumn, though, the Monetary Policy Committee has managed to raise rates twice without unduly jeopardising financial market stability or broader growth. Both the Bank and the Fed, as the economies they oversee have strengthened, are shifting from post-crisis emergency measures towards some kind of normality. The eurozone, in contrast, remains on life support. ECB nominal interest rates remain negative, at minus 0.4pc – deep in Alice in Wonderland territory.
The single currency zone grew just 0.2pc over the three months from July to September, the slowest pace in over four years. The UK economy, in contrast, expanded 0.7pc over the same period. This eurozone slump has sparked renewed speculation that ECB QE, still €15bn (£13.3bn) of virtual money-printing a month, will continue into 2019 and beyond – as Economic Agenda has long predicted. ECB supremo Mario Draghi denies this, as do the minutes of the central bank’s October meeting, just released.
The ECB has, since the 2008 financial crisis, conducted “extraordinary monetary measures” on a, well, quite extraordinary scale. Draghi has overseen a fourfold expansion of the central bank’s balance sheet – which now stands at the equivalent of $5,300bn (£4,132bn). That’s 30pc bigger than the Fed, despite the eurozone economy being 25pc smaller than America.
The ECB currently faces its worst ever political crisis. Draghi’s still wildly expansionary monetary policy is deeply unpopular in Germany. The eurozone’s paymaster has been pushing hard, for years, for QE to end. Negative rates rile the nation’s army of savers, while Draghi’s loose-money antics play on German fears, forged during the inter-war years, of sudden inflation. December 2018 has been circled in Berlin’s diary for a long time.
Yes, Angela Merkel and Emmanuel Macron are at odds over the future of the eurozone. The leaders of “Project Europe” last week struck a deal that, once again, fell woefully short of the budget-sharing and banking union needed if the single currency is to avoid breaking up. Such integration is vital to any long-term currency union, as financially literate historians know.
Unless democracy is crushed completely, though, and Europe’s nation states dissolved, it is never going to happen. Why? Because, in a competitive world, voters in more productive countries like Germany and the Netherlands will never ever accept a permanent, annual bailout for the poorer nations to their south.
This eurozone mismatch is crystallised, of course, in the now serious stand-off between Brussels and Rome. Italy’s populist government was elected last year on a promise to rip up the EU’s fiscal rule book and, having submitted a high-spending budget, is determined to make good on that commitment. The European Commission last week escalated this trial of strength, dismissing Rome’s plan as “in particularly serious non-compliance”, threatening to impose sanctions on Italy of 0.5pc of GDP.
Should such fines be levied, Italy’s already smouldering political atmosphere, fanned by yet another looming recession, would erupt. There would be renewed calls, not least from the government itself, for the eurozone’s third largest economy to ditch the single currency altogether. If Brussels rolls over, though, and Rome prevails, expect a budget free-for-all, with the likes of Portugal, Spain and even France dropping all pretence of spending control – again presenting huge systemic dangers.
This Italy-EU showdown is astonishingly dangerous. As the grip of Angela Merkel’s steadying hand gets looser, it could spiral out of control, upending financial markets across the world. The spread between yields on 10-year German and Italian bonds is now well over 300 basis points, a sign of growing market distress. With Italian banks holding €380bn of domestic government debt, far from a domestic bailout, spiking bond markets would see Italy’s government and banks go into a downward spiral. Greece is back on the agenda too, with the Athens stock exchange down 60pc since May, amid market speculation this hammered economy now needs a fourth bailout to stop yet another implosion. Ominously, the share price of Deutsche Bank just hit yet another all-time low.
Both these battles – over eurozone budgetary pooling and next year’s Italian budget – hinge, for now at least, on the ECB’s next move. Rome is openly calling for Draghi to keep printing money during 2019 and beyond, so as to douse down Italy’s increasingly angst-ridden bond markets. Bundesbank president Jens Weidmann, meanwhile, is crying foul.
The entire German establishment, of course, has been both mortified and deeply spooked by the recent electoral surge of Alternative fur Deutschland, a hard-Right party that resents not only QE and freedom of movement, but also Germany footing the broader region’s bills. Eurozone QE won’t be extended, then, without a major, market-spooking tussle. And Andrea Enria, the incoming head of the ECB’s supervisory arm, has just warned that the eurozone’s banking system, without a major clean-up that for a decade has been avoided, would “not survive the next crisis”.
What you’ve just read has barely featured in the mainstream UK media over recent weeks. Yet it is an axiomatic truth that the EU remains blighted not just by rising populist outrage, but by an ill-designed and deeply dysfunctional monetary union – a union that will lurch back into a fully-blown crisis, which it lacks the fiscal and monetary scope to tackle, when the next global economic downturn hits in 2019 or 2020.
This is the context in which British politicians are calling for a second referendum, lashing us to the EU. This is the background to Theresa May’s utter capitulation – backing a legally binding Withdrawal Agreement that vetoes a true Brexit and a non-binding “future relations” statement that’s nothing but warm words.
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