The ECB is irrelevant and the Euro is a failure

The ECB is irrelevant and the Euro is a failure

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The latest money supply figures from the Euro area are awful.

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M3 lending is particularly bad. The only components of M3 lending growth that are positive are residential mortgages and lending to governments, and those not by much:

Turning to the main counterparts of M3 on the asset side of the consolidated balance sheet of Monetary Financial Institutions (MFIs), the annual growth rate of total credit to euro area residents was less negative at -1.7% in January 2013, from -2.0% in the previous month. The annual growth rate of credit extended to general government increased to 0.2% in January, from -0.7% in December, while the annual growth rate of credit extended to the private sector was less negative at -2.2% in January, from -2.4% in the previous month. Among the components of credit to the private sector, the annual growth rate of loans stood at -2.2% in January, compared with -2.3% the previous month (adjusted for loan sales and securitisation, the rate stood at -2.0% unchanged from the previous month). The annual growth rate of loans to households stood at -0.2% in January, compared with -0.1% in December (adjusted for loan sales and securitisation, the rate stood at -0.2%, compared with -0.3% in the previous month). The annual growth rate of lending for house purchase, the most important component of household loans, decreased to 0.5% in January, from 0.7% in the previous month. The annual growth rate of loans to non-financial corporations stood at -2.9%, compared to -3.0% in the previous month (adjusted for loan sales and securitisation, the rate stood at -2.9% in January, unchanged from the previous month). Finally, the annual growth rate of loans to non-monetary financial intermediaries (excluding insurance companies and pension funds) was less negative at -11.1% in January, from -12.2% the previous month. 

Although the ECB tries to sound upbeat, "less negative" simply means "falling more slowly". The fact is that lending across the Eurozone is suffering a severe contraction.  

This does not bode well for M3 itself. M3 growth has been slowing for the last year due to LTRO repayments and is now at a shockingly low 1.2%, though admittedly this is better than December’s 1.0%. This isn’t outright deflation but it’s getting dangerously close to it, and the M3 lending figures suggest that deflation is likely, whatever Draghi may think.

The real question for the ECB is whether deflation would be short-lived. Their focus is on the medium-term inflation outlook, not on short-term changes. This post from the NY Fed suggests that deflation, if it happened at all, would indeed be short-lived: inflation expectations are “stable", and indeed inflation surprised on the upside in January, remaining stable at 0.8% although far below the target of 2%.  But the NY Fed researchers add that these stable inflation expectations might be due to belief that the ECB would ease monetary policy further. So perversely, stable inflation expectations due to anticipated monetary easing might induce the ECB not to ease - a fine example of Goodhart’s Law in action.

It seems the ECB’s own models don’t indicate that deflation is a serious risk. So although the European Commission apparently disagrees, I doubt if the ECB will do QE. In fact I doubt if it will do anything much, except perhaps abandon its futile attempts to sterilise its bond purchases under the (now ended) Securities Markets Programme (SMP), and possibly introduce some measures to support bank lending. When everything you do is subject to criticism from Bundesbank hawks, sitting on your hands looks like a good option.

But actually I don’t think what the ECB does matters much anyway. In fact I think it is largely irrelevant. It is time I came off the fence and said what I REALLY think about the Euro project.

Twenty-three years ago, as a young MBA student, I fell out with my macroeconomics lecturer about the virtues of a single currency. This was during the period of the ill-fated Exchange Rate Mechanism, of which he was a strong supporter and I was an equally strong opponent. Events the following year proved me right. But he was also firmly in favour of a single currency. He would have introduced it at that time: “I would lock exchange rates now”, he said. I thought he was wrong then, and I said so – hence the disagreement. And even now, fourteen years after the creation of the single currency, I still think he was wrong.

