BlogSpot - December 2nd, 2013
The importance of politics in Europe
A “Coalition Contract” was reached in Germany between the CDU/CSU and the SPD (see Handelsblatt). Spiegel details the agreement: a minimum wage of 8.50 euro/hour to be introduced in 2015, a pension package, a highway-toll for foreigners at no cost to German drivers, dual citizenship option for children born in Germany, and, last but not least no tax increases. Ministerial jobs were postponed to after the December 6 SPD referendum.
Opinion on the coalition agreement is showing some disappointment, as reported in EuroIntelligence, with limited commitment on reforms and investment—as discussed in a FAZ article or by Heribert Prantl in Süddeutsche Zeitung. In his Spiegel Online column, Wolfgang Münchau finds the lack of a macroeconomic focus and commitment to eurozone crisis resolution disappointing, despite praising the implicit fiscal relaxation and the minimum wage. BarCap Thomas Harjes expects the economic impact to be modest and gradual.
Christan Odendahl, on Roubini.com, notes that the approach on banking is tougher with the new coalition while growth initiatives take a back seat. Odendahl notes that ESM direct bank recapitalization is dead, only allowed as an absolute last resort (see Handelsblatt); that common European deposit insurance is rejected outright. He stresses three issues are of macroeconomic and financial importance: (i) the use of available fiscal space for additional spending and investment, with debt reduction achieved through growth and inflation; (ii) the commitment to keep the small and regional banks outside the ECB’s reach and the single supervisory mechanism; and (iii) the willingness to support the evolution of European institutions but only after countries deliver in terms of fiscal discipline and structural reforms. Odendahl, in another Roubini entry, notes that while the SPD may have made concessions on the future personnel of the government, it traded those against policy concessions and is expected to place its people in central roles within the finance ministry—and even the chancellery’s office—with ECB’s Jorg Asmussen being the prime candidate.
In the meantime, in Italy, Berlusconi is expelled from Parliament (see EuroIntelligence), a source of renewed instability according to Brunello Rosa on Roubini, possibly leading to new elections in early 2014.
Thinking out of the box on monetary policy—is moving rates below a serious option for the ECB?
Based on Reuters, the ECB is considering a funding for lending proposal, i.e., a new long-term liquidity operation available only to banks that agree to use the funding to lend to businesses (industrial, retail and services businesses). In an analytical note, Citi Research suggests that a fixed-rate LTRO tailored for SME lending would make a lot of sense as a policy tool aimed at reducing financial fragmentation across euro area member states. David Keohane, in FT Alphaville, notes that this is only one of the available options, and a difficult one to implement. He presents the various options on the table and argues that speed may be a key deciding factor, which could make a negative deposit rate cut or a liquidity measure first lines of defense.
The discussion has shifted towards the possibility of negative interest rates. Deutsche Bank (hat-tip FT Alphaville) argues that further ECB action is likely because of the asymmetry of monetary policy mistakes: keeping rates “too high” and failing to prevent the economy from falling in a deflationary spiral is worse than keeping rates “too low” and triggering an acceleration in consumer prices. A possible compromise solution would be to leave the refi where it is and take the deposit rate only slightly in negative territory, taking EONIA further down. How effective would negative interest rate be? According to Keohane, the Danish example points to unintended consequences, e.g. an actual rise in lending rates (the experience of Denmark is reviewed here). Taking the deposit rate down would also disproportionately hurt the cash-rich banks, often French, and could even reduce the overall quantity of liquidity. And for the cash-constrained banks in the periphery, a negative deposit rate would not change anything on the willingness to lend, since they no longer hold excess cash in the first place. The positive impact may be through the exchange rate, though that may happen with Fed tapering in coming months. Izabella Kaminska, in FT Alphaville, quotes Capital Economics on the dubious benefits and possible costs of cutting deposit rates below zero. Negative deposit rates should encourage banks to find ways to make profits with their money instead of just paying to leave it on deposit, but there are two issues: (i) weak demand for loans, as pointed out in Coppola Comment (see the ECB’s October Bank Lending Survey and the Bank of England report); (ii) banks may actually pay for safe deposits with the ECB instead of making risky loans (see the same argument by Swaha Pattanaik in Reuters blog). Negative rate could be even more damaging if banks offset them by higher lending rates (Denmark again). Coppola Comment summarizes the issue noting that negative policy rates do not work in a world that is both risky and risk-averse and are akin to state-funded bank recapitalization, through the back door; while negative rates on excess reserves act as a tax on deposits, i.e., a fiscal tightening, with a deflationary bias. Zerohedge quotes Valentin Marino from Citi with a similarly mixed endorsement.
Asset purchases have also been mentioned, including by Peter Praet, the ECB’s chief economist, but the technicalities are challenging, notably because of underdeveloped financial markets in some member states. Purchasing public sector assets is institutionally more challenging than buying private assets because of strict conditionality.
Another LTRO would be another dovish signal but may have limited efficiency as intra-Euro area spreads and tensions on the money market are more limited now.
The policy decision is related to the potential impact on competitiveness through the exchange rate. With massive capital inflows into the eurozone, Jens Nordvig in VoxEU argues that the ECB may need to intervene more aggressively to counter appreciation, a serious threat for the fragile recovery in progress. EuroIntelligence writes that a softening of the euro is not very high, as illustrated with the muted impact of latest rate cut. On Bruegel, Jim O’Neill and Alessio Terzi take a different approach and write that a well-designed banking union has the potential to significantly restore competitiveness in Europe. Based on the Global Competitiveness Indicator, the authors observe that the "sharp fall in competitiveness observed in European countries throughout the crisis is to be attributed largely to financial stress and the economic downturn, more than faltering structural reforms,” and defend further banking integration.