The history of Europe is long and blood-spattered. It is nothing like the United States, which is a young country with a common language, clear boundaries and a single political structure. Yes, the USA fought a civil war to achieve its current degree of political unity, and there are no doubt still stresses and strains. But Europe – if you must regard it as one entity, which is problematic in itself – has fought HUNDREDS of civil wars. We do not have a single language, we still cannot agree where our boundaries should fall and national interests always trump “European” politics. You can’t overturn tribal and cultural identities that go back thousands of years at the stroke of a few politicians’ pens.

My objections to the single currency, therefore, are historical and cultural, rather than economic. I have read Mundell.  I understand the benefits of a single currency, where there is economic convergence. I know that the founders of the Euro project expected that the discipline of a single currency would force European countries to implement reforms that would over time create the necessary economic convergence. I know that this is STILL what politicians and Eurocrats are trying to achieve with measures such as the fiscal compact. But call me Cassandra if you like: I do not think any of this will work.

The Euro is founded primarily on wishful thinking. It is fair to say that this has turned out to be a stronger foundation than might have been expected. But the political convergence that is required for a currency union is missing. There is no sense of being “in this together”. On the contrary, there is political and social divergence; a sense of superiority from those countries that – for now – are doing well, and growing anger among the populations of those countries that are introducing painful and damaging austerity measures to create the illusion of economic convergence.

Economic convergence is an impossible dream while there is no political or fiscal union. It cannot be achieved through wholesale economic destruction in weaker countries in the name of “structural reform” while stronger ones benefit in the form of lower borrowing costs, capital inflows and immigration of skilled workers. This creates economic DIVERGENCE, not convergence. The fact is that weaker countries in the Eurozone are diverging from stronger ones. Unemployment is at 5% in Germany, 12.8% in Italy and 25% in Spain. And as for Greece – if this report in The Lancet is to be believed, health outcomes there are heading for third world standards.  Even France is now on the downwards path, helped by a shockingly inept government.  How can any of this be considered progress?

No country in the Eurozone is prepared to give up its national sovereignty in order to create a genuine fiscal, political and monetary union. Politicians pay lip service to the idea of “closer union”, but when they are at the negotiating table, national politics always win out. They couldn’t even agree on a proper banking union! How on earth can a currency union possibly work when the banking system is fragmented along national lines? And how can it possibly work when there is no framework for sharing risk?

Whether or not the ECB does QE – or any other form of monetary easing, for that matter – will in the end make little difference. QE cannot be done in any way that would genuinely benefit the periphery without incurring political and legal challenge from Germany: there is already a legal challenge to the ECB’s OMT programme that has prevented Spanish and Italian yields from spiralling out of control. If QE were done in a more even-handed way (for example, buying a weighted basket of Eurozone government bonds) it would worsen the existing credit bifurcation by making German bunds even scarcer. There are other things that the ECB could do, such as another round of LTROs to prop up the Eurozone’s dysfunctional banks YET again, or FLS-style funding support for SME lending, or even buying up packages of SME bonds. It could even experiment with negative rates on reserves. But it’s all so much window dressing.

The combination of a common currency with national politics is poisonous.  Without closer political and fiscal union, including a proper banking union, pooling of debt and sharing of risk, the benefits of currency union are a chimera. The reality will be debt deflation and depression without end.

Well, not quite without end, actually – it is all too easy to see how this could end. The Euro is the biggest threat to peace in Western Europe that I have seen in my lifetime.

So let’s end it now. Rather than waiting for country exits and disorderly collapse (probably when the Franco-German alliance fractures, as it will if France heads into depression), we should put in place plans now for orderly wind-up of the Euro and restoration of national currencies. We should offer debt forgiveness and international aid along the lines of a Marshall plan to those countries that have been so badly hurt by the misbegotten Euro project. And we should decapitate the hydra banks that have sucked the life out of the Eurozone periphery countries.  

The Euro is a failed experiment. We should not waste any more effort trying to make it work. It is time to consign it to the dust of history.


Related reading:

The ECB must face the deflation risk – Gavyn Davies, FT (paywall)

Will we look back on the Euro as a mistake? – Conversable Economist

Image courtesy of The Telegraph.


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